A haircut refers to the percentage difference between the amount of the loan given and the value of the asset used as collateral. For example, let’s say small bank A needs to borrow from big bank B. Small bank A wants to borrow $500,000 and puts up assets as collateral to borrow that loan. Big bank B values those assets at $375,000—or 25% less than the loan amount. The 25% difference is the haircut.
Alternate definition: The term “haircut” may also be used in investing. The difference between a buying and selling price of a share is known as the “spread,” but it is sometimes referred to as a haircut when it is so thin. Another phrase used often is “to take a haircut,” which means to take a loss on an investment.
How a Haircut Works
A haircut appears when a financial institution places a value on a collateral asset that is lower than the requested loan amount. A lender will determine the haircut amount—usually a percentage difference—and it varies by institution and instance. The lender determines the haircut amount by calculating the risk involved. If a lender determines there’s a high risk of loaning to the borrower, they might increase the haircut amount compared to an asset or loan that has lower risk. When a lender devalues an asset, they increase their protection in case the market value drops. If a lender ever needs to sell an asset because the borrower defaults, they calculate how much they can reasonably expect in a sale. That’s usually the value they place on the asset. Since every asset is treated differently, haircuts don’t have a one-size-fits-all percentage. One asset could be worth $10,000 but given a haircut of 10%, meaning it’s treated as though it has a value of $9,000. Another asset could be worth $10,000, but given a haircut of 30%, meaning it’s treated as though its value is $7,000.
What It Means for Investors
While we’re looking at haircuts in terms of loans, the term is sometimes used in investing. Keep an eye out if you ever need to borrow on margin from a brokerage firm. When you borrow a margin loan, your broker will put a value on the securities used as collateral for that loan. The larger the haircut, the lower the value of those securities you put up as collateral. This gives the brokerage a larger cushion in case the market price of the securities decreases. Since a haircut also refers to the difference in the buying and selling price of an asset, if you were to buy 100 shares of company ABC for $100 per share (a total cost of $10,000) then sell those 100 shares a moment later, you might see that you’d only get $90 per share, for a total of $9,000. This is because of market makers. The 10% difference in price is the haircut, which is the fee market makers charge to offset risk. This may happen if you hope to buy and sell shares quickly. Market makers help provide that liquidity.
