Liquidity adjustment facility (LAF) is a

monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...

which allows banks to borrow money through

repurchase agreements A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and, by agreement between the two par ...

(REPO).

Description

LAF is used to aid banks in adjusting the day to day mismatches in

liquidity Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity, the ease with which an asset can be sold * Accounting liquidity, the ability to meet cash obligations when due * Liqui ...

. LAF helps

banks A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets. Because ...

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 A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and, by agreement between the two par ...

(repurchase agreement) and reverses repo operations. Repo or repurchase option is a collateralized lending i.e. banks borrow money from

Reserve bank of India The Reserve Bank of India, chiefly known as RBI, is India's central bank and regulatory body responsible for regulation of the Indian banking system. It is under the ownership of Ministry of Finance, Government of India. It is responsible for ...

(RBI) to meet short term needs by selling

securities A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...

to RBI with an agreement to repurchase the same at predetermined rate and date. The rate charged by

for this transaction is called the repo rate. Repo operations, therefore, inject

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 Collateral may refer to: Business and finance * Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan * Marketing collateral, in marketing and sales Arts, entertainment, and media * ''Collate ...

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 Real-time gross settlement (RTGS) systems are specialist funds transfer systems where the transfer of money or securities takes place from one bank to any other bank on a "real-time" and on a " gross" basis. Settlement in "real time" means a payme ...

, an

online In computer technology and telecommunications, online indicates a state of connectivity and offline indicates a disconnected state. In modern terminology, this usually refers to an Internet connection, but (especially when expressed "on line" or ...

money transfer method).

History

The origin of repo rates, one of the components of liquidity adjustment facility, can be traced to as early as 1917 in U.S.

financial market A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial markets ...

when wartime taxes made other sources of lending unattractive. The introduction of the liquidity adjustment facility in

India India, officially the Republic of India (Hindi: ), is a country in South Asia. It is the seventh-largest country by area, the second-most populous country, and the most populous democracy in the world. Bounded by the Indian Ocean on the so ...

was on the basis of the recommendations of

Narasimham Committee on Banking Sector Reforms (1998) From the 1991 India economic crisis to its status of third largest economy in the world by 2011, India has grown significantly in terms of economic development, so has its banking sector. During this period, recognizing the evolving needs of th ...

. 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 that absorbed liquidity from the system and reverse repo actions for operations that injected liquidity into the system. However, in international

nomenclature Nomenclature (, ) is a system of names or terms, or the rules for forming these terms in a particular field of arts or sciences. The principles of naming vary from the relatively informal naming conventions, conventions of everyday speech to the i ...

, repo and

reverse repo A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and, by agreement between the two par ...

implied the reverse. Hence in October 2004, when the 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 until the monetary policy statement on 3 May 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 the repo rate. The reverse repo rate will be 100

basis points A basis point (often abbreviated as bp, often pronounced as "bip" or "beep") is one hundredth of 1 percentage point. The related term ''permyriad'' means one hundredth of 1 percent. Changes of interest rates are often stated in basis points. If ...

below the 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. From 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 that signals the

stance of the economy.

References

*{{cite news, url=https://www.wsj.com/articles/SB10001424052748704816604576333112027893324, title=RBI to End Second Liquidity Adjustment Facility, last=Vasant, first=Hhushita, date=19 May 2011, work=Wall Street Journal, accessdate=30 October 2011 Monetary policy Finance in India