Haircut
What is Haircut in finance?
In finance, a haircut refers to the reduction in the value of an asset used as collateral when determining how much can be borrowed against it. It acts as a risk buffer for lenders to protect themselves against a drop in the collateral’s value.
In simple terms:
Haircut = % deduction from the market value of an asset to calculate its loanable value
Types of Haircuts
| Type | Explanation |
|---|---|
| Market haircut | Standard deduction based on asset class (e.g., equity: 20%-50%) |
| Negotiated haircut | Agreed upon during loan settlements or restructuring |
| Regulatory haircut | Prescribed by authorities like SEBI, RBI, or Basel norms |
Why Haircuts Are Used?
Haircuts are applied due to the risk that the value of the collateral may decline before the lender can sell it in case of a default. Factors influencing a haircut include:
- Asset volatility
- Liquidity
- Credit risk
- Market conditions
Where Haircuts Are Commonly Used
| Context | Use of Haircut |
|---|---|
| Collateralized lending | Loans against shares, bonds, etc. |
| Repo transactions | Haircuts on securities sold and repurchased |
| Margin trading | To cover market risk from pledged securities |
| Banking regulations | Haircuts on non-performing assets (NPAs) |
| Credit risk assessments | Risk-adjusted asset valuation |
Example
Suppose you pledge government bonds worth ₹1 crore as collateral to borrow funds. If the lender applies a 10% haircut:
- Market value of collateral: ₹1,00,00,000
- Haircut (10%): ₹10,00,000
- Loan amount sanctioned: ₹90,00,000
Here, the lender deducts ₹10 lakh as a safety margin in case the value of the bond drops.
Haircut in Indian Context
In India, haircuts are especially relevant in:
- RBI-regulated lending (e.g., repo deals)
- Loan recoveries under IBC (Insolvency and Bankruptcy Code)
E.g., if a bank agrees to recover only ₹400 crore of a ₹1000 crore loan, it takes a 60% haircut. - Loan against shares/securities provided by NBFCs and banks.
Haircut vs. Discount
- Haircut: Used in lending; reflects risk margin deducted from collateral value.
- Discount: General reduction in price, often in bond or stock valuation.