Whenever there is a rise or decrease in the interest rates of personal loan, the borrowers wonder how and why it has happened. This is actually related to 'LAF', a term that you might have stumbled upon several times during your search for personal loans. Though this term is not directly connected to the loan borrowing process, it has a vital role to play in deciding the interest rates on the loans. To get a better idea of how the borrowing and lending system works in India you should understand this term clearly.
LAF or Liquidity Adjustment Facility is a monetary tool devised by the Reserve Bank of India to adjust or stabilise the liquidity and money supply in the economic system of India. This liquidity support measure is especially helpful when there is a mismatch in liquidity and the commercial banks find it difficult to adjust the gap created in their banking system.
Through this tool, banks can borrow money from RBI by selling their excess government securities in case of urgent requirements. Thus, with the help of this tool banks can meet their day to day liquidity requirement.
The repo (Repurchasing Option) and the reverse repo (Reverse Repurchasing Option) operations are the two major components of LAF. The repo and reverse repo operations are conducted using the Government of India securities. Money transfer in LAF is done through RTGS or Real-time Gross settlement, an online money transfer method.
LAF was introduced in India temporarily in the year 1999 based on the recommendations of the second Narsimham committee made in 1998. Proper Liquid Adjustment Facility came into effect in the month of June 2000. After the introduction, this policy has been revised two times, once in the year 2001 and another in 2004.
After the launch of this liquidity adjustment tool, the banks in India started working in a more structured format and flow of liquidity of money in the economic system came under the direct control of RBI. LAF, which is operated mainly through the repo and reverse repo transactions, started working as reasonable financial window or corridor for the banks to approach RBI and adjust their liquidity with its support.
The major components of Liquidity Adjustment Facility are Repo and Reverse Repo operations. Here are the details of these components and how they work:
Under the Repo window, banks can borrow money from the RBI for a short period of time at a specified rate of interest by selling eligible bank’s securities. While availing funds through this contract, banks have to make the commitment to purchase the securities back from RBI. The rate at which RBI lends money to the banks under this facility is called the Repo Rate. When there is a need for cash flow in the economy, RBI reduces the repo rate thus providing banks easy access to funds. On the contrary, the central bank increases the Repo rate in case of excess cash flow or inflation in order to limit the access of the banks. In this way, by using the repo instrument RBI regulates the flow of currency in the financial system while controlling its inflation and depreciation.
The Reverse repo operation facility is just the opposite of Repo. Through this facility, the banks can give their extra funds as loans to RBI against an interest rate. In other words, using this liquidity adjustment window the Reserve Bank of India borrows money from the banks whenever they want. The interest rate at which banks lend money to RBI is called reverse repo rate. An increase in the reverse repo rate enables banks to get higher interest rates for parking their money with RBI which thereby decreases money supply in the market and increases RBI assets. RBI makes use of this monetary tool whenever it feels the need to soak up the surplus funds available with the banks for maintaining a balance in the economic system. By taking in the surplus money that banks have in hand, RBI controls and stabilises the supply of money in the Indian economy.
The repo rate is considered to be more important than the reverse repo rate as the reverse repo rate is based on the repo rate. When the repo rate is revised by the Reserve Bank of India, the reverse repo rate automatically gets changed by an equal percentage. Moreover, the repo rate is always higher than the reverse repo rate. This is because banks are happy to lend money to RBI against a good interest rate for keeping their money in the safe hands of RBI.
RBI makes use of LAF to regulate liquidity in the Indian financial system in three different ways which are as follows:
Current rate- The repo rate at which the banks can borrow fund at present is 6.00% p.a.
Current rate- As per the latest amendment in RBI policy, the current reverse repo rate is 5.75% p.a.
Formula- The reverse repo rate is connected to repo rate in the following manner:
Reverse Repo Rate = Repo Rate – 1
Current rate- According to the latest RBI monetary policy, the MSF rate is fixed at 6.25% p.a.
Formula- The MSF rate is connected to repo rate in the following manner:
MSF = Repo Rate + 1
The elements of the three types of LAF vary from each other and here are the details of the vital elements of a repo, reverse repo and MSF transaction between the commercial banks and RBI.
Note: SLR is the reserved asset that a bank has to maintain before giving loans in the form of government securities.
RBI is very stringent about the criteria of Liquid Adjustment Facility and the financial institutions strictly need to abide by the LAF guidelines of the central bank of India. The revised LAF guidelines are listed out below:
The LAF auctions are conducted by RBI in Mumbai every working day starting from Monday to Friday. While the repo transactions are done before noon, the reverse repo transactions and the MSF auctions are conducted in the afternoon. The tenure for Repo auction is 7 days as per the revised LAF guidelines.
Each and every Scheduled Commercial Bank in India can participate in the LAF auctions held in the Mumbai headquarters of RBI except the RGS (Regional Rural Banks). Apart from that, the PDs (Primary Dealers) who have Current Account and Subsidiary General Ledger Account (SGL Account) with the Reserve Bank of India, Mumbai is also qualified to take part in the LAF Repo and Reverse Repo auctions.
Whenever RBI observes huge inflation in the market, it increases its repo rate. When the repo rate becomes high, banks have to borrow money from the RBI at a higher interest rate. The commercial banks cover this loss by increasing the rate of interest for lending the loan to its borrowers. But, the increased interest rate discourages the borrowers from applying for funds from the banks in the form of loans. Instead of borrowing more, they tend to cut down their needs to a certain extent due to which the demand for products come down automatically. It directly affects the economy and the flow of cash in the market comes down.
LAF offered by RBI is of immense benefit for the commercial banks in India as it helps the banks to overcome their periodic liquidity crisis without affecting the interests of the customers. This special financial arrangement not only ensures the flow of liquidity in the economic system of the country, but it also comes handy for the banks whenever they have a dearth of liquid assets to meet the unexpected expenses. Under the LAF window, banks can quickly borrow money from RBI at the time of emergency or at times when they need immediate funds to balance their SLR or CRR requirements. This facility mainly helps the banks to overcome their periodic liquidity crisis without affecting the interests of the customers.
As discussed earlier, this powerful RBI monetary policy works on the basis of two major components, the Repo or Repurchasing Option and Reverse Repo or Reverse Repurchasing option. In other words, these are the instruments through which the Reserve Bank of India facilitates liquidity in the financial system of the country. While repo is used to infuse liquidity in the economy, reverse repo is utilised to absorb liquidity present in the system. RBI monitors the prevailing market conditions and changes the repo and reverse repo rate as per the market behaviour and condition. Currently, the reverse repo rate is 25 basis point lower than the repo rate.
The difference between both the rates is used by RBI as a tool to control liquidity, cash flow, and inflation in the economy. When there is increased cash flow in the financial system, the rate of the Repo transactions is increased to make the commercial banks borrow less amount of fund thereby releasing less amount of money into the economy. Contrarily, in situations when there is shortage of money in the economic system, the reverse repo rate is increased to prompt the banks for offering more amount of funds to RBI which will ultimately pump the supply of money in the economy of the country.
LAF has a major role to play in the increase and decrease of the rates of personal loans. Whenever, there is a shortfall or surge in money supply, the Reserve Bank of India take help of LAF to maintain a balance in the economy. If the economy gets inflated, RBI increases the repo rate so that the commercial banks borrow less amount of money. However, banks which are in extreme need have to borrow money at a high-interest rate. With an intent to make up their loss, banks increase the rate of the personal loans which impacts the borrowers. Similarly, when RBI decreases the repo rate, banks can borrow funds from the bank at reasonable rates thus enabling the borrowers to get loans at affordable cost. In the same manner, the increase and decrease of other liquidity adjustment facilities such as the reverse repo rate and marginal stability ratio also affect the personal loan borrowers in both positive and negative way.
The Reserve Bank of India declares the Liquidity Adjustment Facility calendar before the auctions mentioning the dates and the related terms and conditions under which the LAF auctions will be conducted. All the details of the LAF auctions are available on the official website of RBI. Based on the nature of their requirements, the eligible banks engage either with a repo, reverse repo or MSF transaction to resolve their illiquidity issues.
With the launch of the Liquidity Adjustment Facility, the monetary policy in India underwent a major transformation and the Repo rate became the most important tool for RBI to gain control over the Indian banking system as well as economy in a better way. At present, it is not only limited to be a monetary tool that stabilises the economy of the country by resolving the liquidity issues, but it has become the most effective medium of monetary transmission in India.