Financial Haircuts

“The financial system…makes choices about haircuts. The haircuts in question are the amount of collateral a borrower places with the lender over and above the face value of borrowing. But collateral haircuts tend to behave rather differently to personal haircuts. They fall when the financial temperature is increasing and rise when the chill sets in. This strategy is explicitly  pro-cyclical. It will tend to result in financial markets being hot-headed in the summer and frozen-eared in the winter….This haircut cycle played an important causal role in the crisis…Hot heads make for bad decisions, frozen ears for uncomfortable ones. Financial markets have felt the effects of this change in the weather more dramatically than most. Suitably designed, macroprudential policy can help moderate those swings in temperature, thereby improving the health of the financial system. “

A.G. Haldane, BoE Executive Director, 1 August 2011

“In the good old days, haircuts were made in barbershops, not on financial markets. Until the late 80ies, economists writing about haircuts in the “American Economic Review” (AER) referred to real hairdressing. The first economist to use the term in the AER with regard to finance was Herbert Bear, a researcher with the Federal Reserve Bank of Chicago, in 1989. It took another 15 years and the default of Argentina until financial haircuts made it into “The Economist” for the first time, after all.”

The science of haircuts,

Why Do Central Banks Require Reserves?

“Over 90% of central banks oblige depository institutions(commercial banks) to hold minimum reserves against their liabilities, predominantly in the form of balances at the central bank. The role of these reserve requirements has evolved significantly over time. The overlay of changing purposes and practices has the result that it is not always fully clear what the current purpose of reserve requirements is, and this necessarily complicates thinking about how a reserve regime should be structured…..”

The IMF has produced a timely background paper that describes the three main purposes for reserve requirements – prudential, monetary control and liquidity management – and suggests best practice for the structure of a reserves regime. As well as discussing the use of reserves remuneration as a policy signal, the paper illustrates current practices using a 2010 IMF survey of 121 central banks.

Central Bank Balances and Reserve Requirements, IMF Working Paper, February 2011