What Is Liquidity Adjustment Facility And How Does It Impact The Indian Economy?
With the dynamic nature of the Indian banking system, where money changes hands almost instantaneously, it’s difficult for banks to project their liquidity requirements. Due to demand and supply forces, banks can have excess liquidity on some days while it may bleed dry on other days. To stabilize the financial markets and satisfy the liquidity needs of the banking system, the Reserve Bank Of India introduced Liquidity Adjustment Facility in 2004.
This article explores the Liquidity Adjustment Facility, its importance and objectives, and how it impacts the Indian economy. Keep reading!
What is Liquidity Adjustment Facility
The Liquidity Adjustment Facility (LAF) is available daily to ensure banks have optimum capital for the overnight market. RBI allows banks to meet their liquidity requirements when banks are short on cash reserves during times of economic instability or on account of unforeseen events. Banks can borrow from RBI using repurchase agreements (repos) against eligible securities as collateral. Similarly, banks can park surplus funds with RBI when they have excess liquidity by entering a reverse repo agreement with RBI.
Objectives of Liquidity Adjustment Facility
Here are the key objectives of the Liquidity Adjustment Facility:
- Ensuring economic stability: The RBI uses Liquidity Adjustment Facility to maintain economic stability by ensuring optimum liquidity in the banking system.
- 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.
- Providing financial stability: The Liquidity Adjustment Facility RBI injects liquidity into the banking channels and ensures banks can meet their daily cash requirements.
- 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.
Also Read: 10 Best Long Term Investment Plans In India
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.
Also Read: Prime Lending Rate, MCLR, RBI Base Rate & How Do These Rates Work
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
As discussed, the primary objective of RBI behind floating LAF was to facilitate the smooth flow of credit in the country’s banking system by ensuring optimum liquidity. The binding nature of LAF enables RBI to tackle situations like inflation and recession.
LAF has given RBI an inherent control over the rates at which commercial banks offer credit. Banks are bound to change the interest rates if there is a rate hike or rate cut from RBI.
For instance, in June 2022, RBI withdrew its accommodative stance on the repo rate and increased it by 50 basis points to 4.9%. Consequently, banks were bound to increase the interest rates for their various products by 50 basis points with immediate effect. If you are planning to avail a loan, do it now because with improving prospects for the economy, rate hikes are said to be around the corner and all the lenders will have to increase interest rates on their various products accordingly. If you are looking for a home loan, consider Navi home loans starting at just 7.39% p.a.
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.
FAQs on Liquidity Adjustment Facility
Ans: 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.
Ans: 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.
Ans: 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.
Ans: 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.
Ans: 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.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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