Risk-averse institutions often limit the amount they are willing to lend against collateral to no more than the market value of that collateral less a haircut. Central banks are no exception.
At first glance, the idea of any secured lender taking collateral haircuts seems eminently sensible and, in the case of central banks, characteristically prudent. But do central banks really need haircuts (or at least haircuts of the size they typically demand, which are higher than those taken in the interdealer market)? To answer that question, we need to ask why anyone needs a haircut.
The principal purpose of a haircut is to protect a secured lender against the market liquidity risk of the collateral he has been given. Specifically, a haircut is intended to provide a buffer against potential loss arising from:
• the likely market impact of liquidating particular holdings of collateral after a default by the borrower —the price loss due to the tendency of selling pushing down prices;
• the probable impact of price volatility on market value until the collateral is fully liquidated — the longer this takes (and the lower the market impact of selling), the longer the collateral will be exposed to price fluctuations; and
• uncertainty about the accuracy of the initial market price even for a normal trade size.
A haircut can also be used to hedge:
• the credit risk of the issuer of the collateral, realised either as a deterioration in the creditworthiness of the issuer of the collateral or by the issuer’s default, both of which would depress the price of the collateral
• currency risk, where collateral is denominated in a currency different to that of the cash
• operational risks, such as extended intervals between the revaluation of collateral and/or margin calls and the possibility that a default could occur after the value of the collateral has fallen but before a margin has been paid
• legal risk, in the form of the possible impact of legal impediments to closing out and setting off contracts (netting) after an event of default by the repo counterparty, which could either delay liquidation, exposing the collateral to further price fluctuations, or deprive the secured lender of his collateral altogether.
The credit risk of the repo counterparty may also be relevant to the size of a haircut but this should only be to the extent that the counterparty’s default might affect the liquidity of the collateral. Such a correlation could result from: the counterparty’s systemic status; his role as liquidity-provider in that collateral; or a significant correlation between the default probabilities of the collateral and counterparty (wrong-way risk).
With the exception of the credit risk on the issuer of collateral, currency risk on foreign currency collateral and uncertainty about the accuracy of the initial market price of collateral, all the risks addressed by a haircut arise because the lender expects to have to liquidate collateral as quickly as possible after a default by the borrower because the lender needs to restore his liquidity. Consequently, the lender needs to ensure that the sale of his collateral realises enough cash to make him whole, despite the fact that the act of selling an asset tends to depress its market price. And the more urgently that a lender would need his cash, the bigger the haircut he must take. In other words, haircuts are about the urgency of liquidity.
But what are the needs of a central bank? Of all financial institutions, it is the one that has no need for liquidity. After all, the essential purpose of a central bank is to be lender of last resort in a financial crisis. As Walter Bagehot explained a long time ago, this means that the central bank should to be ready to lend freely to solvent but illiquid commercial banks, albeit against good collateral and at a higher-than-normal rate of interest. So, the collateral needs to be creditworthy (and indeed, possession of good quality collateral is the measure of a solvent bank). But does the collateral taken by a central bank have to be liquid as well? Bagehot didn’t mention it and one is obliged to ask, if banks held liquid assets, why would they need to pay higher-than-normal rates to buy liquidity from the central bank?
Just what urgency would a central bank face in having to sell off collateral, if a borrower defaulted? In extremis, it could wait until the collateral matured. Of course, the default would mean that the central bank would not be able to call further variation margins from the borrower. This would expose the central bank to the risk of a mark-to-market loss during the life of the collateral. In other words, it would suffer a loss if it tried to sell off collateral in the secondary market. But there would be no loss if the collateral were creditworthy and the central bank waited until maturity. It would get its money back in the form of coupons and redemption payments over the life of the collateral, and would earn fair compensation for holding it in the form of the market yield-to-maturity.
Nor should a central bank need to take haircuts against legal or operational risks. They have privileged legal positions. On the operational side, they control the large-value payments system at the core of the domestic financial system. And lack of a commercial imperative means that a central bank has no reason to tolerate operational weakness in its counterparties, while its regulatory powers give it the means to enforce efficiency on its counterparties.
One must also ask, from a practical point of view, what use haircuts would really be to a central bank if a borrower defaulted? If the default occurred in normal market conditions, the central bank should have little difficulty in liquidating good quality collateral at or close to market prices. If, on the other hand, the market was distressed, it is inconceivable that the central bank would risk triggering a fire sale by trying to liquidate any significant amount of collateral with any degree of urgency. It also needs to be remembered that haircuts undermine the solvency of a bank by encumbering a portion of its assets.
In practice, of course, central banks may take haircuts in order to keep up some public semblance of prudence and disguise the fact that they have lent to weak banks against weak collateral, driven by desperation to keep the financial system afloat in a crisis and political pressure not to allow important domestic banks to fail, even if they are insolvent.
So, is this blog just provocative speculation? Well, I was delighted to discover that the Swiss National Bank does not take haircuts when it does repos.