Accepting the recommendation of the Narasimham Committee on Banking Reforms, Reserve Bank of India introduced Liquidity Adjustment Facility (LAF) with effect from June 5, 2000. It is a mechanism by which the Reserve Bank of India draws funds from the money market at a time of surplus and infuses liquidity whenever there is a temporary shortage. For this purpose, Reserve Bank of India asks banks and primary dealers to bid for funds if there is a shortage and borrows from them if there is a surplus.
In the first stage, effective from June 5, 2000 the additional CLF and Level II support to Primary Dealers have been replaced by variable rate repo auctions with same day settlement. Repo are a mode of borrowing where the borrower sells securities sells securities with an agreement to buy them back the next day at a pre-determined price. The difference between the sale and repurchase price indicates the interest cost on the funds.
Under LAF system Reserve Bank of India assesses the liquidity position on a daily basis, on the basis of various factors e.g. the conversion of the foreign currencies into rupee, the turnover in the call market the previous day, the CRR requirements of the banking system and the quantum of funds exiting the system as advance payment of taxes.
On the basis of its assessment of liquidity, Reserve Bank of India decides the rate at which it should lend and also the quantum it wishes to lend. Under LAF facility, funds are made available through reverse repo auctions. It is just opposite to repo. The lender buys securities with an agreement to sell them back at a pre-determined rate. In the auction, borrowers bid for funds indicating the amount they want to borrow and the rate they are willing to pay. The Reserve Bank of India has the right to reject the bids of any borrower. Initially, repo / reverse repo auctions were conducted on a daily basis from Monday to Friday and with one day maturity (except on Fridays and before holidays). In August 2000 multiple repo / reverse repo auctions with 3 to 7 days maturity were introduced. Interest rates in case of both are cut off yields emerging from auctions. Auctions are conducted on uniform price basis.
Under LAF the quantum of adjustment and also the rates would be flexible, responding immediately to the needs of the system. Funds made available by Reserve Bank of India would meet primarily the day-to-day liquidity mismatches in the system and not the normal financing requirements of banks. Short term interest rates will move within a corridor and will have greater stability.
The Second Stage of LAF:
The LAF worked satisfactorily as a flexible instrument for injecting / absorbing liquidity and also as an interest rate signal for the short term money market. Reserve Bank of India felt that it can be made fully effective only when it becomes the primary instrument of liquidity adjustment and other forms of liquidity support are gradually replaced with LAF over a reasonable period of time. In order to move in this direction, Reserve Bank of India made further modifications while announcing its credit policy on April 19, 2001.