What is a liquidity adjustment facility?
A liquidity adjustment facility (LAF) is a tool used in monetary policy, mainly by the Reserve Bank of India (RBI), which allows banks to borrow money via repurchase agreements (repos ) or banks make loans to the RBI through reverse repurchase agreements. This arrangement manages liquidity pressures and provides basic stability in the financial markets. In the United States, the Federal Reserve trades repurchase and reverse repurchase agreements as part of its open market operations.
The RBI introduced the LAF following the Narasimham Committee on Banking Sector Reforms (1998).
Basic principles of a liquidity adjustment facility
Liquidity adjustment mechanisms are used to help banks resolve short-term cash shortages during times of economic instability or any other form of stress caused by forces beyond their control. Various banks use eligible securities as collateral under a repurchase agreement and use the funds to alleviate their short-term needs, thereby remaining stable.
The facilities are implemented on a day-to-day basis, with banks and other financial institutions ensuring they have sufficient capital in the market overnight. The liquidity adjustment facilities are traded at a fixed time of the day. An entity wishing to raise capital to fill a deficit enters into repurchase agreements, while an entity with excess capital does the opposite – performs reverse repo.
Easy liquidity adjustment and economy
The RBI can use the liquidity adjustment facility to manage high levels of inflation. It does this by increasing the repo rate, which increases the cost of servicing the debt. This, in turn, reduces investment and the money supply in the Indian economy.
Conversely, if the RBI tries to stimulate the economy after a period of weak economic growth, it can lower the repo rate to encourage companies to borrow, thereby increasing the money supply. For example, analysts expect the RBI to reduce the repo rate by 25 basis points in April 2019 due to weak economic activity, benign inflation and slower global growth . However, analysts expect repo rates to pick up in 2020 as growth picks up and inflation picks up.
Key points to remember
- An LAF is a monetary policy tool, mainly used by the RBI, to manage liquidity and ensure economic stability.
- LAFs include both repo and reverse repo agreements.
- The RBI introduced an LAF following the Narasimham Committee on Banking Sector Reforms (1998).
- LAFs can manage inflation by increasing and reducing the money supply.
Real example of a liquidity adjustment facility
Suppose a bank has a shortage of short-term liquidity due to a recession that is plaguing the Indian economy. The bank would use the RBI’s liquidity adjustment facility by executing a repurchase agreement by selling government securities to the RBI in exchange for a loan with a repurchase agreement for those securities. For example, suppose the bank needs a one-day loan for 50,000,000 Indian rupees and is executing a 6.25% repo agreement. The interest payable by the bank on the loan is ₹ 8,561.64 (₹ 50,000,000 x 6.25% / 365).
Suppose now that the economy is growing and that a bank has excess liquidity. In this case, the bank would execute a reverse repurchase agreement by granting a loan to the RBI in exchange for government securities, in which it agrees to repurchase these securities. For example, the bank may have ₹ 25,000,000 to lend to the RBI and decides to enter into a 6% overnight repurchase agreement. The bank would receive ₹ 4,109.59 in interest from the RBI (₹ 25,000,000 x 6% / 365).