What is liquidity adjustment facility?

Liquidity Adjustment Facility What is liquidity adjustment facility?   

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Liquidity adjustment facility (LAF) is a monetary policy tool used by RBI to manage market liquidity and money supply targets.

LAF was introduced in June 2000 and conducted daily on overnight basis.

It helps banks to adjust their daily liquidity mismatches by pledging government securities over and above the SLR of 23% (Banks generally maintain SLR excess of 23% to borrow under LAF).

LAF consist of Repo and Reverse Repo transactions.

To meet liquidity shortage, banks can borrow from RBI through a repo transaction.

In a Repo (Repurchase agreement) transaction banks make short term borrowing by selling government securities to RBI in agreement to buy back the same security at repo rate.

Repo rate is the rate at which banks borrow from RBI. Repo transaction injects liquidity by RBI into the market through banks.

Reverse repo transaction is opposite of a repo transaction.

Since May 2011, RBI has linked reverse repo rate to repo rate. Reverse repo rate will be 100bps lower than repo rate.

Chart below shows how a repo and reverse repo transaction takes place.

Repo Transaction Liquidity moves to

Bank

RBI Govt securities move to to

Reverse Repo Transaction

RBI

Govt securities move to to Liquidity moves to

Bank

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When there is shortage of liquidity banks borrow from RBI at repo rate and when there is excess liquidity banks park their surplus liquidity with RBI at reverse repo rate.

Chart below shows daily liquidity requirement and repo and reverse repo rate from April 2006 till 16th July 2013.

Source: RBI

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From the above chart, we can see from 2010 banks have being facing liquidity shortage and borrowing from RBI. When there is excess liquidity one of the reasons RBI starts hiking repo rate is to ensure money doesn’t flow into speculative transactions.

This can be observed from 2010 RBI hiking rates when there was excess liquidity.

RBI’s comfort level of liquidity is  1% of Net Demand and Time liability (NDTL).

Chart below shows the trend of net liquidity injection and absorption and RBI’s liquidity comfort level of  1% of NDTL.

Source: RBI

Marginal Standing Facility (MSF)    

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MSF was introduced by RBI in 2011, where banks can borrow from RBI when there is a considerable shortfall of liquidity.

Under MSF, banks can borrow from RBI up to 1 % of NDTL and can pledge securities within the SLR unlike under LAF where has to be above the SLR .

RBI recently restricted borrowing under LAF to 1 % of NDTL or approximately ` 75000cr.

This implies that any addional borrowing required banks will have to go though other routes like call money market or marginal standing facility (MSF) which increases their cost of borrowing.

RBI recently hiked MSF by 200 bps above repo rate and currently stands at 10.25%.

Prior to the recent RBI announcement, borrowing under MSF route has been minimal.

However after the announcement borrowing under MSF route can increase.

For any further clarification contact mahvash.ariyanfar@idfc.com