LIQUIDITY ADJUSTMENT FACILITY

Liquidity Adjustment Facility(LAF)

• A central bank is a ‘bankers’ bank.’ It provides liquidity to banks when the latter face shortage of liquidity. This facility is provided by the Central Bank through its discount window. The scheduled commercial banks can borrow from the discount window against the collateral of securities like commercial bills, government securities, treasury bills, or other eligible papers. This type of support earlier took the form of refinance of loans given by commercial banks to various sectors (e.g. Exports, agriculture etc).
•  By varying the terms and conditions of refinance, the RBI could employ the sector-specific refinance facilities as an instrument of credit policy to encourage /discourage lending to particular sectors. In line with the financial sector reforms, the system of sector-specific refinance schemes (except export credit refinance scheme) was withdrawn. From June 2000, the RBI has introduced Liquidity Adjustment Facility (LAF).
• The Liquidity Adjustment Facility(LAF) is a facility extended by the Reserve Bank of India to the scheduled commercial banks (excluding RRBs) and primary dealers to avail of liquidity in case of requirement (or park excess funds with the RBI in case of excess liquidity) on an overnight basis against the collateral of government securities including state government securities. 
• The introduction of LAF is an important landmark since it triggered a rapid transformation in the monetary policy operating environment in India. As a key element in the operating framework of the RBI, its objective is to assist banks to adjust their day to day mismatches in liquidity. Currently, the RBI provides financial accommodation to the commercial banks through repos/reverse repos under the Liquidity Adjustment Facility (LAF). 
• Repurchase Options or in short ‘Repo’, is defined as ‘an instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed’. In other words, repo is a money market instrument, which enables collateralised short term borrowing and lending through sale/purchase operations in debt instruments. 
• The Repo transaction in India has two elements: - in the first, the seller sells securities and receives cash while the purchaser buys securities and parts with cash. In the second, the securities are repurchased by the original holder. The user pays to the counter party the amount originally received, plus the return on the money for the number of days for which the money was used, which is mutually agreed. All these transactions are reported on the electronic platform called the Negotiated Dealing System (NDS).
•  The Clearing Corporation of India Ltd. (CCIL) has put in an anonymous online repo dealing system in India, with an anonymous order matching electronic platform. Repo or repurchase option is a collaterised lending. The rate charged by RBI for this transaction is called the ‘repo rate’. Repo operations thus inject liquidity into the system.

The policy rate *
You might have read in business dailies about the ‘policy rate’. In India, the fixed repo rate quoted for sovereign securities in the overnight segment of Liquidity Adjustment Facility (LAF) is considered as the policy rate. (It may be noted that India has many other repo rates in operation). The RBI uses the single independent ‘policy rate’ which is the repo rate (in the LAF window) for balancing liquidity. The policy rate is in fact, the key lending rate of the central bank in a country. A change in the policy rate gets transmitted through the money market to the entire the financial system and alters all other short term interest rates in the economy, thereby influencing aggregate demand – a key determinant of the level of inflation and economic growth. If the RBI wants to make it more expensive for banks to borrow money, it increases the repo rate. Similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate. In other words, an increase in the repo rate will lead to liquidity tightening and vice-versa, other things remaining constant.

As per the Second Bi-Monthly Monetary Policy Statement 2017-18 of the RBI on June 7th 2017, the Monetary Policy committee (MPC) has decided to keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.25 per cent, the reserve repo rate at 6.00 per cent and the Marginal Standing Facility (MSF) rate and the Bank rate at 6.50 per cent.

* Learners are requested to refer the RBI website (www.rbi.org.in) for up- to- date information on the prevailing policy rates.

‘Reverse Repo’ is defined as an instrument for lending funds by purchasing securities with an agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds lent . Reverse repo operation takes place when RBI borrows money from banks by giving them securities. The securities transacted here can be either government securities or corporate securities or any other securities which the RBI permits for transaction. The interest rate paid by RBI for such transactions is called the ‘reverse repo rate’. Reverse repo operation in effect absorbs the liquidity in the system. The collaterals used for repo and reverse repo operations consist of primarily Government of India securities i.e. all SLR-eligible transferable Government of India dated securities/treasury bills.

The ‘repo rate’ and the reverse repo rate’ are changed only through the announcements made during the Monetary Policy Statements of the RBI. From May, 2011 onwards, the reverse repo rate is not announced separately, it will belinked to repo rate. The Reserve Bank also conducts variable interest rate reverse repo auctions, as necessitated under the market conditions.

There are three types of repo markets operating in India namely:

(i) Repo on sovereign securities

(ii) Repo on corporate debt securities ,and

(iii) Other Repos

In addition to the existing overnight LAF (repo and reverse repo) and MSF, from October 2013, the Reserve Bank has introduced ‘Term Repo’ (repos of duration more than a day) under the Liquidity Adjustment Facility (LAF) for 14 days and 7 days tenors. LAF is conducted at a fixed time on a daily basis on all working days in Mumbai (excluding Saturdays).