What Is a Liquidity Adjustment Facility?
An instrument employed in monetary policy, mainly by the Reserve Bank of India (RBI), is the liquidity adjustment facility (LAF), which permits banks to lend money to the RBI through reverse repo agreements or borrow money through repurchase agreements (repos). This structure effectively achieves the management of liquidity demands and the maintenance of fundamental market stability. Under its open market operations, the United States Federal Reserve transacts repos and reverse repos.
In response to the Narasimham Committee on Banking Sector Reforms (1998), the RBI implemented the LAF.
A Liquidity Adjustment Facility’s Fundamentals
The purpose of liquidity adjustment facilities is to help banks deal with temporary cash shortages that may arise during unstable economic times or from any other type of stress brought on by external factors. Through a repo agreement, several banks utilize qualifying securities as collateral. They then use the funds to reduce their short-term needs and stay steady.
Banks and other financial institutions ensure adequate capital in the overnight market every day by implementing the facilities. At a specific time of day, an auction is used to conduct liquidity adjustment facilities. A party seeking to raise funds to cover a deficit enters a reverse repo agreement, whereas a party with surplus funds does the opposite.
The Economy and the Liquidity Adjustment Facility
The liquidity adjustment facility is a tool that the RBI can employ to control excessive inflation. It accomplishes this by raising the repo rate, which drives up debt servicing expenses. As a result, India’s economy receives less investment and money supply.
In contrast, the RBI can cut the repo rate to encourage firms to borrow, expanding the money supply, if it attempts to revive the economy following a period of sluggish economic development. The RBI reduced the repo rate by 40 basis points, from 4.40% to 4.00%, in May 2020 due to slowing global growth, benign inflation, and sluggish economic activity. The reverse repo rate was likewise decreased by 40 basis points, from 3.75% to 3.35%, at the same time.
Example of a Liquidity Adjustment Facility
Let’s say that the Indian economy is experiencing a recession and a bank is experiencing a temporary liquidity crunch. The bank would use the RBI’s liquidity adjustment facility by completing a repo agreement and selling government securities to the RBI in exchange for a loan with an obligation to repurchase those assets. For example, the bank executes a repo deal at 6.25% and wants a one-day loan for 50,000,000 Indian rupees. For the loan, the bank will be paid ₹8,561.64 in interest (₹50,000,000 x 6.25% / 365).
Let’s assume that a bank has extra cash, and the economy is growing. Under these circumstances, the bank would carry out a reverse repo arrangement by lending money to the RBI in return for government assets, with the RBI agreeing to buy back the securities from the bank. For instance, the bank may execute a one-day reverse repo arrangement at 6% and have ₹25,000,000 ready to loan the RBI. The RBI would pay the bank interest of ₹4109.59 (₹25,000,000 x 6% / 365).
CONCLUSION
- The Reserve Bank of India (RBI) uses a liquidity adjustment facility (LAF) as a monetary policy instrument.
- The RBI implemented the LAF as part of the Narasimham Committee on Banking Sector Reforms’ 1998 recommendations.
- LAFs assist the RBI in managing liquidity and providing economic stability by allowing banks to borrow money through repurchase agreements or repos or to lend to the RBI through reverse repo arrangements.
- LAFs can control inflation by increasing and decreasing the money supply.
