Liquidity Adjustment Facility or LAF is a facility extended by the Reserve Bank of India to the scheduled commercial banks (excluding RRBs) and Primary Dealers (PDs) to meet their mismatches in daily liquidity.
It is an important monetary policy instrument which helps the RBI to manage liquidity and provide economic stability by offering banks the opportunity to borrow money through repurchase agreements or repos or to make loans to the RBI via reverse repo agreements.
Various tools under the LAF including the popular repo and reverse repo are used by the RBI to manage liquidity in the financial system.
COMPONENTS OF LAF
There are two major components of liquidity adjustment facility –
REPO RATE – When banks need liquidity to meet its daily requirement, they borrow from RBI through repo. The rate at which they borrow fund is called the repo rate.
REVERSE REPO RATE – The rate at which the RBI borrows money from the commercial banks against government approved securities is called a reverse repo rate. Through reverse repo operations, the liquidity is absorbed from the economy or the financial system.
On the liquidity management front, the LAF, is also supported by other instruments such as the CRR (Cash Reserve Ratio), OMO (Open Market Operations) and MSS (Market Stabilization Scheme).
IMPORTANCE OF LAF
The liquidity adjustment facility is used to aide banks in the emergency arising out of severe cash shortage or acute liquidity crisis. It is used for modulating the short-term liquidity and transmitting the interest rate into the market.
LAF’s can manage inflation in the economy by increasing and reducing the money supply.
WORKING OF LIQUIDITY ADJUSTMENT FACILITY
Liquidity adjustment facility has emerged as the principal operating instrument for modulating short term liquidity in the economy. It is used to inject liquidity in the economy during the time of shortages through Repo rate operations. Similarly, it absorbs liquidity from the economy when there is excess liquidity through Reverse Repo Rate operations.
The reverse repo rate is fixed lower than the repo rate. This means whenever the repo rate changes, the reverse repo rate also changes equally.
Thus, in simple words the Liquidity Adjustment Facility or LAF is the principal operating monetary policy tool that allows banks to borrow money through repurchase agreements.