What is Liquidity Adjustment Facility (LAF)?
Liquidity Adjustment Facility (LAF) is a monetary policy tool used by the Reserve Bank of India (RBI) to regulate liquidity and short-term interest rates in the financial system. It allows banks to:
- Borrow funds from the RBI through repo agreements.
- Lend excess funds to the RBI using reverse repo agreements.
This system helps manage liquidity fluctuations, ensuring financial market stability and smooth operations within the banking sector.
How Liquidity Adjustment Facility Works
LAF helps banks manage short-term cash shortages, especially during times of financial stress. Here’s how it works:
- Banks offer eligible securities as collateral and get short term funds through a repo agreement.
- Banks with surplus funds park excess funds with RBI through a reverse repo agreement.
- RBI conducts auctions daily at a predetermined time to facilitate LAF transactions.
These transactions impact liquidity in the system and overall credit and interest rates.
Impact of LAF on the Economy
RBI uses LAF as a tool to control inflation and economic growth:
- During high inflation:
- RBI raises the repo rate making borrowing expensive.
- Higher borrowing costs reduces credit flow and controls inflation.
- During economic slowdown:
- RBI lowers the repo rate making borrowing cheaper.
- This encourages businesses to take loans and invest, boosts economic activity.
For example, in April 2019, analysts predicted RBI would cut the repo rate by 25 bps to counter slowdown, low inflation and weak global growth. But as growth picked up, repo rates were expected to rise again by 2020.
Key Takeaways
Liquidity Adjustment Facility is an essential mechanism for monetary policy implementation in India. It helps the RBI maintain liquidity balance, control inflation, and support economic growth by adjusting short-term interest rates.
