Haircut

Anyone who borrows money often has to deposit something valuable with the lender as collateral. The lender, however, deliberately values this collateral lower than it is currently worth. This discount is exactly what is called a haircut. An example: someone deposits shares worth 100 euros and receives only 70 euros in credit for them. The haircut is then 30 percent. The reason is simple: the value of the shares could fall before the lender is able to sell them in an emergency. The same word is also used in a second meaning, namely for the loss suffered by creditors in a debt restructuring.

The buffer that protects banks from price crashes

Loans against collateral are the backbone of the financial system. Banks lend each other and borrow from the central bank huge sums every day. Almost always, they deposit securities for this, usually government bonds. Without a discount, this system would be extremely fragile. If the price of the collateral falls by ten percent, the lender would immediately be left without sufficient coverage.

The size of the discount shows how risky a security is assessed to be. German government bonds with short maturities often receive a discount of only one to two percent. For shares of small companies, it can be 50 percent or more. The haircut is thus a kind of public vote of no confidence expressed in numbers. When the European Central Bank raises the discounts on a country’s bonds, that is a clear signal.

In crises, this becomes dangerous. When prices fall, discounts rise at the same time, because everything seems more uncertain. Debtors then have to put up more collateral, often precisely when they have no money. To get money, they sell securities, which pushes prices down further. This feedback loop was an important driver of the 2008 financial crisis.

How the discount is calculated

The basis is always the question of how strongly the value of a security can fluctuate. Risk departments look at the price history of recent years for this. They calculate how far the price has typically fallen during a bad period. This possible loss becomes the discount. Added to this is a surcharge for the case that the security is difficult to sell in an emergency.

Three factors determine the outcome. First, the range of price fluctuation, known in technical language as volatility. Second, the maturity: the longer a bond runs, the more strongly its price reacts to interest rate changes. Third, tradability, i.e. whether there are enough buyers at all. A security that hardly anyone trades receives a high discount.

A common misconception is confusing this with interest. Interest is the price for the borrowed money. The haircut, on the other hand, determines how much money one receives in the first place. Both can change independently of one another. In the second meaning, the debt restructuring, the calculation works differently. There, it is determined retroactively what share of their money creditors will lose.

From sovereign defaults to crypto accounts

The best-known example is Greece in 2012. Private creditors waived a good half of their claims. In the news, this was consistently referred to as a haircut or debt restructuring. Similar debates regularly occur with highly indebted states, such as Argentina or Sri Lanka.

In everyday life, the term is mainly encountered with securities-backed loans. Anyone who buys shares on credit through a broker sees a lending value in the app. This is the price minus the discount. If the price falls, this value drops, and the broker demands additional funds. On crypto exchanges, the discounts are particularly high because prices fluctuate strongly.

The word also appears in the tech industry, usually in a figurative sense. When analysts significantly lower their valuation of an AI company after bad news, the media speak of a haircut on the valuation. In that case, no collateral is meant, simply a hefty discount on a number.