What is a Liquidity Adjustment Facility?

A liquidity adjustment facility (LAF) is a tool used in monetary policy, primarily by the Reserve Bank of India (RBI), that allows banks to borrow money through repurchase agreements (repos) or for banks to make loans to the RBI through reverse repo agreements. This arrangement manages liquidity pressures and assures basic stability in the financial markets. In the United States, the Federal Reserve transacts repos and reverse repos under its open market operations.

The RBI introduced the LAF as a result of the Narasimham Committee on Banking Sector Reforms (1998). 

Basics of a Liquidity Adjustment Facility

Liquidity adjustment facilities are used to aid banks in resolving any short-term cash shortages during periods of economic instability or from any other form of stress caused by forces beyond their control. Various banks use eligible securities as collateral through a repo agreement and use the funds to alleviate their short-term requirements, thus remaining stable.

The facilities are implemented on a day-to-day basis as banks and other financial institutions ensure they have enough capital in the overnight market. The transacting of liquidity adjustment facilities takes place via an auction at a set time of the day. An entity wishing to raise capital to fulfill a shortfall engages in repo agreements, while one with excess capital does the opposite – executes a reverse repo. 

Liquidity Adjustment Facility and the Economy

The RBI can use the liquidity adjustment facility to manage high levels of inflation. It does so by increasing the repo rate, which raises the cost of servicing debt. This, in turn, reduces investment and money supply in India’s economy.

Conversely, if the RBI is trying to stimulate the economy after a period of slow economic growth, it can lower the repo rate to encourage businesses to borrow, thus increasing the money supply. For example, analysts expect that RBI is likely to cut the repo rate by 25 basis points in April 2019 due to weak economic activity, benign inflation, and slower global growth. However, analysts expect repo rates to resume rising in 2020 as growth accelerates and inflation picks up.

Key Takeaways

  • A LAF is a monetary policy tool, primarily used by the RBI, to manage liquidity and provide economic stability.
  • LAF’s include both repos and reverse repo agreements.
  • The RBI introduced a LAF as a result of the Narasimham Committee on Banking Sector Reforms (1998). 
  • LAF’s can manage inflation by increasing and reducing the money supply.

Real World Example of a Liquidity Adjustment Facility

Let’s assume a bank has a short-term cash shortage due to a recession gripping the Indian economy. The bank would use the RBI's liquidity adjustment facility by executing a repo agreement by selling government securities to the RBI in return for a loan with an agreement to repurchase those securities back. For example, say the bank needs a one-day loan for 50,000,000 Indian rupees and executes a repo agreement at 6.25%. The bank's payable interest on the loan is ₹8,561.64 (₹50,000,000 x 6.25% / 365).

Now let’s suppose the economy is expanding and a bank has excess cash on hand. In this case, the bank would execute a reverse repo agreement by making a loan to the RBI in exchange for government securities, in which it agrees to repurchase those securities back. For example, the bank may have ₹25,000,000 available to loan the RBI and decides to execute a one-day reverse repo agreement at 6%. The bank would receive ₹4109.59 in interest from the RBI (₹25,000,000 x 6% / 365).