European Parliament issues report on haircuts applied to the collateral used in securities financing transactions, principally repurchase agreements (repos) and securities lending, assessed the recommendations of a Financial Stability Board working group on their effectiveness as a tool to enhance stability in the financial market. A haircut is intended to hedge the credit, liquidity and other risks on a security being used as collateral by adjusting its value to reflect the potential loss arising from liquidation during a time of funding need or after a possible default by either a counterparty or the issuer of the asset. However, the report noted that haircuts create problems. They represent the share of a security which cannot be funded in the repo market and requires a firm to draw on its own funds or unsecured borrowing, which increases the overall cost of funding. They also expose the borrower to the credit risk of the lender.
The FSB is concerned that changes in haircuts fuel pro-cyclicality. In buoyant markets, firms may narrow haircuts, which would amplify the expansion of credit. But in a depressed market, they may widen them, which would amplify the tightening of credit. The working group has proposed a dual approach to stabilizing and controlling the level of haircuts. First, it would introduce minimum standards for the methodologies for the calculation of collateral haircut. Second, it is considering placing a floor under firms’ calculations in the form of a mandatory minimum haircuts.
The FSB is also considering the use of haircuts to control the build-up of leverage, in a manner similar to the use of reserve requirements in a fractional banking system. The recommendations set out appropriate methodological approaches to calculating haircuts, and various adjustments and additional risk factors to be taken into account. These approaches do indeed reflect best practice in the market, noted the report, at least where haircuts are being applied, although some further risk factors have been identified for consideration. However, haircut practices vary very widely in the European market and the need for haircuts is not accepted in low-risk transactions such as short-term interdealer repos of government securities. The role of haircuts reflects the fact that collateral is considered secondary in importance in risk management to counterparty credit risk.
Another recommendation makes the case for mandatory minimum haircuts for collateral that exhibits material pro-cyclicality. The FSB recognizes the possible unintended consequences for market liquidity and efficiency, and asks for comments on whether mandatory minimum haircuts would be effective and workable.
The European Parliament welcomes the intention to introduce minimum standards for the methodologies for the calculation of collateral haircuts, adding that the detail of the proposal accords with best practice in the market. However, better market data will be required to support such calculations. This should become available through initiatives to improve market transparency; but the market should process such data into risk statistics to avoid the perception of official approval.