What are Haircuts in Economy?

 

Relevance:

  • Prelim, Mains paper III, Economy

Haircuts on loans:

  • A haircut refers to the extent of sacrifice a lender needs to make on a loan while getting a defaulting borrower to pay back his pending dues.
  • During boom period, banks extended large project loans to steel, power, telecom and other infrastructure players.
  • When these industries fell on hard times, the borrowers stopped servicing their loans.
  • Banks started considering these loans as non-performing assets (NPAs) and hauled some of them to the bankruptcy court for recovering their dues.
  • In the cases where the assets of the borrowers are of lower value than their liabilities, lenders usually arrive at a compromise formula.
  • In this compromise, the borrower offers to pay part of his loan amount as a one-time settlement.
  • The ‘haircut’ here is the permanent sacrifice made by a lender to recover whatever he can from the loan-taker in distress.

What is its significance?

  • When banks, financial institutions or mutual funds find borrowers delaying the repayments on loans, they usually follow standard regulatory norms to recognise them as doubtful loans in their books.
  • When the assets of the borrower are valued in real life, they may not be enough to repay his dues in full.
  • Stretching the repayment period further may serve no purpose for the lenders, as the assets will lose more value leading to poorer recoveries.
  • In such situations, lenders often reckon that a bird in hand is worth two in the bush and sit across the table with the loan-taker to thrash out a haircut.

What in the case of Mutual funds?

  • Earlier, we discussed about the loans. Let’s now understand the case of Mutual funds.
  • In the case of mutual funds, schemes are expected to immediately reflect the realisable value of their bonds in their net asset values.
  • Therefore, SEBI rules require a scheme holding a defaulting or downgraded bond to immediately reflect its true market value.
  • Till recently, there was no standard practise on the size of this haircut in different situations.
  • But after SEBI’s nudging, industry body AMFI has now come up with a haircut matrix that tells funds the extent of losses they must budget for on their non-investment grade bonds in different situations.

Key takeaways:

  • A haircut is the lower-than-market-value placed on an asset when it is being used as collateral for a loan.
  • The size of the haircut is largely based on the risk of the underlying asset. Riskier assets receive larger haircuts.

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