Liquidity Adjustment Facility

Recently, the Reserve Bank of India (RBI) has decided to extend liquidity adjustment facility (LAF) to Regional Rural Banks (RRB) to make liquidity management more efficient. The LAF was introduced in RBI in 1998 based on the recommendations of Narasimham Committee on Banking Sector Reforms. It is a monetary policy tool that enables banks to resolve temporary cash shortages through repurchase agreements or repos. It can also make loans to RBI through reverse-repos to raise cash.

What are the other tools used by RBI to control liquidity?

RBI uses four tools to control the flow of liquidity in the country. They are Cash Reserve Ratio (CRR), Liquidity Adjustment Facilities (includes repo rate and reverse repo rate), Statutory Liquidity Ratio and Open Market Operations.

What are the two main components of Liquidity Adjustment Facility?

The two main components of the Liquidity Adjustment Facility are Repo rate and Reverse Repo Rate. Repo rate is the rate at which the banks borrow money from the Reserve Bank of India. While borrowing the money, the banks will put the Government Securities as collateral. The Reverse Repo rate is the rate at which the RBI borrows money from the banks. The Reverse Repo helps to absorb the liquidity from the system.

Narasimham Committee

The Narasimham Committee basically recommended changes in the working of banking and financial systems. The committee made the following recommendations

  • To reduce the higher proportion of Cash Reserve Ratio and Statutory Liquidity Ratio.
  • The committee recommended to reduce the number of public sector banks and develop three to four big banks in the country to international bank.
  • It recommended the establishment of Asset Reconstruction Fund. This is to help banks get rid of their bad debts.
  • To set up new agency to set up supervise financial institutions such as mutual funds, merchant banks, leasing companies, factor companies, etc.

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