Liquidity Adjustment Facility
What Is a Liquidity Adjustment Facility?
A liquidity adjustment facility (LAF) is a device utilized in monetary policy, principally by the Reserve Bank of India (RBI) that permits banks to borrow money through repurchase agreements (repos) or to make loans to the RBI through reverse repo agreements. This arrangement is effective in overseeing liquidity pressures and guaranteeing fundamental stability in the financial markets. In the United States, the Federal Reserve executes repos and reverse repos under its open market operations.
The RBI presented the LAF because of the Narasimham Committee on Banking Sector Reforms (1998).
Rudiments of a Liquidity Adjustment Facility
Liquidity adjustment facilities are utilized to aid banks in settling any short-term cash shortages during periods of economic instability or from some other form of stress brought about by powers unchangeable as far as they might be concerned. Different banks utilize eligible securities as collateral through a repo agreement and utilize the funds to ease their short-term requirements, in this way staying stable.
The facilities are executed on an everyday basis as banks and other financial institutions guarantee they have sufficient capital in the overnight market. The executing of liquidity adjustment facilities happens through a auction at a set time. An entity wishing to raise capital to satisfy a shortfall takes part in repo agreements, while one with excess capital does the inverse, and executes a reverse repo.
Liquidity Adjustment Facility and the Economy
The RBI can utilize the liquidity adjustment facility to oversee high levels of inflation. It does as such by expanding the repo rate, which raises the cost of servicing debt. This, thusly, diminishes investment and money supply in India's economy.
On the other hand, in the event that the RBI is attempting to invigorate the economy after a period of slow economic growth, it can bring down the repo rate to urge organizations to borrow, hence expanding the money supply. As of late, the RBI cut the repo rate by 40 basis points in May 2020 to 4.00% from 4.40% already, due to weak economic activity, harmless inflation, and more slow global growth. Simultaneously, the reverse repo rate was cut to 3.35% from 3.75%, likewise a decline of 40 basis points.
Liquidity Adjustment Facility Example
We should expect a bank has a short-term cash shortage due to a recession holding the Indian economy. The bank would utilize 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 instance, 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 \u20b98,561.64 (\u20b950,000,000 x 6.25%/365).
Presently we should assume the economy is extending and a bank has excess cash close by. 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 consents to repurchase those securities. For instance, the bank might have \u20b925,000,000 accessible to loan the RBI and chooses to execute a one-day reverse repo agreement at 6%. The bank would receive \u20b94109.59 in interest from the RBI (\u20b925,000,000 x 6%/365).
Highlights
- A liquidity adjustment facility (LAF) is a monetary policy device utilized in India by the Reserve Bank of India or RBI.
- LAF's assist the RBI with overseeing liquidity and give economic stability by offering banks the opportunity to borrow money through repurchase agreements or repos or to make loans to the RBI by means of reverse repo agreements.
- The RBI presented the LAF as part of the outcome of the Narasimham Committee on Banking Sector Reforms of 1998.
- LAF's can oversee inflation in the economy by expanding and diminishing the money supply.
