Liquidity Adjustment Facility (LAF) is
a monetary policy tool used by the Reserve Bank of India (RBI) to manage
short-term liquidity in the banking system. It consists of two components: the
repo rate and the reverse repo rate. Let's understand how LAF works in
real-time:
Repo
Rate:
The repo rate is the rate at which the
RBI lends money to commercial banks. When banks face a shortage of funds, they
can borrow from the RBI through repurchase agreements (repos) by pledging
government securities as collateral. Here's how the process works:
a.
Liquidity Shortage:
If banks need funds to meet their short-term liquidity requirements, they can
approach the RBI and submit eligible securities as collateral.
b.
Repo Auctions:
The RBI conducts repo auctions, where banks bid for funds by specifying the
amount they want to borrow and the interest rate they are willing to pay.
c.
Lending Funds:
Based on the bids received, the RBI determines the cut-off rate and allocates
funds to the banks accordingly. The allocated funds are transferred to the banks'
accounts, and the collateralized securities remain with the RBI.
d.
Repayment:
The borrowing banks are obligated to repurchase the securities from the RBI at
a future date (usually the next working day) at a pre-determined price, which
includes the principal amount and interest.
e.
Liquidity Impact:
By adjusting the repo rate, the RBI influences the cost of borrowing for banks,
thereby affecting the overall liquidity in the banking system. A lower repo
rate encourages borrowing and increases liquidity, while a higher repo rate
discourages borrowing and reduces liquidity.
Reverse
Repo Rate:
The reverse repo rate is the rate at
which the RBI borrows funds from commercial banks. It serves as a tool for
absorbing excess liquidity from the banking system. The process of reverse repo
operations is as follows:
a.
Liquidity Surplus:
If there is excess liquidity in the banking system, commercial banks can
deposit their surplus funds with the RBI through reverse repurchase agreements
(reverse repos).
Detailed LAF Flowchart
b.
Reverse Repo Auctions:
The RBI conducts reverse repo auctions, where banks submit bids specifying the
amount they want to lend to the RBI and the interest rate they expect to
receive.
c.
Absorbing Funds:
Based on the bids received, the RBI determines the cut-off rate and accepts
funds from banks at that rate. The surplus funds are transferred from the
banks' accounts to the RBI.
d.
Repurchase:
At a future date (usually the next working day), the RBI repurchases the
securities from the banks at a pre-determined price, which includes the
principal amount and interest.
e.
Liquidity Impact:
By adjusting the reverse repo rate, the RBI controls the interest rate banks
earn on their surplus funds. A higher reverse repo rate incentivizes banks to
deposit more funds with the RBI, reducing liquidity in the banking system.
Conversely, a lower reverse repo rate discourages banks from parking excess
funds with the RBI, thereby increasing liquidity.
The RBI uses LAF operations on a daily
basis to manage liquidity conditions in the banking system. By adjusting the
repo rate and reverse repo rate, the RBI aims to maintain price stability and
control inflation while ensuring adequate liquidity for economic growth.
