Liquidity Adjustment Facility (LAF) is a liquidity support mechanism administered by the RBI by including several liquidity tools for managing liquidity in the financial system.
Liquidity Adjustment Facility is thus a mechanism by the RBI through which the central bank supports the liquidity needs of the banking system. The LAF was launched in June 5, 2000.
Both liquidity injection and liquidity absorption are made by the RBI through various instruments of the LAF. Liquidity injection is provided through several instruments, including short-term loans (like MSF and variable rate repo) through auction. Liquidity absorption (through instruments like Standing Deposit Facility and Variable Rate Reverse Repo) is the opposite activity where the central banks receive excess funds from the banking system by giving an interest rate.
The main tools of liquidity management under the LAF are the Standing Deposit Facility (SDF) and Variable Rate Reverse Repo for liquidity absorption and Marginal Standing Facility (MSF) and Variable Rate Repo for liquidity injection. The RBI prefers the more durable (14 day) variable rate repo (injection) and variable rate reverse repo (liquidity absorption) and considers these as the main instruments of LAF. Both the variable rate repo and variable rate reverse repo are conducted on every Fridays. The MSF is a daily available emergency liquidity facility. For liquidity absorption, the Standing Deposit Facility has been emerged as the main overnight liquidity absorption facility since its inception in April 2022.
Working of the LAF: the components of LAF
The LAF works through various instruments devised by the RBI to inject liquidity into the banking system when the system/institutions need cash as well as to absorb liquidity when the banking system has excess money.
Initially, the overnight Repo and Reverse Repo were the main instruments of the LAF. But with the entry of the more long term instruments of variable rate repo and variable rate reverse repo, and the frequent use of MSF and the launch of SDF, the overnight repo and reverse repo were phased out as of now.
The following figure shows the importance of SDF and MSF and the relative unimportance of repo and reverse repo in the RBI’s LAF operations.
Table: Liquidity operations of the RBI for June last week, showign higher transactions of MSF and SDF and the LAF is dominated by these two as of now.
Figure: Turnover in various LAF components during January and February 2023.
The LAF works through several instruments. The most important instruments are the variable rate repo and reverse repo (conducted on Fridays), the Marginal Standing Facility (emergency facility conducted daily) and the Standing Deposit Facility (SDF). Till February 2020, the overnight repo was the main instrument, but as part of the new framework, the RBI has withdrawn it and instead is relying on more long-term and auction-based instruments. Similarly, the use of overnight reverse repo also became insignificant with the launch of the SDF. Now, the 14-day variable-rate repo and reverse repo auction are configured as the main liquidity instruments and the SDF has emerged as the most popular liquidity absorption instrument. Following are the components of LAF.
LAF instruments and their use status
|1||Variable Rate Repo||Main liquidity injection instrument, auction based and mainly for 14 days.|
|2||Variable Rate Reverse Repo||Main liquidity absorption instrument, auction based and mainly for 14 days.|
|3||Marginal Standing Facility||Emergency liquidity injection facility, overnight and is available on working days and holidays.|
|4||Standing Deposit Facility||Main liquidity absorption facility, without collateral and is overnight.|
|5||Repo (overnight fixed)||Not using as of now (not using since February 2020)|
|6||Reverse Repo (overnight fixed)||Not using as of now (not using since the launch of SDF)|
Why the LAF?
The central bank is responsible in facilitating the smooth functioning of the financial system. An important distorting phenomenon associated with the operation of the financial system is illiquidity. Liquidity means adequate and timely cash in the system for financial institutions to carry out their functions. Liquidity situation in the economy as a whole may fluctuate highly due to many factors. Excess liquidity may transfer itself into price rise. Simultaneously, liquidity shortages lead to havoc in the financial system especially in the banking system. The responsibility of the RBI is to keep liquidity in a daily manner.
How it works?
The LAF as its name suggests is a liquidity adjustment mechanism for the banking system. It is aimed to inject liquidity into the system when there occur liquidity shortages. Simultaneously, it absorbs liquidity when there is excess liquidity.
Expansion of LAF devices
After the launch of the LAF in 2013 with the two instruments of repo (we can call it as fixed repo) and reverse repo (call it as fixed reverse repo), the RBI introduced several other measures to supplement liquidity adjustment under the LAF. These includes, the MSF, variable rate repo, variable rate reverse repo and the Marginal Standing Facility.
Variable repo or variable rate reverse repo means that the RBI makes auctions (based on interest rate) to inject or absorb liquidity through the LAF. What is varying is here the interest rate as the participating banks makes their auctions on interest rates. The working of the auction route can be understood through the operation of term repo.
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 in monetary policy operation
An important outcome of LAF operations by the RBI is that banks in India generally use the LAF repo window more compared to other options like Call money market to obtain temporary funds or liquidity whenever they need it. Hence, the interest on that repo, which is called repo rate, has become very influential for the banks. It became very binding for the banks in India to change their interest rate whenever the RBI changes its repo rate.
Thus, the LAF has helped the RBI to develop short term interest rate as an effective instrument of monetary transmission.