Table of Contents
- What Is a Liquidity Adjustment Facility?
- Key Takeaways on Liquidity Adjustment Facilities
- Basics of a Liquidity Adjustment Facility
- Liquidity Adjustment Facility and the Economy
- Liquidity Adjustment Facility Examples
- Why Was the LAF Introduced?
- How Do Repo and Reverse Repo Operations Work in LAF?
- What Is the Purpose of the Repo Rate?
- The Bottom Line
What Is a Liquidity Adjustment Facility?
Let me explain what a liquidity adjustment facility, or LAF, really is. It's a monetary policy tool that the Reserve Bank of India uses to let banks borrow money through repurchase agreements, known as repos, or lend money to the RBI via reverse repo agreements. This setup helps handle liquidity issues and keeps the financial markets stable. You should know that in places like the United States, the Federal Reserve does something similar with repos and reverse repos as part of open market operations.
The RBI brought in the LAF after the Narasimham Committee on Banking Sector Reforms in 1998. That's the foundation of it.
Key Takeaways on Liquidity Adjustment Facilities
Here's what you need to grasp: A liquidity adjustment facility is the RBI's way of managing liquidity and promoting economic stability. It gives banks options to borrow via repos or lend through reverse repos. This tool also plays a role in controlling inflation by tweaking the money supply.
Basics of a Liquidity Adjustment Facility
You deal with liquidity adjustment facilities when banks face short-term cash shortages, maybe from economic instability or other external stresses. Banks put up eligible securities as collateral in a repo agreement to get the funds they need and stay operational.
These facilities run daily, as banks and financial institutions check their capital in the overnight market. Transactions happen through auctions at specific times. If you're a bank needing cash for a shortfall, you go for a repo; if you have extra, you opt for a reverse repo.
Liquidity Adjustment Facility and the Economy
The RBI uses the LAF to tackle high inflation by raising the repo rate, which makes debt more expensive and cuts down on investment and money supply in India's economy.
On the flip side, to boost the economy during slow growth, the RBI lowers the repo rate, encouraging businesses to borrow and increasing the money supply. Take May 2022, when the RBI hiked the repo rate by 40 basis points to 4.40% from 4.00%. Or in 2020, when they cut the reverse repo rate to 3.35% from 3.75%. As of May 2025, the repo rate stands at 6.00%.
Liquidity Adjustment Facility Examples
Suppose a bank hits a short-term cash crunch because of a recession in India. It would turn to the RBI's LAF and do a repo agreement, selling government securities for a loan and agreeing to buy them back. For instance, if the bank needs a one-day loan of 50,000,000 Indian rupees at 6.25%, the interest payable is ₹8,561.64, calculated as ₹50,000,000 times 6.25% divided by 365.
Now, imagine the economy is growing, and a bank has extra cash. It would do a reverse repo, lending to the RBI in exchange for securities with a repurchase agreement. Say the bank lends ₹25,000,000 for one day at 6%; it earns ₹4,109.59 in interest from the RBI, figured as ₹25,000,000 times 6% divided by 365.
Why Was the LAF Introduced?
The RBI introduced the LAF based on the Narasimham Committee's 1998 recommendations. The main aim was to give banks a way to handle short-term liquidity mismatches.
How Do Repo and Reverse Repo Operations Work in LAF?
In a repo, banks borrow from the RBI by selling securities and agreeing to repurchase them, which adds liquidity to the system. In a reverse repo, banks lend to the RBI by buying securities, absorbing excess liquidity.
What Is the Purpose of the Repo Rate?
The repo rate is the rate at which the RBI lends to banks under the LAF. By adjusting it, the RBI affects bank borrowing costs, which in turn influences the money supply and inflation.
The Bottom Line
To wrap this up, the liquidity adjustment facility is how the RBI controls short-term liquidity in the banking system using repurchase and reverse repurchase agreements. It came about after the Narasimham Committee's suggestions and lets banks deal with temporary cash flows. Through changes in repo and reverse repo rates, the RBI directs credit, money supply, and inflation in the economy.
Other articles for you
Series I Bonds are U.S
Activist investors acquire minority stakes in public companies to influence management and drive changes for better performance or value.
A zero-investment portfolio is a theoretical investment strategy with a net value of zero, balancing long and short positions without requiring equity.
An inherited IRA is a retirement account passed to a beneficiary after the original owner's death, with specific rules for distributions and taxes varying by relationship to the deceased.
The sustainable growth rate (SGR) is the maximum growth a company can achieve using internal resources without additional debt or equity.
Net Foreign Factor Income (NFFI) is the difference between a nation's GNP and GDP, capturing net earnings from abroad.
The Markets in Financial Instruments Directive (MiFID) is an EU regulation aimed at boosting transparency and standardizing disclosures in financial markets, later updated to MiFID II.
Gross dividends represent the total dividends an investor receives before any taxes or fees are deducted, including ordinary dividends, capital gains, and non-taxable distributions.
Preferred stock is a type of equity that offers priority in dividends and assets over common stock but typically lacks voting rights.
Greenmail involves buying shares to threaten a takeover, prompting the company to repurchase them at a premium to avoid it.