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What Is A Liquidity Adjustment Facility?

A liquidity adjustment facility (LAF) is a monetary policy tool primarily used by the Reserve Bank of India (RBI) to manage liquidity and provide economic stability. Through a LAF, banks can borrow money from the RBI through repurchase (repo) agreements or lend money to the RBI through reverse repo agreements. The RBI introduced the LAF in 1998 based on recommendations from the Narasimham Committee on Banking Sector Reforms. A LAF allows banks to resolve short-term cash shortages by using government securities as collateral for repo loans from the RBI. It also enables the RBI to manage inflation by increasing or decreasing the money supply through adjusting the repo rate.

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54 views

What Is A Liquidity Adjustment Facility?

A liquidity adjustment facility (LAF) is a monetary policy tool primarily used by the Reserve Bank of India (RBI) to manage liquidity and provide economic stability. Through a LAF, banks can borrow money from the RBI through repurchase (repo) agreements or lend money to the RBI through reverse repo agreements. The RBI introduced the LAF in 1998 based on recommendations from the Narasimham Committee on Banking Sector Reforms. A LAF allows banks to resolve short-term cash shortages by using government securities as collateral for repo loans from the RBI. It also enables the RBI to manage inflation by increasing or decreasing the money supply through adjusting the repo rate.

Uploaded by

Shiva Mehta
Copyright
© © All Rights Reserved
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Download as DOCX, PDF, TXT or read online on Scribd
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What is a Liquidity Adjustment Facility?

A liquidity adjustment facility (LAF) is a tool used in monetary policy, primarily


by the Reserve Bank of India (RBI), that allows banks to borrow money
through repurchase agreements (repos) or for banks to make loans to the RBI
through reverse repo agreements. This arrangement
manages liquidity pressures and assures basic stability in the financial
markets. In the United States, the Federal Reserve transacts repos and
reverse repos under its open market operations.

The RBI introduced the LAF as a result of the Narasimham Committee on


Banking Sector Reforms (1998). 

Basics of a Liquidity Adjustment Facility


Liquidity adjustment facilities are used to aid banks in resolving any short-term
cash shortages during periods of economic instability or from any other form
of stress caused by forces beyond their control. Various banks use eligible
securities as collateral through a repo agreement and use the funds to
alleviate their short-term requirements, thus remaining stable.

The facilities are implemented on a day-to-day basis as banks and other


financial institutions ensure they have enough capital in the overnight market.
The transacting of liquidity adjustment facilities takes place via an auction at a
set time of the day. An entity wishing to raise capital to fulfill a shortfall
engages in repo agreements, while one with excess capital does the opposite
– executes a reverse repo. 

Liquidity Adjustment Facility and the Economy


The RBI can use the liquidity adjustment facility to manage high levels
of inflation. It does so by increasing the repo rate, which raises the cost of
servicing debt. This, in turn, reduces investment and money supply in India’s
economy.

Conversely, if the RBI is trying to stimulate the economy after a period of slow
economic growth, it can lower the repo rate to encourage businesses to
borrow, thus increasing the money supply. For example, analysts expect that
RBI is likely to cut the repo rate by 25 basis points in April 2019 due to weak
economic activity, benign inflation, and slower global growth. However,
analysts expect repo rates to resume rising in 2020 as growth accelerates and
inflation picks up.

KEY TAKEAWAYS

 A LAF is a monetary policy tool, primarily used by the RBI, to manage


liquidity and provide economic stability.
 LAF’s include both repos and reverse repo agreements.
 The RBI introduced a LAF as a result of the Narasimham Committee on
Banking Sector Reforms (1998). 
 LAF’s can manage inflation by increasing and reducing the money
supply.
Real World Example of a Liquidity Adjustment Facility
Let’s assume a bank has a short-term cash shortage due to
a recession gripping the Indian economy. The bank would use the RBI's
liquidity adjustment facility by executing a repo agreement by
selling government securities to the RBI in return for a loan with an agreement
to repurchase those securities back. For example, say the bank needs a one-
day loan for 50,000,000 Indian rupees and executes a repo agreement at
6.25%. The bank's payable interest on the loan is ₹8,561.64 (₹50,000,000 x
6.25% / 365).

Now let’s suppose the economy is expanding and a bank has excess cash on
hand. In this case, the bank would execute a reverse repo agreement by
making a loan to the RBI in exchange for government securities, in which it
agrees to repurchase those securities back. For example, the bank may have
₹25,000,000 available to loan the RBI and decides to execute a one-day
reverse repo agreement at 6%. The bank would receive ₹4109.59 in interest
from the RBI (₹25,000,000 x 6% / 365).

WHAT IS THE CREDIT CHANNEL OF MONETARY POLICY TRANSMISSION?

Monetary policy works in part by altering credit flows. The use of legal reserve requirements
provide monetary authorities with considerable leverage over the quantity of funds that banks
may maintain, just as open market sales reduces the real quantity of deposits banks can issue.
This in turn induces banks to contract or expand lending which ultimately constrain or
increase the spending capacity of borrowers. In addition to affecting short term interest rates,
monetary policy affects aggregate demand by affecting the availability or terms of new credit.
The credit channel of monetary policy generates direct impact on aggregate demand and
output and this is supported by certain fundamental assumptions. The underlying premise is
that bank loans are an important source of funds for business activity, and that there is no
perfect substitute for this kind of credit such as certificates of deposit or commercial papers
or other sources of funds. Second, the central bank in practical terms is in a position to
constrain bank’s ability to lend, and finally, there exists bank dependent businesses that are
unable to substitute credit from other financing sources. If these conditions exit, it is assumed
that banks cannot just reduce commercial papers in order to keep the supply of loans at the
level prior to the tightening or expansion signals in monetary policy; and businesses are
unable to offset at no extra costs a decline in loan supply by issuing more papers, or effecting
any substitution. Thus, the credit channel presupposes that banks play an important role in the
financial system. The credit channel at a glance is presented below:

Contractionary Monetary Policy


ÆSupply of Bank Loans (Reduce)ÆInvestment (Reduce)ÆEmployment (Reduce)ÆOutput
(Reduce)

Expansionist Monetary Policy


ÆSupply of Bank Loans (Increase)ÆInvestment (Increase)Æ Employment
(Increase)ÆOutput (Increase)

In economics, potential output (also referred to as "natural gross domestic


product") refers to the highest level of real gross domestic product (potential
output) that can be sustained over the long term.

MPC and Economic Policy


Given data on household income and household spending, economists can
calculate households’ MPC by income level. This calculation is important
because MPC is not constant; it varies by income level. Typically, the higher
the income, the lower the MPC because as income increases more of a
person's wants and needs become satisfied; as a result, they save more
instead. At low-income levels, MPC tends to be much higher as most or all of
the person's income must be devoted to subsistence consumption.

According to Keynesian theory, an increase in investment or government


spending increases consumers’ income, and they will then spend more. If we
know what their marginal propensity to consume is, then we can calculate how
much an increase in production will affect spending. This additional spending
will generate additional production, creating a continuous cycle via a process
known as the Keynesian multiplier. The larger the proportion of the additional
income that gets devoted to spending rather than saving, the greater the
effect. The higher the MPC, the higher the multiplier—the more the increase in
consumption from the increase in investment; so, if economists can estimate
the MPC, then they can use it to estimate the total impact of a prospective
increase in incomes.

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