I’d never have guessed haircuts caused chaos in money markets

Wednesday, 17 August, 2011

Haircuts, but not haircuts as most of us would know them, apparently played a big part in the recent chaos that gripped the world’s money markets.

The cause, it seems, are “haircuts”, Wall Street jargon for the amount subtracted from the market value of an asset, such as a government bond, that is used as security when a bank borrows cash from another bank. During boom times, haircuts range from 1 to 10 per cent, making it easy for bankers to borrow. Having a cheap and plentiful source of ready cash tempts bankers to gamble it on risky and potentially “toxic” investments, as happened in the run-up to the crash in 2008. But in recession, haircuts zoom up as high as 100 per cent as banks rein in their assets, which can paralyse the financial system through a cash-flow drought.

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