What Is a Liquidity Adjustment Facility (LAF) in Monetary Policy?

What Is a Liquidity Adjustment Facility?

A liquidity adjustment facility (LAF) is a tool used in monetary policy, primarily by the 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 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 collateral through a repo agreement 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 inflation. It does so by increasing the repo rate, which raises the cost of servicing debt. This, in turn, reduces investment and 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. Recently, the RBI cut the repo rate by 40 basis points in May 2020 to 4.00% from 4.40% previously due to weak economic activity, benign inflation, and slower global growth. At the same time, the reverse repo rate was cut to 3.35% from 3.75%, also a decline of 40 basis points.

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 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 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% / 365).

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 to 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).