Liquidity Adjustment Facility

Liquidity Adjustment Facility

Subject: Economy

Why in the news?

The Reserve Bank of India increased the repo rate to 5.40 per cent under the liquidity adjustment facility (LAF)

Details:

Repo rate, which is the rate at which the RBI lends money to commercial banks, is now higher than the pre-Covid level of 5.15 per cent.

Impact:

• Immediate-Increase in the interest rate and decline in the money supply.
  • It raises the cost of borrowing by banks from the RBI which in turn is passed on to lenders by raising the rate of interest on loans.
  • This will result in higher EMIs on loans-auto, home, consumer durables and may increase the tenure of floating rate loans
• Long run- 
  • As credit interest rises- corporates especially the manufacturing sectors reduce their company expansion and production further increasing the already high unemployment rate.
  • Delayed infrastructure and real estate products due to increase cost of borrowing
  • Increased cost of borrowing and delayed recovery for MSMEs.
  • Fixed income securities demand will increase
    • Fixed-Income securities are debt instruments that pay a fixed amount of interest—in the form of coupon payments—to investors. The interest payments are typically made semiannually while the principal invested returns to the investor at maturity. Bonds are the most common form of fixed-income securities.
  • Asset quality of Banks degrade- given the higher cost of borrowing increase difficulty to repay loans thus, increase Gross Non Performing Assets of the Banks.
    • GNPA in March 2022 was 5.9 and banks target it to be 5,3%by March 2023

Liquidity Adjustment Facility:

• Liquidity Adjustment Facility was recommended by the Narasimham Committee on Banking Reforms and was introduced by the RBI in 1998.
• A liquidity adjustment facility (LAF) is a monetary policy tool used largely by the Reserve Bank of India (RBI)
• It allows banks to borrow money via repurchase agreements (repos) or make loans to the RBI via reverse repo agreements. 
• There are two main components of Liquidity Adjustment Facility (LAF):
  • Repo Rate: It is the rate at which the Reserve Bank of India (RBI) lends to other banks.
  • Reverse Repo Rate: It is the rate at which the Reserve Bank of India (RBI) borrows from commercial banks.
• This structure is helpful in reducing liquidity demands and ensuring financial market fundamental stability.
• Liquidity Adjustment Facility – Example
  • Assume a bank is experiencing a short-term cash shortage as a result of the Indian economy’s recession.
  • The bank would use the RBI’s liquidity adjustment facility by entering into a repo agreement with the RBI and selling government securities in exchange for a loan with an agreement to repurchase those securities.
  • Assume the bank requires a one-day loan of ₹ 50,000,000 and enters into a repo agreement at 6.25 percent.
  • The interest payable by the bank on the loan is ₹8,561.64 (50,000,000 x 6.25 % / 365).
• Another Example
  • Assume the economy is expanding and a bank has extra cash on hand.
  • In this case, the bank would enter into a reverse repo agreement with the RBI by making a loan in exchange for government securities and agreeing to repurchase those securities.
  • For example, suppose a bank has ₹25,000,000 available to lend to the RBI and decides to enter into a one-day reverse repo agreement at 6%.
  • The RBI would pay the bank ₹4109.59 in interest (25,000,000 x 6 % / 365).