Liquidity Adjustment Facility
LAF is a facility extended by the Reserve Bank of India to the scheduled commercial banks (excluding RRBs) and primary dealers to avail of liquidity in case of requirement or park excess funds with the RBI in case of excess liquidity on an overnight basis against the collateral of Government securities including State Government securities. Basically LAF enables liquidity management on a day to day basis.
Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements or repos. LAF is used to aid banks in adjusting the day to day mismatches in liquidity. Liquidity of a more durable nature are managed with other instruments like, cash reserve ratio (CRR) or Market Stabilization Scheme (MSS).
The operations of LAF are conducted by way of repurchase agreements (repos and reverse repos) with RBI being the counter-party to all the transactions. Repo or repurchase option is a collaterised lending i.e. 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. The rate charged by RBI for this transaction is called the repo rate. Repo operations therefore inject liquidity into the system.
Reverse repo operation is when RBI borrows money from banks by lending securities. The interest rate paid by RBI is in this case is called the reverse repo rate. Reverse repo operation therefore absorbs the liquidity in the system.
The collateral used for repo and reverse repo operations comprise of primarily Government of India securities.
Through LAF, banks are permitted to borrow only a certain percentage of its Net Demand and Time Liabilities (NDTL).In case the Bank requires more funds, beyond what is permissible under LAF, it can access another window called Marginal Standing Facility (MSF).
Note: The introduction of Liquidity adjustment facility in India was on the basis of the recommendations of Narsimham committee on banking sector reforms.