Andrew G Haldane: Haircuts
Remarks by Mr Andrew G Haldane, Executive Director, Financial Stability, of the Bank of
England and member of the Financial Policy Committee, summarising a forthcoming paper in the
Journal of Monetary Economics "Complexity, Concentration and Contagion", 1 August 2011.
* * *
The views are not necessarily those of the Bank of England or the Financial Policy Committee. I would like to
thank Marnoch Aston, Benjamin Nelson, Sujit Kapadia, Vasileios Madouros, Priya Kothari and Andrew Mason for
comments and contributions.
During the summer months, I have my hair cut slightly shorter than during the winter months.
This helps keep my head a little cooler in the summer heat and my ears a little warmer in the
winter cold. Anyone who has seen them will know this is a smart strategy for my ears, to say
nothing of my head. This strategy is explicitly counter-cyclical. When the temperature goes
up, my hair-length comes down and vice-versa. I am not alone. National statistics show that
expenditure on haircuts increases as temperatures rise.
The financial system also 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.
Table 1 demonstrates this pattern. It compares haircuts on a range of financial instruments
used to back borrowing - so-called securities financing. They are shown on two dates,
before (June 2007) and after (June 2009) the financial crisis. Haircuts rose by up to
90 percentage points in the space of these two years, as the scorching pre-crisis summer
gave way to a frozen crisis winter. In other words, haircuts exhibited a rather dramatic
procyclicality over the course of the crisis.
Table 1:
Typical haircut on term securities financing transactions (per cent)
June 20071 June 20091
Medium-term G7 government 0 1
bonds
Medium-term US agencies 1 2
AAA-rated prime MBS 4 10
Asset-backed securities 10 25
AAA-rated structured products 10 100
AAA- and AA-rated investment 1 8
grade bonds
High-yield bonds 8 15
G7 countries equity 10 15
Source: Committee on the Global Financial System (2010).
1
Prime counterparty.
This haircut cycle played an important causal role in the crisis. Secured financing became an
increasingly important source of credit in both bank and non-bank markets over the past
decade. In the US, the repo market financed roughly half of the growth in investment banks'
balance sheets between 2002 and 2007. In the UK, the securitisation market trebled in size
over the same period. Those were the heady days of summer. Since then the US repo
market has shrunk by 40%, while the UK securitisation market remains frozen.
Pro-cyclicality in the haircuts applied to secured financing transactions in turn amplified the
cycle in credit. Thin haircuts made it cheaper for banks to mobilise collateral to finance
borrowing when the credit cycle was in the upswing, adding momentum to the upward
pendulum of asset prices and credit. And fat haircuts immobilised collateral when the credit
cycle reversed, exaggerating the downward pendulum swing.
A further factor amplifying these swings came from the fact that much of the secured
financing took place within the financial sector. In the run-up to crisis, banks and near-banks
entered into secured financing transactions with one another, inflating both counterparties'
balance sheet. In the UK, fully two-thirds of the trebling in balance sheets between 2002 and
2007 can be explained by expanding claims on other parts of the financial system.
These cross-system dependencies in financing have "externality-like" effects. During a
generalised boom, individual banks lend freely to one another and all of the moving parts of
the financial system are lubricated. The system co-ordinates itself on a high liquidity
equilibrium. Liquidity has positive spillover effects or externalities; liquidity is a public good.
And with rising asset prices and liquidity and falling haircuts, the credit multiplier is high and
self-reinforcing.
But that cycle can just as quickly reverse. In a situation of stress, individual banks hoard
rather than lend liquidity. The system then co-ordinates itself on a low liquidity equilibrium.
Liquidity then has negative spillovers, imposing negative externalities; illiquidity is a public
bad. And with asset prices and liquidity falling and haircuts rising, the credit multiplier
becomes self-reinforcing downwards.
Given these pro-cyclicalities, there have been recent proposals by both policymakers and
academics to regulate collateral requirements.1 This is one possible arm of so-called
macroprudential policy. Within the UK, haircuts on secured financing or OTC derivative
transactions have been identified as one possible tool for executing macroprudential policy.2
The UK's new interim Financial Policy Committee, housed in the Bank of England, will
provide advice to government on possible macroprudential tools over the next year or so.
The debate on haircuts as a policy tool is live internationally too. In a recent speech in Atlanta,
US Treasury Secretary Tim Geithner proposed the introduction of international minimum
standards for margins on derivatives transactions.3 This would be akin to the international
minimum standards for capital adequacy introduced through the Basel agreements. Since
1934, the US authorities have had regulatory powers to impose minimum margin requirements
on lending against equity and some other assets - so-called Regulation T. But these policies
have not been used actively, with minimum margins unchanged since 1974.
To date, analysis of the macroprudential role of haircuts has been largely descriptive. A
recent paper, co-authored with Prasanna Gai and Sujit Kapadia, attempts to fill that gap.4 We
develop a model of a banking network, inter-connected through unsecured interbank lending
and secured funding markets. This financial web exhibits classical tipping point properties. It
is even-tempered most of the time. Indeed, having a tight-knit circle of financial friends helps
keep the financial system strong and stable. Risks are diffused across the system. A problem
shared is a problem halved. The system is in a high-liquidity equilibrium.
But, on occasion, the system can be pushed beyond its tipping point. Connectivity then
generates contagion. A problem shared is a problem multiplied. The best of financial friends
become the worst of enemies. In the model, one of the key channels for contagion is the
secured financing market as banks hoard rather than lend liquidity when haircuts rise. The
liquidity feast then turns to famine as secured and unsecured financing markets dry up. The
system switches to a low-liquidity equilibrium. These liquidity droughts were perhaps the
defining feature of the financial crisis during 2007 and 2008.
In the model, the likelihood of such systemic liquidity crises depends critically on two key
structural characteristics of the financial system - the two c's: concentration and complexity.
The greater the concentration within the financial system, the greater the potential for
systemic collapse as larger banks spread a disproportionate amount of financial pain around
a densely networked financial system. A greater degree of system complexity has a similar
effect, creating more channels for contagion and heightening banks' incentives to hoard
liquidity when the weather worsens. The two c's are very much features of today's financial
system. On the face of it, that bodes ill for future systemic crises.
So what role might policy play in avoiding those crises? The model provides a test-bed to
consider a range of policy options, including for haircuts policy. An illustrative policy
experiment, based on a simulation of the model in which haircuts spike sharply, is shown in
Chart 1. Up the vertical axis is a measure of the probability of a systemic liquidity crisis.
Along the horizontal axis is the initial size of the haircut on secured financing transactions.
The three lines trace three policy options. Consider first the "baseline" path without policy
intervention. Provided haircuts remain high come rain or shine - in the example, above
around 20% - the probability of a liquidity crisis remains very low. But if haircuts are lowered
even modestly, resilience is eroded. In the example, lowering haircuts from 20% to 5% raises
the crisis probability by an order of magnitude, from less than 0.1 to almost 1. In other words,
a hands-off haircuts policy runs a significant risk of systemic collapse if haircuts are
procyclically trimmed during the upswing.
To prevent this, policy makers could seek to control haircuts directly. In the example,
significantly greater resilience could be achieved by imposing a haircut limit of 20%.
Alternatively, policy makers could seek to lean against the pro-cyclical tendencies of the
financial system as systemic risk increases. The other two lines in Chart 1 show different
sets of activist policy intervention. Both require banks to build up larger liquid asset buffer
stocks in the event of haircuts being trimmed. This lessens the need for banks to hoard
liquidity, so reducing system-wide liquidity stress.
The two policies differ in how aggressively they respond to such excesses - "weak" and
"tough". Either way, the effects are striking. Even the weak policy shrinks the probability of
collapse by more than half, whatever the initial level of haircuts. And under the tough policy,
the financial system is effectively inoculated against haircut-induced pro-cyclicality.
It may be over-optimistic to think policy could eliminate the adverse effects of haircut-induced
pro-cyclicality. For example, we have little theoretical understanding of how haircut-based
policies might affect banks' behaviour. And we have little empirical case law on the
implementation of these policies. For example, haircuts policy might be circumvented by
banks substituting towards unsecured finance. So any quantitative calibration of the effects
of a haircut-based policy rule is necessarily tentative. Nonetheless, the model simulations are
suggestive - and, at least qualitatively, encouraging.
Chart 1:
Aggregate haircuts and probability of a systemic liquidity crisis
1
0.9
Baseline
0.8
crisis
0.7
liquidity
0.6
0.5
systemic
a
of
0.4
0.3
Weak
Probability
0.2
Tough
0.1
0
25 20 15 10 5 0
Initial aggregate haircut (h)
Baseline
'Weak' haircut-dependent liquidity requirement
'Tough' haircut-dependent liquidity requirement
Source: Gai, Haldane and Kapadia (2011).
This financial network set-up can be used to assess a number of other topical policy issues.
These include:

Central clearing: Central clearing of financial transactions tackles the complexity of,
and concentration within, the financial system at source. The dense knitting of the
financial web is unravelled and replaced with a simple hub-and-spokes topology.
This will tend to reduce the liquidity hoarding incentives of investors, so making for
more resilient funding markets in the event problems strike. Provided the central
clearing house is beyond reproach, this topology also reduces the contagious
consequences of individual bank stress: liquidity cascades are headed-off at the
clearing house. The proviso is important, though. Robustness of the central clearing
basket becomes more important as more eggs are placed in it. This calls for a
seachange improvement in risk management practices among the clearing houses, as
more financial transactions come to be centrally cleared to meet G20 commitments.
Otherwise the too-important-to-fail problem simply re-emerges in a different guise.

Liquidity policy: One implication of the model is the importance of banks
maintaining buffers of the highest-quality liquid assets. These have a doubly
beneficial effect. First, they reduce banks' need to hoard liquidity in situations of
stress. Second, high-quality assets reduce the amplitude of the haircut cycle in the
first place, as Table 1 demonstrates. The first reduces the impact of a liquidity event,
the second its probability. The upshot is a fall in the chances of a systemic liquidity
crisis. The new Basel III liquidity regulation uses a strict definition of what counts as
liquid assets. The model underlines the importance of sticking to that definition. The
model suggests that financial system robustness would be further enhanced by
targeting liquidity requirements on the most connected banks in the system, as this
would lean against the destabilising effects of system-wide concentration.
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.