What are haircuts
Last Updated: 30 June 2023
In financial markets, a haircut refers to a reduction applied to the value of an asset. It is expressed as a percentage. For example, if an asset, such as a particular government bond, is worth €1 million but is given a haircut of 20%, it means it is treated like it has a value of only €0.8 million.
When are haircuts used?
One example of the use of haircuts is when central banks lend money to commercial banks. In return for the loan, as a form of insurance, the central bank will ask for collateral (find out more about collateral). However, it will apply a haircut (that is, a reduction) to the value of this collateral. Taking the example above, a commercial bank would receive a loan of €0.8 million, as that is what the asset is valued at after a 20% haircut.
Why are haircuts used?
Central banks need to be sure that the money they lend will be paid back. Of course, the first line of defence is the agreement with the borrower regarding repayment. But if the borrower fails to repay the loan, the central bank will sell the collateral. The central bank therefore needs to be sure that it will be able to sell the collateral at a price that will cover the amount of the loan. But assets can go up or down in value and central banks may need some time to sell specific assets. So, a haircut provides a safety buffer against any loss in value during the time it takes to sell the collateral.
To illustrate this, let’s consider a €1 million bond. It may be worth €1 million now, but there is no guarantee that, when the time comes to sell it, it will still be worth €1 million. Financial markets can be volatile, and the value of assets could be affected by various factors, including the financial health of the issuer of this bond. This is why assets with a current market value of €1 million are not enough to receive a loan of the same amount.
What determines the size of a haircut?
The lender (in this case the central bank) must consider what size of haircut is sufficient to cover the risk of not being able to sell the asset at its current value. This will depend on the factors mentioned above, including how risky a certain type of asset is, how volatile its price is, and how “liquid” it is (that is, how easy it is to sell it in a quickly without a loss of value). In other words, the size of a haircut depends on the characteristics of both the collateral and the issuer of this collateral. For example, central government bonds tend to be relatively safe, liquid investments, so they receive a smaller haircut than bank loans.
What haircuts does the Eurosystem apply?
The Eurosystem, which consists of the ECB and euro area national central banks, carefully decides what haircuts to apply to the collateral it accepts. It always makes sure that the haircut is sufficient and proportionate to minimise the risk of losses.
When accepting collateral, the Eurosystem does not favour any particular kind of asset, provided it meets its requirements. For example, as collateral for a €1 million loan, the borrower could provide €1.7 million of bank loans with a 40% haircut or €1.06 million of government bonds with a 5% haircut, as both have a collateral value of just over €1 million. What is essential is that the total value of the collateral, after accounting for the haircuts, is equal to (or above) the total loan amount. This means that the borrower must provide a larger amount of assets with bigger haircuts or a smaller amount of assets with lower haircuts.
The Eurosystem has a strict risk management process in place and the use of haircuts is one of several risk control measures to ensure that it does not take on any undue risk. The risk control framework is reviewed regularly and the ECB publishes a list of the haircut categories it applies to collateral.
Additional information on haircuts can be found in the occasional paper entitled “The valuation haircuts applied to eligible marketable assets for ECB credit operations”.