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Liquidity Adjustment Facility (LAF):
The commercial banks often struggle from liquidity crunch due to disequilibrium between deposits and withdrawal ratio and at the same time, they have to maintain the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) on day to day basis as per the guidelines of the Reserve Bank of India.
Therefore, LAF plays a vital role in arranging funds (short term) for commercial banks during the shortage of funds.
History of LAF (Liquidity Adjustment Facility):
The LAF was first recommended by the Narasimham Committee on Banking sector reform in 1998. Further, the RBI introduced interim LAF in 1999 and finally, RBI laughed full-fledge Liquidity Adjustment Facility in 2000.
Moreover, as per the monetary policy statement, the Repo rate and Reserve Repo rate were declared until 3 May 2011. According to this monetary policy, it was declared that the Reverse Repo should not be fixed separately however it has been correlated with the Repo Rate.
The Reverse Repo rate was fixed 100 basis points below the Repo Rate. This range between Repo Rate and Reverse Repo Rate is known as Liquidity Adjustment Facility Corridor in which a movement was observed between 100 to 300 basis points from April 2001 to June 2008.
The LAF corridor is a bit narrow than previous years which has been 25 basis points from 2008 onward.
Later in 2013, the Reserve Bank of India introduced ‘Term Repo’ under LAF for the period of 7 days and 14 days other than the existing LAF.
In fact, Liquidity Adjustment Facility, used by the Central Bank to control the supply of money and to stabilise the rate of inflation in the economy. Although the RBI controls the supply of money and ensures the solvency of commercial banks through various instruments in addition to the following components such as CRR, SLR and being a monetary authority of India, it is also responsible for penalties in case of defaults of rules and regulations. The RBI uses Bank Rate as a penal rate to impose a penalty over the commercial banks.
Instruments of Liquidity Adjustment Facility (LAF):
Reverse Repo Agreement:
For more details regarding Reverse Repo Rate follow the link.
Marginal Standing Facility (MSF):
For comprehensive description regarding MSF follow the link.
Thus we can conclude the Liquidity Adjustment Facility (LAF) is used to maintain daily liquidity variations of commercial banks.
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