What Is a Liquidity Adjustment Facility?

A liquidity adjustment facility (LAF) is a tool used in monetary policy, primarily by the 澳洲幸运5官方开奖结果体彩网:Reserve Bank of India (RBI), that allows banks to borrow money through repurchase agreements (repos) or to make loans to the RBI through reverse repo agreements. This arrangement is effective in managing liquidity pressures and assuring basic stability in the financial markets. In the United States, the Federal Reserve transacts repos and reverse repos under its open market operations.

The RBI introduced the LAF as a result of the Narasimham Committee on Banking Sector Reforms (1998). 

Basics of a Liquidity Adjustment Facility

Liquidity adjustment facilities are used to aid banks in resolving any short-term cash 澳洲幸运5官方开奖结果体彩网:shortages during periods of economic instability or from any other form of stress caused by forces beyond their control. Various banks use eligible securities as 澳洲幸运5官方开奖结果体彩网:collateral through a repo agreeme൩nt and use the funds to alleviate their short-term requirements, 🎃thus remaining stable.

The facilities are implemented on a day-to-day basis as banks and other financial institutions ensure they have enough capital in the overnight market. The transacting of liquidity adjustment facilities takes place via an auction at a set time of the day. An entity wishing to raise capital to fulfill a shortfall engages in repo agreements, while one with excess capital does the opposite and executes a reverse repo. 

Liquidity Adjustment Facility and the Economy

The RBI can use the liquidity adjustment facility to manage high levels of 澳洲幸运5官方开奖结果体彩网:inflation. It does so by increasing the repo rate, which raises the cost of servicing debt. This, in turn, reduces investment and 澳洲幸运5官方开奖结果体彩网:money supply in India’s economy.

Conversely, if the RBI is trying to stimulate the economy after a period of slow economic growth, it can lower the repo rate to encourage businesses to borrow, thus increasing the money supply. For example, the RBI increased the repo rate by 40 澳洲幸运5官方开奖结果体彩网:basis points in May 2022 to 4.40% from 4.00%. In another example, the reverse repo rate was cut to 3.35% from 3.75% in 2020.

Liquidity Adjustment Facility Example

Let’s assume a bank has a short-term cash shortage due to a recession gripping the Indian economy. The bank would use the RBI's liquidity adjustment facility by executing a repo agreement by selling 澳洲幸运5官方开奖结果体彩网:government securities to the RBI in return for a loan with an agreement to repurchase those securities. For example, say the bank needs a one-day loan for 50,000,000 澳洲幸运5官方开奖结果体彩网:Indian rupees and executes a repo agreement at 6.25%. The bank's payable interest on the loan is ₹8,561.64 (₹50,000,000 x 6.25% / 365𒀰).

Now, let’s suppose the economy is expanding, and a bank has excess cash on hand. In this case, the bank would execute a reverse repo agreement by making a loan to the RBI in exchange for government securities, in which it agrees to repurchase those securities. For example, the bank may have ₹25,000,000 available to loan the RBI and decide t🐷o execute a one-day reverse repo agreement at 6%. The bank would receive ₹4109.59 in interest from the RBI (₹25,000,000 x 6% / 365).

The Bottom Line

The liquidity adjusꦰtment facility is a tool used by the Reserve Bank of India to regulate short-term liquidity in the banking system through repurchase and reverse repurchase agreements. Introduced after the Narasimham Committee’s recommendations, it helps banks manage temporary cash flow shortages. By changing theꩵ repo and reverse repo rates, the RBI can steer credit availability, money supply, and inflation levels in the economy.