What is meant by Haircut in finance?
The word haircut is not only used in the world of hairs. It is also used in the world of finance. A haircut has two meanings in finance. One meaning is the value by which the asset that you have placed as collateral is reduced when a loan is being given against that asset. The second is the amount by which the lender reduces the amount owed to it when it is trying to close a loan that has become a non-performing asset (NPA) for it.
You take various types of loans such as gold loan, business loan, personal loan etc. Except for personal loans, in every type of loan you need to place a collateral or security with the lender. The lender gives you loan against this collateral. If you do not pay back the loan, then the lender sells the collateral to recover the amount due to it. Any amount recovered in excess of what is due to the lender, from the sale of the collateral, is returned back to you.
Take the case of a gold loan. You put your gold jewelry or gold holding as collateral with the lender. The lender can be a bank, NBFC, or any other type of lender. The maximum loan amount that the lender will give you against your gold collateral is usually 75% of the value of the gold in the collateral. It does not give you loan equal to 100% of the value of the gold because 25% margin it keeps to account for any risk. This risk is the risk of decline in the price of gold. For example, you default on paying back this gold loan. And the price of gold also falls sharply in the period. So the lender would not be able to recover the amount due, even by selling the gold collateral that you placed with it, if it had not taken a safety margin and given you loan equal to the value of gold placed as collateral.
If you take a loan against any other asset, and not just gold, lenders apply a haircut to the value of the asset, while giving the loan.
Debt restructuring happens when the borrower is unable to make the full payments owed by him, on the loan. A common aspect of debt restructuring is the lender taking a haircut. This means that the lender closes the loan by accepting a lesser amount than what is due to him. For example, a borrower X owes Rs 100 to lender Y. X has to pay back this amount to Y by the end of 1 year from now. At the end of 1 year, X expresses his inability to pay back the full Rs 100 to Y. X and Y enter into debt restructuring negotiation. They reach the settlement that X will pay Y Rs 90 and Y will close the loan. Here Y, the borrower, has taken a haircut of Rs 10.
Haircut in debt restructuring is more common in corporate and business loans. They are usually part of the corporate insolvency process. They are done to prevent corporations and businesses from going into liquidation. A number of insolvency cases under the Indian Insolvency & Bankruptcy code have been successfully resolved after creditors agreed to take significant haircuts on the loans due to them, and close the loan.