Liquidity Adjustment Facility (LAF)

Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements. LAF is used to aid banks in adjusting the day to day mismatches in liquidity.LAF consists of repo and reverse repo operations. Repo or repurchase option is a collaterised lending i.e. banks borrow money from Reserve bank of India to meet short term needs by selling securities to RBI with an agreement to repurchase the same at predetermined rate and date. The rate charged by RBI for this transaction is called the repo rate. Repo operations therefore inject liquidity into the system. Reverse repo operation is when RBI borrows money from banks by lending securities. The interest rate paid by RBI is in this case is called the reverse repo rate. Reverse repo operation therefore absorbs the liquidity in the system. The collateral used for repo and reverse repo operations comprise of Government of India securities. Oil bonds have been also suggested to be included as collateral for Liquidity adjustment facility Liquidity adjustment facility has emerged as the principal operating instrument for modulating short term liquidity in the economy. Repo rate has become the key policy rate which signals the monetary policy stance of the economy. The origin of repo rates, one of the component of liquidity adjustment facility, can be traced to as early as 1917 in U.S financial market when war time taxes made other sources of lending unattractive . The introduction of Liquidity adjustment facility in India was on the basis of the recommendations of Narsimham committee on banking sector reforms. In April 1999, an interim LAF was introduced to provide a ceiling and the fixed rate repos were continued to provide a floor for money market rates. As per the policy measures announced in 2000, the Liquidity Adjustment Facility was introduced with the first stage starting from June 2000 onwards. Subsequent revisions were made in 2001 and 2004. When the scheme was introduced, repo auctions were described for operations which absorbed liquidity from the system and reverse repo actions for operations which injected liquidity into the system. However in international nomenclature, repo and reverse repo implied the reverse. Hence in October 2004 when revised scheme of LAF was announced, the decision to follow the international usage of terms was adopted. Repo and reverse repo rates were announced separately till the monetary policy statement in 3.5.2011. In this monetary policy statement, it has been decided that the reverse repo rate would not be announced separately but will be linked to repo rate. The reverse repo rate will be 100 basis points below repo rate. The liquidity adjustment facility corridor, that is the excess of repo rate over reverse repo, has varied between 100 to 300 basis points. The period between April 2001 to March 2004 and June 2008 to early November 2008 saw a broader corridor ranging from 150-250 and 200-300 basis points respectively. During March 2004 to June 2008 the corridor was narrow with the rates ranging from 100-175 basis points. A narrow LAF corridor is reflected from November 2008 onwards. At present the width of the corridor is 100 basis points. This corridor is used to contain any volatility in short term interest rates.

Marginal Standing Facility

Marginal Standing Facility (MSF) is a new scheme announced by the Reserve Bank of India (RBI) in its Monetary Policy (2011-12) and refers to the penal rate at which banks can borrow money from the central bank over and above what is available to them through the LAF window.

MSF, being a penal rate, is always fixed above the repo rate. The MSF would be the last resort for banks once they exhaust all borrowing options including the liquidity adjustment facility by pledging through government securities, which has lower rate of interest in comparison with the MSF. The MSF would be a penal rate for banks and the banks can borrow funds by pledging government securities within the limits of the statutory liquidity ratio. The scheme has been introduced by RBI with the main aim of reducing volatility in the overnight lending rates in the inter-bank market and to enable smooth monetary transmission in the financial system.

MSF represents the upper band of the interest corridor and reverse repo as the lower band and the repo rate in the middle. To balance the liquidity, RBI intend to use the sole independent "policy rate" which is the repo rate and the MSF rate automatically gets adjusted to a fixed per cent above the repo rate (MSF was originally intended to be 1% above the repo rate).

MSF came into effect from 9th May 2011. MSF scheme is provided by RBI by which the banks can borrow overnight upto 1 per cent of their net demand and time liabilities (NDTL) i.e. 1 per cent of the aggregate deposits and other liabilities of the banks. However, with effect from 17th April 2012 RBI has raised the borrowing limit under the MSF from 1 per cent to 2 per cent of their NDTL outstanding at the end of the second preceding fortnight. The rate of interest for the amount accessed through this facility is fixed at 100 basis points (i.e. 1 per cent) above the repo rate for all scheduled commercial banks. However, the rate of interest on the amount accessed from this facility got fixed at 300 basis points (i.e. 3%) above the repo rate with effect from 15/07/2013. In addition, access to the LAF window was reduced by RBI to just 0.5% of their NDTL which in turn forced banks to access the MSF window for their requirements, as LAF window was not sufficient enough. In the credit policy of September 2013, i.e., after one month, this was reversed, whereby MSF rate was cut by 75 bps from 10.25% to 9.5% and as on September 2013 MSF stands at 200 bps (2%) above the repo rate, which is considered as the "policy rate" in the economy. However, the amount that can be accessed using LAF window remains at 0.5% of the NDTL.

Thus, as on September 2013, the MSF rate is 9.5 per cent, which is 2 per cent above the repo rate which is at 7.5 per cent.

Banks can borrow through MSF on all working days except Saturdays, between 3.30 and 4 30 p.m. in Mumbai where RBI has its headquarters. The minimum amount which can be accessed through MSF is Rs.1 crore and in multiples of Rs.1 crore. ( Rs 1 crore = Rs 10 million). The application for the facility can

be submitted electronically also by the eligible scheduled commercial banks. The banks used the facility for the first time in June 2011 and borrowed Rs.1 billion via the MSF.

The ECB (European Central Bank) also offers standing facilities called marginal lending facilities similar to the MSF introduced in India. The Federal Reserve has discount window systems similar to Standing facilities. Like the MSF, the secondary credit facility made available by the Federal Reserve to the depository institutions in USA is typically overnight credit on a very short term basis at rates above the primary credit rate.

The effectiveness of standing facilities in reducing volatility have been examined by many scholars and certain studies have pointed out that in the Federal Reserve System in the United States, the design of the facility decreases a banks incentive to participate actively in interbank market due to the perceived stigma from using such facility. This in turn reduces the effectiveness of standing facility in reducing interest rate volatility.

LAF Liquidity adjustment facility, this is for short term Minimum bidding amount is 5 cr. All clients of RBI are eligible to bid.

MSF Marginal standing facility, this is for long term 1 cr. Only scheduled commercial banks can bid. bank can sell the Government security from its SLR quota to RBI. Bank can maximum borrow upto 2% of its NDTL. MSF lending rate is always (r+x)% current rate [08-10-2013] : 9%

Bank cannot sell Government security to RBI that is part of bank's SLR quota. Bank can borrow any amount of money as long as it has the securities to sell. Suppose repo rate is "r%" current rate [08-10-2013] : 7.5%