When a big company goes bankrupt after taking a loan from the bank, the bank has to forget forever a large part of the money given to it. This is called Haircut in the language of banking and this is the word which gives sleepless nights to every banker. This is not a small matter in India, in many big cases banks have had to see more than half of the money given to them being lost.
The term comes from an old English proverb. In earlier times, middlemen used to say ‘taking a haircut on the deal’ i.e. taking a little loss in the deal. Meaning, if someone wanted to get 100 rupees, the middleman would come in between and say that I will give you 70 rupees now and the remaining 30 will be mine. The haircut of Rs 30 is the same. It is just like when you cut your hair, some hair goes away forever. Gradually this word spread throughout the banking world. Today, whenever a big company fails to repay its loan and the bank makes a settlement with it, the amount that the bank has to leave is called haircut.
How is haircut calculated?
A company took Rs 100 crore from the bank, the company got closed, after a long legal battle, the bank got back only Rs 45 crore and the remaining Rs 55 crore was cut, that is, 55 percent of the money was lost. The bigger the haircut, the bigger the loss. In many cases in India, banks have had to face haircuts of 60 to 90 percent.
Why does this happen?
Haircut occurs when the loan taking company goes bankrupt. In India, there is a law for such cases, which is called Insolvency and Bankruptcy Code. Under this law, all the assets of the company are sold and a responsible person is appointed who finds a new buyer for the company. Whatever money comes is distributed among the banks. This money is always less than the loan and this reduction is called haircut.
How do banks avoid this?
To avoid haircut, banks investigate the company thoroughly before giving loan, take some pledge and keep an eye on it from time to time. RBI rules also prevent banks from giving loans arbitrarily. Still, sometimes the circumstances become such that it is not possible to avoid haircut and then the bank just tries to minimize the loss.
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