What is Liquidity Adjustment Facility (LAF) ?
A Liquidity Adjustment Facility (LAF) is a tool used by central banks to manage money flow in the economy. Introduced by the Reserve Bank of India as a result of Narasimham Committee on Banking Sector Reforms in 1998, LAF lets banks either borrow money from the RBI through short-term repurchase agreements (repos) or lend money to the RBI through reverse repos. This further helps the financial system to remain stable and resolve any liquidity issues.
Role of Liquidity Adjustment Facility in Economy
- Managing Short-Term Liquidity
- Helps banks manage short-term cash shortages or surpluses, especially during economic stress or instability.
- Stabilizing Interest Rates
- By adjusting the supply of money, LAF helps control short-term interest rates, which can influence broader economic conditions.
- Ensuring Financial Stability
- Provides a safety measure for banks during periods of economic stress, preventing disruptions in the financial markets.
- Banks use eligible securities as collateral in repo agreements to obtain funds
- Supporting Monetary Policy
- Complements overall monetary policy goals by helping central banks implement interest rate targets and manage inflation.
Components of Liquidity Adjustment Facility
The Liquidity Adjustment Facility (LAF) typically consists of two main components:
Repo (Repurchase Agreement):
- Allows banks to borrow funds from RBI by selling securities with an agreement to repurchase them at a later date.
- Banks provide eligible securities as collateral for the loan.
- The central bank charges an interest rate (repo rate) for the funds borrowed.
Reverse Repo:
- Enables banks to lend surplus funds to the central bank by purchasing securities from it with an agreement to sell them back later.
- The central bank pays an interest rate (reverse repo rate) on the funds deposited.
