Liquidity Adjustment Facility (LAF): Meaning, Importance and Roles
What is Liquidity Adjustment Facility (LAF)?
The Liquidity Adjustment Facility (LAF) is a monetary policy tool used by central banks to manage liquidity in the banking system. It involves providing liquidity to commercial banks through repo transactions, where the central bank buys government securities from banks with an agreement to sell them back at a future date. The difference between the purchase and sale price represents the interest charged by the central bank. The LAF has two parts, the repo rate and the reverse repo rate, which can be adjusted to influence the availability of credit and control inflation.
Basics of Liquidity Adjustment Facility (LAF)
Liquidity adjustment facility is available to assist banks in resolving any short-term cash shortages caused by economic insecurity or other forms of stress beyond their control. Various banks use eligible securities as collateral in a repo agreement and use the funds to meet their short-term needs, allowing them to remain stable.
The facilities are used on a daily basis to ensure that banks and other financial institutions have enough capital in the overnight market. At a predetermined time of day, liquidity adjustment facilities are traded in an auction. Repo agreements are used by entities seeking to raise capital to meet a shortfall, whereas reverse repo agreements are used by entities with excess capital.
Objectives of Liquidity Adjustment Facility (LAF)
Here are the key objectives of the Liquidity Adjustment Facility:
1. Ensuring Economic Stability
The RBI uses Liquidity Adjustment Facility to maintain economic stability by ensuring optimum liquidity in the banking system.
2. Controlling Money Market Interest Rates
RBI uses Liquidity Adjustment Facility to regulate the flow of money in the economy when there are fears of inflation or recession. When the economy feels the heat of inflation, RBI increases the repo rate, thereby pulling out excess liquidity from the economy. Whereas, whenever the economy is nearing recession, RBI injects more money into the depressed economy by lowering the repo rate.
3. Providing Financial Stability
The Liquidity Adjustment Facility RBI injects liquidity into the banking channels and ensures banks can meet their daily cash requirements.
4. Smooth Flow of Credit
The Liquidity Adjustment Facility makes the credit system more dynamic. It encourages institutions with excess cash reserves to park them with the central bank and allows institutions feeling a cash crunch to borrow funds from RBI.
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Liquidity Adjustment Facility Operations
Liquidity Adjustment Facility is available to banks from Monday to Friday; the central bank, i.e., the RBI conducts an auction every day, requiring banks to submit their repo and reverse repo bids by 10:30 AM. The result of the auction is declared at noon. LAF RBI is available in the following two instruments:
Repo Operation
A repo operation is a short-term collateralized lending facility. The holder of securities sells those securities to a buyer in exchange for cash reserves. The seller promises to repurchase the sold securities at a predetermined rate and date. The rate at which the lender (RBI) transfers funds to the borrower (Banks) is called the repo rate.
Reverse Repo Operation
A reverse repo operation is exactly the opposite of a repo operation. It gives institutions with idle cash an opportunity to earn some interest on their idle cash. In reverse repo operation, the lender of funds acquires securities from a seller with an agreement to resell on a specified date and rate.
Note: Reverse repo rate is always lower than the repo rate for the simple reason that the RBI cannot pay more on deposits than what they charge on loans. The reverse repo rate is automatically changed equally whenever RBI changes the repo rate.
Liquidity Adjustment Facility in the Economy
To manage high levels of inflation, the RBI can use the liquidity adjustment facility. It accomplishes this by raising the repo rate, which raises the cost of debt servicing. As a result, investment and money supply in India’s economy are reduced. In contrast, if the RBI wants to stimulate the economy after a period of slow growth, it can lower the repo rate to encourage businesses to borrow, thereby increasing the money supply.
Let us illustrate this with an example. The RBI reduced the repo rate by 40 basis points to 4.00% in May 2020, due to weak economic activity as a result of benign inflation, the COVID outbreak, and slower global growth. Simultaneously, the reverse repo rate was cut by 40 basis points to 3.35% from 3.75%.
The year 2020 did not turn out to be financially prosperous, which is why the RBI lowered the repo rate, which resulted in increased money supply from banks to businesses and even between individuals..
Role of Liquidity Adjustment Facility in the Economy
Here is how the Liquidity Adjustment Facility plays an important role in the Indian economy:
- Maintains liquidity in the Indian banking system and pushes economic growth.
- Regulates the money market interest rates.
- Injects liquidity in the banking system to maintain and promote monetary stability.
- Helps banks meet their daily liquid cash requirements.
- Ensure a smooth flow of credit to the economy and banks.
Importance of Liquidity Adjustment Facility
The Liquidity Adjustment Facility (LAF) is an important monetary policy tool that serves several key purposes.
- The LAF helps manage liquidity in the banking system by providing banks with access to short-term funding. This ensures that banks have sufficient funds to meet their obligations and promotes financial stability.
- Allows central banks to control inflation by influencing short-term interest rates. By adjusting the repo and reverse repo rates, central banks can make borrowing more expensive or cheaper for banks, which affects the availability of credit in the economy.
- Helps promote economic growth by providing banks with access to liquidity when needed. This stimulates spending and investment, which can boost economic activity.
- Helps maintain investor confidence by ensuring that banks have sufficient liquidity to weather any financial shocks or crises.
- An important tool for central banks to maintain their monetary policy objectives and achieve macroeconomic stability.
Final Word
The Liquidity Adjustment Facility has left no room for autonomy in the banking system and helped the central bank gain control over the monetary transmission. This facility makes sure liquidity never dries up in the banking system because that would be detrimental to the economy. Banks benefit from liquidity adjustment facilities by resolving their short-term liquidity needs. Banks with excess cash reserves are offered interest against their cash reserves for parking the reserves with RBI. Whereas banks low on cash reserves can borrow funds from RBI to keep their cash operations running.
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FAQs
All scheduled commercial banks having current accounts and SGL accounts with RBI are eligible for availing of the Liquidity Adjustment Facility. However, Regional Rural Banks are not allowed to avail of LAF.
Banks can participate in LAF with a minimum bid of Rs 5 crores, and beyond which the bids can be in multiples of 5 crores only. However, such transactions are allowed only against transferable Securities/Treasury Bills, issued by the Government of India.
The Liquidity Adjustment Facility consists of two legs, the repurchase (repo) agreement, and the reverse repo agreement. The former enables banks to meet their short-term liquidity requirements, while the latter allows them to park their excess funds with the RBI.
Since Liquidity Adjustment Facility is a short-term credit facility, its tenure is 7 days. On the seventh day, the banks would be required to repurchase their collateral securities. Liquidity Adjustment Facility is available on all days, from Monday to Friday. In case there is a holiday on the seventh day, the reversal of the liquidity adjustment facility will take place on the day immediately preceding the seventh day.
RBI fears inflation to hit the Indian economy; thus, it is withdrawing the accommodative measures it took considering the impact of covid. In the last two months, i.e., May and June, RBI has increased the repo rate by 90 basis points, taking it to 4.90%. Moreover, given the projections of inflation, expect more aggressive rate hikes in the coming months.
A LAF is a monetary policy tool used by the RBI in India to inject or absorb liquidity into or out of the banking system. While The Reserve Bank of India established the Marginal Standing Facility (MSF) to allow scheduled commercial banks to obtain liquidity overnight if inter-bank liquidity completely dried up.
In addition to the existing daily LAF (repo and reverse repo) and MSF, the Reserve Bank has introduced Term Repo (repos of more than a day) under the Liquidity Adjustment Facility (LAF) for 14 days and 7 days tenors for banks (scheduled commercial banks other than RRBs).
The Reserve Bank of India (RBI) has granted regional rural banks (RRBs) access to the liquidity adjustment facility (LAF), marginal standing facility (MSF), and call or notice money markets in order to help these lenders manage their liquidity more effectively.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
