Liquidity Adjustment Facility (LAF) & Repo Transactions
Liquidity Adjustment Facility or LAF is a facility extended by the Reserve Bank of India to the scheduled commercial banks (excluding RRBs) and Primary Dealers (PDs) to meet their mismatches in daily liquidity. Under LAF, SCBs and PDs can avail of funds from RBI in case of shortage in daily liquidity or park surplus funds with RBI in case of excess liquidity. LAF transaction is carried out through repurchase agreement, which is basically borrowing funds backed by government security as collateral.
How is Liquidity Adjustment Facility (LAF) carried out?
LAF is a monetary policy tool that allows banks to borrow money. LAF is an overnight liquidity management tool, carried out on a day to day basis. The transactions of LAF are conducted through repurchase (repo and reverse repo) agreements. RBI is always one of the counter parties of both repo and reverse repo agreements. The interest rate applicable to LAF is announced by RBI from time to time. The interest rate charged by RBI for lending is known as Repo rate and the interest rate paid on surplus fund deposited with RBI is called Reverse Repo rate. These rates are periodically revised by RBI.
Which are the securities permitted for LAF?
Borrowings under LAF are permitted against Government securities and SDLs. Government Security (G-Sec) is a tradable instrument that represents the debt obligation of government.
Government securities are short term in nature with original maturities less than one year. They are popularly known as treasury bills. Long term debt instruments, issued with original maturity of one year or more are known as government bonds or dated securities. In India, the central government issues both treasury bills and bonds/dated securities. However, state governments issue only bonds or dated securities. Such instruments issued by the state governments are called the State Development Loans (SDLs). G-Secs carry practically no risk of default and are known as risk-free gilt-edged instruments.
What is a Repo transaction?
Repo or ready forward contact is an instrument for borrowing funds by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price. The agreed price for repurchase covers the interest on the borrowed funds too. Thus a repo transaction has two legs:
• Borrowing fund by selling securities
• Repurchasing the securities by returning the fund along with interest
The first leg is called Repo transaction and the second leg is called Reverse Repo transaction. The period between the two legs is known as ’Repo period’. Majority of repurchase agreements happens on overnight basis, with one day Repo period. However, term repos too exist with facility for substitution of underlying collaterals, subject to conditions.
