Liquidity Adjustment Facility (LAF) | Meaning, Definition | History, Instruments

Liquidity Adjustment Facility (LAF):

 
“The Liquidity Adjustment Facility (LAF) is an instrument of monetary policy of the Reserve Bank of India through which commercial banks or other financial institutions or primary dealers manage their surplus funds as well as deficit of funds by Repurchase Option Agreement keeping their Government of India securities such as Government bond, Treasury Bills etc as collateral. Oil Bonds have also been used as collateral of liquidity adjustment facility (LAF).”

 

 
In other words, Liquidity Adjustment Facility (LAF) is a tool that facilitates commercial banks to borrow money in case of liquidity crunch and to park in case of surplus funds with Reserve Bank of India through repurchase or resell agreement of the government securities respectively.

 

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):

The major instruments of LAF are explained below.

 

Repo Agreement:

It is a most important component of LAF through which scheduled commercial banks and primary dealers borrow funds for short term period from the Reserve Bank of India in case of shortage of funds against the collateral of their Government securities through a repurchase (Repo) agreement of the same securities. Moreover, the rate of interest at which banks borrow the money is called the Repo Rate.

 

Reverse Repo Agreement:

It is the facility by which the commercial banks deposit their surplus funds by purchasing Government securities with the Reserve Bank of India promising to resell (by signing Resell Agreement) those securities on maturity.
 
Also, the interest rate on which commercial banks lend the money to RBI is known as Reverse Repo Rate.

 

For more details regarding Reverse Repo Rate follow the link.

What are the Repo Rate and Reverse Repo Rate?

Marginal Standing Facility (MSF):

Since availing loans under Repo Agreement has a limit of 1% of NDTL (Net Demand and Time Liability) hence for further requirements of funds, commercial banks borrow money under MSF scheme. In this case, there is no need to sign a repurchase agreement.

 

For comprehensive description regarding MSF follow the link.

What is the Marginal Standing Facility (MSF)?

Thus we can conclude the Liquidity Adjustment Facility (LAF) is used to maintain daily liquidity variations of commercial banks.

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