Liquidity Adjustment Facility (LAF)
Liquidity Adjustment Facility
Liquidity Adjustment Facility is the primary instrument of Reserve Bank of India for modulating liquidity and transmitting interest rate signals to the market.
- The Committee for Banking Sector Reforms (Narsimham committee -II) , 1998 recommended that the RBI’s support to the market should be through a Liquidity Adjustment Facility (LAF) operated by way of repo and reverse repo providing a reasonable corridor to market players.
- An interim LAF was introduced in 1999 to provide a ceiling and the fixed rate repos were continued to provide a floor for money market rates.
- Liquidity Adjustment Facility was introduced for the first time from June 2000 onwards. Subsequent revisions were made in 2001 and 2004.
Under the scheme, repo auctions (for absorption of liquidity) and reverse repo auctions (for injection of liquidity) are conducted on a daily basis (except Saturdays). It is same-day transactions, with interest rates decided on a cut-off basis and derived from auctions on a uniform price basis.
The objective of the Liquidity adjustment facility (LAF) is to aid banks in adjusting the day to day mismatches in liquidity.The two components of LAF are repo rate and reverse repo rate. Under Repo, the 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. Since Banks can sell securities to RBI, Repo thus injects liquidity into the system. Under Reverse repo, RBI borrows money from banks by lending securities. Thus Reverse repo absorbs the liquidity from the system. Please note that ONLY Government securities are used for collateral under LAF as of now. Oil bonds have been also suggested to be included as collateral for Liquidity adjustment facility recently.
Please note that from May 2011 onwards, only repo rate is announced and Reverse Rate is linked to it. Reverse repo rate is 100 basis points below repo rate.
Marginal Standing Facility
Further, Marginal Standing Facility is a new window created by Reserve Bank of India in its credit policy released in the first week of May 2011. The objective of Marginal Standing Facility is to "contain volatility in the overnight inter-bank rates". The rate of interest on this facility is above 100 bps above the Repo Rate. The banks can borrow up to 1 percent of their net demand and time liabilities (NDTL) from this facility. This means that Difference between Repo Rate and MSF is 200 Basis Points. So, Repo rate will be in the middle, the Reverse Repo Rate will be 100 basis points below it, and the MSF rate 100 bps above it.