Whenever we listen to RBI Governor’s address, there would always be a mention of the Liquidity Adjustment Facility (LAF) as a means to inject/absorb liquidity from the system.
LAF is a monetary instrument used by the RBI to regulate short-term liquidity in the economy. LAF allows the bank to borrow money through repurchase agreements (repos) or allow banks to make loans to the RBI through reverse repo agreements. The two major components of LAF are: (1) Repo (2) Reverse Repo options. The collateral used for repo/reverse repo option mainly comprises of government securities.
Repo option allows the scheduled commercial banks to borrow funds from the RBI to meet the short term needs by selling securities to the RBI with an agreement to repurchase the same at a predetermined date and rate. The rate charged by the RBI for this transaction is called repo rate. Thus, when the RBI lowers the repo rate, commercial banks will be able to avail funds at a cheaper rate from the RBI. A lower repo rate, in turn, is a means for injecting more liquidity into the system.
Reverse Repo Option
It is the opposite of repo option. Under the reverse repo option, RBI borrows funds from the banks against approved securities. The rate at which the RBI pays interest to the banks is called the reverse repo rate. In the present scenario, when the RBI reduces the reverse repo rate, it disincentivises the banks to park the funds with RBI as the banks will earn only lower interest rate on those funds. Thus, a lower reverse repo rate would encourage the banks to lend more, and inject more liquidity. On the contrary, at a higher reverse repo rate banks would benefit from parking the funds with RBI, as they would earn higher interest rate on their funds.
When the economy is facing high inflationary pressure, to reduce money supply in the economy, RBI would increase repo/reverse repo rate. Similarly, when there is an economic slowdown, to stimulate growth and increase money supply, RBI would reduce repo/reverse repo rate.