What is a Liquidity Adjustment Facility?
A Liquidity Adjustment Facility (LAF) is an instrument that is used in Monetary policy, especially by the Reserve Bank of India (RBI), which enables banks to borrow money Repurchase agreements (Repos) or to extend loans to RBI via Reverse Repo Agreements. This arrangement is effective in management liquidity Pressure and ensuring basic stability in Financial markets. In the United States, the Federal Reserve conducts repos and reverse repos as part of its open market operations.
The RBI introduced the LAF as a result of the Narasimham Committee on Banking Sector Reforms (1998).
The central theses
- A Liquidity Adjustment Facility (LAF) is a monetary policy instrument used in India by the Reserve Bank of India or RBI.
- The RBI introduced the LAF as part of the 1998 Narasimham Committee on Banking Sector Reforms outcome.
- LAFs help RBI to manage liquidity and ensure economic stability by offering banks the opportunity to borrow money through repurchase agreements or repos, or to issue loans to RBI through reverse repo transactions.
- LAFs can control inflation in the economy by increasing and decreasing the money supply.
Basics of a liquidity adjustment facility
Liquidity adjustment facilities are used to assist banks in handling short-term cash Bottlenecks in times of economic instability or any other form of stress caused by forces beyond their control. Different banks use suitable securities as a safety via a repo agreement and use the funds to meet short-term needs and thus remain stable.
The facilities are implemented on a daily basis as banks and other financial institutions ensure that they have sufficient capital in the overnight money market. Liquidity adjustment facilities are processed via a auction at a set time of day. A company that wants to increase capital city To meet a shortfall, one would do repos, while one with excess capital would do the opposite and do a reverse repo.
Liquidity Adjustment Facility and Economy
The RBI can use the Liquidity Adjustment Facility to hold high stocks inflation. It does this by increasing the repo rate, which increases the cost of debt servicing. This in turn reduces investment and Money supply in India’s economy.
Conversely, when the RBI tries to stimulate the economy after a period of slow economic growth, it can lower the repo rate to encourage companies to borrow and thus increase the money supply. Recently, the RBI lowered the repo rate by 40 Basis points in May 2020 to 4.00% from 4.40% previously due to weak economic activity, favorable inflation and slower global growth. At the same time, the reverse repo rate was lowered from 3.75% to 3.35%, also a decrease of 40 basis points.
Example of a liquidity adjustment facility
Let’s say a bank has a short-term shortage of cash due to a recession the Indian economy under control. The bank would leverage RBI’s liquidity adjustment facility by entering into a repo agreement through sale Government papers to RBI in return for a loan with an agreement to buy back these securities. For example, let’s say the bank needs a one-day loan of 50,000,000 Indian rupees and executes 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).
Now let’s say the economy is expanding and a bank has excess cash on hand. In this case, the bank would enter into a reverse repo arrangement by granting RBI a loan in exchange for government bonds in which it agrees to buy back those securities. For example, the bank may have 25,000,000 yen to borrow the RBI and decide to enter into a one-day 6% reverse repo agreement. The bank would receive 4109.59 yen in interest from the RBI (25,000,000 yen x 6% / 365).