LAF (Liquidity Adjustment Facility), Repo and Reverse Repo26th January 2021
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.
The Liquidity Adjustment Facility or LAF is the principal operating monetary policy tool that allows banks to borrow money through repurchase agreements. This means, in order to meet short-term cash needs, bank, borrow money against government approved securities with an agreement to repurchase the same at a predetermined rate and date.
The liquidity adjustment facility is used to aide banks in the emergency arising out of severe cash shortage or acute liquidity crisis. It is used for modulating the short-term liquidity and transmitting the interest rate into the market.
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.
Repo or repurchase option allows the scheduled commercial banks to borrow funds from the Reserve Bank of India against any government approved securities with an agreement to repurchase them in the near future at a predefined rate of interest. The rate at which RBI charges from the banks against such lending is called the Repo rate. Through these operations, the liquidity is injected into the economy or the financial system.
Banking is the first sector to get affected by any change in monetary policies. A cut in repo rate can allow banks to borrow from the Reserve Bank of India at a cheaper rate and infuse higher liquidity in the banking system. This can lead banks to reduce their lending rates for customer leading to cheaper loans in the long term. As bank loans get cheaper, consumers can borrow and spend more which boosts consumption and can eventually lead to economic growth. However, this is depending on the decision by the bank whether to pass on the RBI repo rate cut benefits to their customers through cheaper loan offers.
Preventing Economy “squeezes”: The Central bank increases or decreases the Repo rate depending on the inflation. Thus, it aims at controlling the economy by keeping inflation in the limit.
Hedging & Leveraging: RBI aims to hedge and leverage by buying securities and bonds from the banks and provide cash to them in return for the collateral deposited.
Short-Term Borrowing: RBI lends money for a short period of time, maximum being an overnight post which the banks buy back their securities deposited at a predetermined price.
Collaterals & Securities: RBI accepts collateral in the form of gold, bonds etc.
Cash Reserve (or) Liquidity: Banks borrow money from RBI to maintain liquidity or cash reserve as a precautionary measure.
Repo Rate Affect on Economy
Repo rate is a powerful arm of the Indian monetary policy that can regulate the country’s money supply, inflation levels, and liquidity. Additionally, the levels of repo have a direct impact on the cost of borrowing for banks. Higher the repo rate, higher will be the cost of borrowing for banks and vice-versa.
- Rise in inflation
During high levels of inflation, RBI makes strong attempts to bring down the flow of money in the economy. One way to do this is by increasing the repo rate. This makes borrowing a costly affair for businesses and industries, which in turn slows down investment and money supply in the market. As a result, it negatively impacts the growth of the economy, which helps in controlling inflation.
- Increasing Liquidity in the Market
On the other hand, when the RBI needs to pump funds into the system, it lowers the repo rate. Consequently, businesses and industries find it cheaper to borrow money for different investment purposes. It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.
Reverse Repo Rate
This is just opposite to the Repo rate, here the RBI borrows money from the commercial banks against government approved securities. The rate at which RBI pays interest to the commercial bank is called a reverse repo rate. Through reverse repo operations, the liquidity is absorbed from the economy or the financial system.
Whenever RBI decides to reduce the reverse repo rate, banks earn less on their excess money deposited with the Reserve Bank of India. This leads the banks to invest more money in more lucrative avenues such as money markets which increases the overall liquidity available in the economy. While this can also lead to lower interest rate on loans for the bank’s customers, the decision will depend on multiple factors including the bank’s internal liquidity situation and the availability of other potentially less risky and equally lucrative investment opportunities.
|Repo Rate||Reverse Repo Rate|
|It is the rate at which RBI lends money to banks||It is the rate at which RBI borrows money from banks|
|It is higher than the reverse repo rate||It is lower than the repo rate|
|It is used to control inflation and deficiency of funds||It is used to manage cash-flow|
|It involves the sale of securities which would be repurchased in future.||It involves the transfer of money from one account to another.|