DEFINITION of Liquidity Adjustment Facility

A liquidity adjustment facility (LAF) is a tool used in monetary policy that allows banks to borrow money through repurchase agreements. This arrangement allows banks to respond to liquidity pressures and is used by governments to assure basic stability in the financial markets.

LAF includes both repos and reverse repo agreements.

BREAKING DOWN 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 will use eligible securities as collateral through a repo agreement and will 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 are conducted via auction at a set time of the day. An entity wishing to raise capital to fulfill a shortfall will engage in repo agreements and one with excess capital will do the opposite; a reverse repo. 

The spread between repos and reverse repos has been as high as 300 basis points during the financial crisis. However, in the years following the crisis the spread has been set at 50 basis points to alleviate any excess volatility in short-term interest rates. A with most financial instruments, the wider the spread the higher the potential volatility. 

The principle behind a liquidity adjustment facility can be traced back to the early 20th century when the introduction of wartime taxes made other sources of lending less attractive.