Liquidity adjustment

facility

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Liquidity adjustment facility (LAF) is a

monetary policy which allows banks
borrow money through repurchase
agreements.[1]

Description
LAF is used to aid banks in adjusting the
day to day mismatches in liquidity. LAF
helps banks to quickly borrow money in
case of any emergency or for adjusting in
their Statutory Liquidity Ratio (SLR)/Cash
Reserve Ratio (CRR) requirements. LAF
consists of repo (repurchase agreement)
and reverse repo operations. Repo or
repurchase option is a collaterised lending
i.e. banks borrow money from Reserve
bank of India to meet short term needs by
selling securities to RBI with an agreement
to repurchase the same at predetermined
rate and date. The rate charged by RBI for
this transaction is called the repo rate.
Repo operations therefore inject liquidity
into the system. Reverse repo operation is
when RBI borrows money from banks by
lending securities. The interest rate paid
by RBI in this case is called the reverse
repo rate. Reverse repo operation
therefore absorbs the liquidity in the
system. The collateral used for repo and
reverse repo operations are Government of
India securities. Oil bonds have been also
suggested to be included as collateral for
Liquidity adjustment facility. In LAF, money
transaction is done via RTGS (Real time
Gross settlement, an online money
transfer method).

History
The origin of repo rates, one of the
component of liquidity adjustment facility,
can be traced to as early as 1917 in U.S
financial market when war time taxes
made other sources of lending
unattractive. The introduction of Liquidity
adjustment facility in India was on the
basis of the recommendations of
Narasimham Committee on Banking
Sector Reforms (1998). In April 1999, an
interim LAF was introduced to provide a
ceiling and the fixed rate repos were
continued to provide a floor for money
market rates. As per the policy measures
announced in 2000, the Liquidity
Adjustment Facility was introduced with
the first stage starting from June 2000
onwards. Subsequent revisions were
made in 2001 and 2004. When the scheme
was introduced, repo auctions were
described for operations which absorbed
liquidity from the system and reverse repo
actions for operations which injected
liquidity into the system. However, in
international nomenclature, repo and
reverse repo implied the reverse. Hence in
October 2004, when revised scheme of
LAF was announced, the decision to follow
the international usage of terms was
adopted.
Repo and reverse repo rates were
announced separately till the monetary
policy statement in 3.5.2011. In this
monetary policy statement, it has been
decided that the reverse repo rate would
not be announced separately but will be
linked to repo rate. The reverse repo rate
will be 100 basis points below repo rate.
The liquidity adjustment facility corridor,
that is the excess of repo rate over reverse
repo, has varied between 100 and 300
basis points. The period between April
2001 to March 2004 and June 2008 to
early November 2008 saw a broader
corridor ranging from 150–250 and 200–
300 basis points respectively. During
March 2004 to June 2008 the corridor was
narrow with the rates ranging from 100–
175 basis points. A narrow LAF corridor is
reflected from November 2008 onwards.
At present the width of the corridor is 25
basis points. This corridor is used to
contain any volatility in short-term interest
rates.

Current status
Liquidity adjustment facility has emerged
as the principal operating instrument for
modulating short term liquidity in the
economy. Repo rate has become the key
policy rate which signals the monetary
policy stance of the economy.

References
1. "Liquidity Adjustment Facility" .
bankingindiaupdate. Archived from the
original on 28 October 2011.
Retrieved 30 October 2011.
Vasant, Hhushita (19 May 2011). "RBI to
End Second Liquidity Adjustment
Facility" . Wall Street Journal. Retrieved
30 October 2011.

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