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Liquidity Adjustment Facility (LAF)

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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. Basically LAF enables liquidity management on a day to day basis.

Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements or repos. LAF is used to aid banks in adjusting the day to day mismatches in liquidity (frictional liquidity deficit/surplus). Liquidity of a more durable nature are managed with other instruments like, cash reserve ratio (CRR) or Market Stabilization Scheme (MSS).

The operations of LAF are conducted by way of repurchase agreements (repos and reverse repos) with RBI being the counter-party to all the transactions. Repo or repurchase option is a collaterised lending i.e. banks borrow money from Reserve bank of India to meet short term needs by selling securities to RBI with an agreement to repurchase the same at predetermined rate and date. The rate charged by RBI for this transaction is called the repo rate. Repo operations therefore inject liquidity into the system. Reverse repo operation is when RBI borrows money from banks by lending securities. The interest rate paid by RBI is in this case is called the reverse repo rate. Reverse repo operation therefore absorbs the liquidity in the system.

The collateral used for repo and reverse repo operations comprise of primarily Government of India securities. In fact, Reverse Repos and Repos can be undertaken in all SLR-eligible transferable Government of India dated Securities/Treasury Bills. Oil bonds have been also suggested to be included as collateral for Liquidity adjustment facility.

Through LAF, banks are permitted to borrow only a certain percentage of its Net Demand and Time Liabilities (NDTL).In case the Bank requires more funds, beyond what is permissible under LAF, it can access another window called Marginal Standing Facility (MSF)

In the LAF for overnight drawings, both the reverse repo and repo operations are conducted at a fixed rate. These rates are changed only through the announcements made during the Monetary Policy Statements of the RBI.

Since 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 for banks (scheduled commercial banks other than RRBs) in addition to the existing daily LAF (repo and reverse repo) and MSF. The aim of term repo is to help develop inter-bank money market, which in turn can set market based benchmarks for pricing of loans and deposits, and through that improve transmission of monetary policy. Thus, at present, the objective of meeting short term liquidity needs is being accomplished through the provision of liquidity by the Reserve Bank under its regular facilities - variable rate 14-day/7-day repo auctions equivalent to 0.75 per cent of banking system NDTL, supplemented by daily overnight fixed rate repos (at the repo rate) equivalent to 0.25 per cent of bank-wise NDTL.Frictional and seasonal mismatches that move the system away from normal liquidity provision are addressed through fine-tuning operations, including variable rate repo/reverse repo auctions of varying tenors.

LAF is conducted at a fixed time on a daily basis on all working days in Mumbai (excluding Saturdays). While the LAF Repo operations are conducted in the forenoon between 9.30 A.M. and 10.30 A.M., the LAF Reverse Repo operations are conducted in the afternoon between 4.45 pm and 5.15 pm (earlier it used to be held at 4.30 P.M. to 5.00 P.M. uptill July 2012, along with the Marginal Standing Facility; However, MSF window now operates from 7.00 PM to 7.30 PM). Also an additional Repo under LAF (Second LAF Repo) is being conducted on reporting Fridays, with effect from February 10, 2012. This is also conducted between 4.45 pm and 5.15 pm. At times, RBI conducts Special Repo window facility for a notified amount for specific periods to meet emergency situations. (For eg. in July 2013 a special window for an amount of Rs. 25,000 crore was opened with a view to enabling banks to meet the liquidity requirement of mutual funds)

While the 14 day term repo of tenor would be conducted every reporting Friday, the 7 day term repo would be conducted on every non-reporting Friday. In case the notified amount for the 14-day term repo is not fully subscribed, a 7-day term repo would be conducted on the following Friday for the remaining un-subscribed amount. In case of full subscription in the 14-day term repo, there will be no 7 day term repo auction on the following Friday.

Liquidity adjustment facility has emerged as the principal operating instrument for modulating short term liquidity in the economy. Repo rate has become the key policy rate which signals the monetary policy stance of the economy.

With effect from November 28, 2014, Liquidity Adjustment Facility (LAF) is being extended to Scheduled Urban Cooperative Banks (UCBs) which are Core Banking System (CBS) enabled, have CRAR of at least 9 per cent and are fully compliant with the eligibility criteria prescribed for LAF.

The introduction of Liquidity adjustment facility in India was on the basis of the recommendations of Narsimham committee on banking sector reforms. In April 1999, an interim LAF was introduced to provide a ceiling and the fixed rate repos were continued to provide a floor for money market rates. As per the policy measures announced in 2000, the Liquidity Adjustment Facility was introduced with the first stage starting from June 2000 onwards. Subsequent revisions were made in 2001 and 2004. When the scheme was introduced, repo auctions were described for operations which absorbed liquidity from the system and reverse repo actions for operations which injected liquidity into the system. However in international nomenclature, repo and reverse repo implied the reverse. Hence in October 2004 when revised scheme of LAF was announced, the decision to follow the international usage of terms was adopted.

Repo and reverse repo rates were announced separately till the monetary policy statement in 3.5.2011. In this monetary policy statement, it has been decided that the reverse repo rate would not be announced separately but will be linked to repo rate. The reverse repo rate will be 100 basis points below repo rate. The liquidity adjustment facility corridor, that is the excess of repo rate over reverse repo, has varied between 100 to 300 basis points. The period between April 2001 to March 2004 and June 2008 to early November 2008 saw a broader corridor ranging from 150-250 and 200-300 basis points respectively. During March 2004 to June 2008 the corridor was narrow with the rates ranging from 100-175 basis points. A narrow LAF corridor is reflected from November 2008 onwards. At present the width of the corridor is 100 basis points. This corridor is used to contain any volatility in short term interest rates.

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