Liquidity Adjustment Facility

Reviewed by Komal | Updated on Aug 27, 2020

What is Liquidity Adjustment Facility?

A liquidity adjustment facility (LAF) is a tool used in monetary policy, mainly by the Reserve Bank of India (RBI), which enables banks to borrow money through repurchase agreements (reposals) or banks to lend to the RBI using reverse repo contracts.

This arrangement manages liquidity pressures and ensures basic financial-market stability. The Reserve Bank of India transacts repositories and reverse repos within its open market operations in India.

Basic of a Liquidity Adjustment Facility

Facilities for liquidity adjustment are used to help banks overcome any short-term cash shortages during periods of economic uncertainty or any other stress caused by circumstances beyond their control. Different banks use eligible securities as collateral through a repo agreement and utilize the funds to ease their short-term requirements, thus remaining constant.

The facilities are introduced on a daily basis as banks and other financial institutions make sure they have sufficient capital on the overnight market.

The transaction of liquidity adjustment facilities takes place at a set time of the day, through an auction. A company that wants to raise capital to accomplish a shortfall is engaged in repo agreements, while one with excess capital is doing the opposite – executing a reverse repo agreement.

Liquidity Adjustment Facility and the Economy

The RBI may use the facility for adjusting liquidity to manage high levels of inflation. It does this by raising the repo rate, which increases the cost of debt servicing. This, in turn, reduces the supply of investment and money within the economy of India.

Alternatively, if the RBI tries to boost the economy after a period of slow economic growth, the repo rate can be lowered to encourage businesses to borrow, thus increasing the supply of money.

For instance, analysts predict RBI to cut the repo rate in April 2019 by 25 basis points due to weak economic activity, low inflation, and slower global growth. However, as growth accelerates and inflation picks up, analysts expect repo rates to resume rising by 2020.