Liquidity Adjustment Facility (LAF)

The Liquidity Adjustment Facility (LAF) is a monetary policy mechanism through which central banks—such as the RBI—regulate the amount of money available in the banking system and guide short-term interest rates. Under this framework, banks can access short-term funds from the central bank when faced with liquidity pressure or place excess funds with it when they have a temporary surplus. This helps maintain orderly financial conditions.

Main Elements:

Repo Rate:

This is the rate at which banks obtain short-term liquidity from the central bank by providing government securities as collateral, with an agreement to buy them back later. It increases the amount of money circulating in the system.

Reverse Repo Rate:

This is the rate at which banks deposit spare funds with the central bank by temporarily acquiring government securities. It helps withdraw excess liquidity from the system.

Illustration:

For example, if banks are short of funds for immediate payments, they can borrow from the central bank at the repo rate. When they have more funds than needed, they can place them under the reverse repo facility and earn interest, which also assists the central bank in managing inflation and liquidity levels.