Liquidity Adjustment Facility is the mechanism by the RBI for managing the liquidity needs of the commercial banking system. The LAF is an important instrument of monetary policy. 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
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.
Besides the usual repo and reverse repo, LAF includes auction-based repo and reverse repo (variable rate) tools for managing liquidity. Tools other than the repo and reverse repo were launched by the RBI later. Following are the components of LAF:
- Repo (Overnight fixed repo or the ‘popular’ repo)
- Reverse repo (Overnight fixed reverse repo or the ‘popular’ reverse repo)
- Term repo (auction)
- Overnight variable rate repo (auction)
- Overnight variable rate reverse repo (auction).
In 2013, the RBI introduced term repo as part of the LAF.
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. For all these purposes, the LAF is working in an automatic manner based on repo and reverse repo operations. The LAF is operating on a daily basis. The central point of LAF is that liquidity injection is done through Repo operations and liquidity (absorption from banks to the RBI) is done through Reverse repo operations.
The working of repo and reverse repo operations under LAF is simple. Banks which have liquidity shortages, approach the RBI and gives government securities to it while obtaining loans. During the time of liquidity stringency, most of the commercial banks will be resorting to repo operations. On the other hand, during the time of excess liquidity, the commercial banks will be parking money with the RBI and thus will be earning an interest rate (at reverse repo rate).
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.
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. One such measure was the term repo. These instruments are the variable rate repo (auction), variable rate reverse repo (auction) and the term repo (auction). Uniqueness of these tools is that they are not used frequently and is used only when the RBI believe that there is a need to deploy them. These facilities work on the basis of auctions.
Variable repo or reverse repo including term 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.