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Liquidity adjustment facility (LAF) is a monetary policy which allows banks to borrow money through repurchase agreements (REPO). [1]
| | This article needs additional citations for verification .(February 2016) |
Liquidity adjustment facility (LAF) is a monetary policy which allows banks to borrow money through repurchase agreements (REPO). [1]
LAF is used to aid banks in adjusting the day to day mismatches in liquidity. LAF helps banks to quickly borrow money in case of any emergency or for adjusting in their Statutory Liquidity Ratio (SLR)/Cash Reserve Ratio (CRR) requirements. LAF consists of repo (repurchase agreement) and reverses repo operations. Repo or repurchase option is a collateralized lending i.e. banks borrow money from Reserve bank of India (RBI) 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 Reserve bank of India 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 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 are Government of India securities. Oil bonds have been also suggested to be included as collateral for liquidity adjustment facility. In LAF, money transaction is done via RTGS (Real Time Gross Settlement, an online money transfer method).
The origin of repo rates, one of the components of liquidity adjustment facility, can be traced to as early as 1917 in U.S. financial market when wartime taxes made other sources of lending unattractive. The introduction of the liquidity adjustment facility in India was on the basis of the recommendations of Narasimham Committee on Banking Sector Reforms (1998). In April 1999, an interim LAF was introduced to provide a ceiling and the fixed-rate repos were continued to provide a floor for money market rates. As per the policy measures announced in 2000, the Liquidity Adjustment Facility was introduced with the first stage starting from June 2000 onwards. Subsequent revisions were made in 2001 and 2004. When the scheme was introduced, repo auctions were described for operations that absorbed liquidity from the system and reverse repo actions for operations that injected liquidity into the system. However, in international nomenclature, repo and reverse repo implied the reverse. Hence in October 2004, when the revised scheme of LAF was announced, the decision to follow the international usage of terms was adopted.
Repo and reverse repo rates were announced separately until the monetary policy statement on 3 May 2011. In this monetary policy statement, it has been decided that the reverse repo rate would not be announced separately but will be linked to the repo rate. The reverse repo rate will be 100 basis points below the repo rate. The liquidity adjustment facility corridor, that is the excess of repo rate over reverse repo, has varied between 100 and 300 basis points. The period between April 2001 to March 2004 and June 2008 to early November 2008 saw a broader corridor ranging from 150–250 and 200–300 basis points respectively. From March 2004 to June 2008 the corridor was narrow with the rates ranging from 100–175 basis points. A narrow LAF corridor is reflected from November 2008 onwards. At present, the width of the corridor is 25 basis points. This corridor is used to contain any volatility in short-term interest rates.
Liquidity adjustment facility has emerged as the principal operating instrument for modulating short term liquidity in the economy. Repo rate has become the key policy rate that signals the monetary policy stance of the economy.
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On March 17, 2008, in response to the subprime mortgage crisis and the collapse of Bear Stearns, the Federal Reserve announced the creation of a new lending facility, the Primary Dealer Credit Facility (PDCF). Eligible borrowers include all financial institutions listed as primary dealers, and the term of the loan is a repurchase agreement, or "repo" loan, whereby the broker dealer sells a security in exchange for funds through the Fed's discount window. The security in question acts as collateral, and the Federal Reserve charges an interest rate equivalent to the Fed's primary credit rate. The facility was intended to improve the ability of broker dealers to access liquidity in the overnight loan market that banks use to meet their reserve requirements.
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On September 17, 2019, interest rates on overnight repurchase agreements, which are short-term loans between financial institutions, experienced a sudden and unexpected spike. A measure of the interest rate on overnight repos in the United States, the Secured Overnight Financing Rate (SOFR), increased from 2.43% on September 16 to 5.25% on September 17. During the trading day, interest rates reached as high as 10%. The activity also affected the interest rates on unsecured loans between financial institutions, and the Effective Federal Funds Rate (EFFR), which serves as a measure for such interest rates, moved above its target range determined by the Federal Reserve.