Liquidity Adjustment Facility

Liquidity Adjustment Facility (LAF)

What it is

A Liquidity Adjustment Facility (LAF) is a central bank tool for managing short-term liquidity in the banking system. Through LAF, commercial banks can borrow from the central bank via repurchase agreements (repos) or lend to the central bank via reverse repos, typically on an overnight basis. Government securities or other eligible instruments are used as collateral.

How it works

• Repo: A bank sells securities to the central bank and agrees to repurchase them later at a higher price. This injects liquidity into the banking system.
• Reverse repo: A bank buys securities from the central bank and agrees to sell them back later. This absorbs excess liquidity.
• Operations are conducted regularly (often daily) through auctions or scheduled windows to meet short-term funding needs and keep the overnight market functioning.

Role in monetary policy

LAF is used to:
– Smooth short-term liquidity mismatches in banks.
– Signal and implement monetary policy by adjusting repo and reverse-repo rates.
– Influence the money supply and credit conditions: raising the repo rate makes borrowing more expensive and can reduce inflationary pressures; lowering it eases borrowing and can stimulate activity.

Central banks in other countries (for example, the U.S. Federal Reserve) use comparable repo/reverse-repo operations as part of open market operations.

Example (one-day operations)

• Bank needs a one-day loan: borrows ₹50,000,000 at 6.25% (repo). Interest ≈ ₹50,000,000 × 6.25% / 365 = ₹8,561.64.
• Bank has excess cash: lends ₹25,000,000 to the central bank at 6.00% (reverse repo). Interest ≈ ₹25,000,000 × 6.00% / 365 = ₹4,109.59.

(Interest is calculated on a simple daily basis: principal × annual rate / 365.)

Benefits and limitations

Benefits:
– Prevents short-term funding stress and supports financial stability.
– Gives central banks a direct tool to manage intraday and overnight liquidity.
– Complements other policy tools to steer inflation and credit conditions.

Limitations:
– Primarily addresses short-term liquidity, not structural banking problems.
– Effectiveness depends on correct calibration of rates and timely operations.
– Relies on the availability of eligible collateral and functioning markets for government securities.

Key takeaways

• LAF enables banks to borrow from or lend to the central bank using repos and reverse repos.
• It is a routine mechanism to manage overnight liquidity and to transmit monetary policy stance by changing repo and reverse-repo rates.
• While useful for short-term stability and liquidity management, LAF is not a substitute for broader regulatory or fiscal measures when deeper problems exist.

Conclusion

The Liquidity Adjustment Facility is a practical, day-to-day monetary tool that helps central banks maintain orderly money markets, manage short-term liquidity mismatches, and influence borrowing costs and money supply through repo and reverse-repo operations.