A haircut, in the business context, refers to the extent of sacrifice a lender needs to make on a loan while getting a defaulting borrower to pay his pending dues. When banks, financial institutions, or mutual funds find that borrowers are delaying the repayments on loans, they usually follow standard regulatory norms to recognise them as doubtful loans in their books. When industries are incapable of repaying the large amounts of loan they have taken from banks, the banks start recognising them as non-performing assets (NPAs) and haul them to the bankruptcy court for recovering their dues.
But today, lenders may be hesitant to drag a big company defaulting on loans to the bankruptcy court as they fear a haircut. This is even as the NCLAT has urged creditors to allow big haircuts to deal with the problem of insolvency.
Banks are required to treat loans as sub-standard and set aside 15–25 per cent as provisions if the borrower fails to service them beyond 90 days from due date. If the loan remains sub-standard for over a year, the provision climbs to 40 per cent, and a further delay may require higher provisions going up to 100 per cent. Now, a bank providing for 25 or 40 per cent on a doubtful loan is no guarantee that it will recover the remaining 75 per cent or 60 per cent. On evaluating the assets of a borrower, it may be found that the borrower is incapable of repaying his dues in full, so stretching the repayment period may further serve no purpose for the lenders.
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Lenders do not hope for a full recovery funds from borrowers nowadays as the assets on the letter’s books are very much short of their liabilities.
The lenders, that is the banks, in such cases, normally arrive at a compromise formula where the borrower offers to pay part of his loan amount as a one-time settlement. The ‘haircut’ here is the amount that a lender forgoes or gives up permanently to recover whatever he can from the loan-taker in distress. Bad loan provisioning rules (for banks) or write-down rules (for debt funds) are only accounting entries that try to assess the approximate losses for investors on bad loans.
Where mutual funds are concerned, schemes are expected to immediately reflect the realisable value of their bonds in their net asset values. As per the Securities and Exchange Board of India (SEBI) rules, there has to be a scheme holding a defaulting or downgraded bond to immediately reflect its true market value. There has been this standard practice in the size of the haircut in different situations. After pressure from SEBI, the Association of Mutual Funds in India (AMFI) has initiated a haircut matrix for debt securities that specifies the extent of losses companies must budget for on their non-investment grade bonds in different situations.
On final resolution of the case, the actual amounts realised are very different from those recorded in the books. So, for investors in banking stocks or debt funds, it is better to be aware about the assessments of approximate losses, which would decide how much of a loss they would have to bear as a result of a bad loans—that is, how big the haircut would be.