The Liquidity Adjustment Facility (LAF) is a key monetary policy tool used by the Reserve Bank of India (RBI) to manage short-term liquidity in the financial system.
It allows banks to borrow money from or lend money to the RBI to maintain a liquidity balance in the economy.
The Liquidity adjustment facility meaning can be simply understood as a mechanism that ensures the banking system always has enough cash flow to function smoothly without excessive inflation or shortage of funds.
How Does the Liquidity Adjustment Facility Work?
Under the LAF, banks can borrow funds through the repo rate (by selling securities to the RBI with an agreement to repurchase them later) or deposit excess funds through the reverse repo rate (by lending to the RBI).
The difference between these two rates forms the liquidity adjustment facility corridor, which sets the range within which the short-term interest rates move in the economy.
The Liquidity Adjustment Facility rate determines how expensive or cheap it is for banks to borrow funds from the RBI.
When liquidity is tight, the RBI reduces this rate to make borrowing easier, thereby injecting funds into the system. Conversely, when there is excess liquidity, it increases the rate to absorb surplus funds and control inflation.
Tools and Example
Some common Liquidity Adjustment Facility tools include repo operations, reverse repo operations and marginal standing facilities.
For instance, if a bank faces a sudden shortage of funds to meet customer withdrawals, it can borrow from the RBI using government securities under the LAF at the prevailing repo rate.In essence, the liquidity adjustment facility plays a vital role in stabilising the money supply and maintaining financial discipline in the banking sector.
It acts as a balancing lever, making sure neither too much liquidity nor too little affects the economy’s overall health.
