The Narasimham Committee on Banking Sector Reforms (Report II, 1998) recommended that the Reserve bank should provide support to the market through a liquidity adjustment facility. This facility would help in the development of a short term money market with adequate liquidity. As per the Narasimham Committee’s recommendation, the Reserve Bank decided to introduce that LAF in phases.
The interim liquidity adjustment of facility, introduced in April 1999, provided a mechanism for liquidity management through a combination of repos, export credit refinance, supported by open operations at set rates of interest. Banks could avail of a collateralized lending facility of up to 0.25 per cent of the fortnightly average outstanding aggregate deposits available for few weeks at bank. Primary dealers were provided liquidity outstanding support against collateral of government securities. These facilities were available subject to quantitative limits (formula based) for a specific duration and at the bank arte. Additional limits could be availed by banks under the additional collateralized lending facility (ACLF) and by primary dealers at 2 per cent points above the bank rate.
The interim liquidity adjustment facility was gradually converted into full fledged liquidity adjustment facility. The LAF was implemented in three phases in the first phase, the ACLF for banks and primary dealers; in the second stage the CLF for banks and primary dealer was replaced by variable reverse repo auctions; and in the final stage, the LAF will be operated at different timings of the same day of necessary.
Thus, LAF is operated through repos and reverse repos, with view to setting a corridor for money market interest rates. It provides a mechanism for injection and absorption of liquidity available to banks and to overcome mismatches in supply and demand from time to time. The objectives of LAF are to meet day to day liquidity mismatches in the system, restricting short term money market rates, and steering these rates, to be consistent with monetary policy objectives.
The LAF was introduced from June 5, 2000, to impart greater stability and facilitate the emergence of a short term rupee yield curve. Repo/reverse repo auctions are conducted on a daily basis except on Saturdays, with a tenor of one day except on Fridays and days preceding holidays. Interest rates in respect of both repos and reverse repos decided through cut off rates emerging from auctions conducted by the Reserve bank on a uniform price basis. In August 2000, repo auctions of tenors ranging between there to seven days were introduced,
The following measures relating to stage II of LAF were announced / implemented a part of the monetary and credit policy for 2001-02.
1) The standing liquidity facilities available from the Reserve Bank under LAF split into two parts.
(a) Normal facility constituting about two thirds of the limit at the bank arte; and
(b) Back stop facility constituting about one-third of the limit at a variable daily arte, which is linked to cut off rates emerging in regular LAF auctions. In the absence of such rates, back stop facility will be linked to NSE MIBOR.
2) The minimum bid size for LAF was reduced from Rs 10 crore to Rs 5 crore to facilitate the participation of small operators. The auction format for LAF was changed from the uniform price auction method to the multiple price auction method to ensure more responsible bidding. The timing for LAF auctions and announcement of results was advanced by 30 minutes.
3) In order to provide quick interest rate signals, the Reserve bank has chosen an additional option for switching over to fixed rate repos on overnight basis.
4) The Reserve bank also has the option of introducing long term repos of up to 14 days as and when required. The Reserve bank has introduced a fortnightly repo auction since November 5, 2001. Since February 15, 2002, members of the negotiated dealing system (NDS) submit LAF bids in an electronic form instead of physical form.
The Reserve bank thus created conditions for the orderly movement of interest rates in the overnight call markets which in turn, will reduce the volatility in the government securities market. This would lead to gilt funds becoming more attractive. Borrowing by banks from the Reserve bank will be on market determined interest rates. Banks can also structure their interest rates on a floating rate basis. LAF may create n alignment between various interest rates and may even facilitate the lowering of interest rates. In the monetary and credit policy for 2001-02, the LAF progressed into its second stage. The medium term objective is to move gradually towards a full fledged LAF and to do away with various sector standing liquidity facilities.
The effectiveness of the LAF will be strengthened when
1) it becomes the primary instrument of liquidity adjustment
2) other forms of liquidity support such as collateralized leading, export credit refinance to banks, and liquidity support to primary dealers are gradually phased out, and
3) a pure inter-bank call / notice money market is in place coupled with the growth of a repo market for non-bank participants
The LAF operations combined with the judicious use of open market operations are expected to merge as the principal operating instrument of the monetary policy.