The RBI implemented the Liquidity Adjustment Facility in 1998 as a result of the recommendations made by the Narasimham Committee on Banking Sector Reforms. The Reserve Bank of India uses a liquidity adjustment facility (LAF) as a monetary policy instrument in India. Repo and reverse repo are the two components of LAF, but now standing deposit facility (SDF) is also used by RBI. LAF is offered by the RBI to Scheduled Commercial Banks, Primary Dealers, Mutual Funds, and Insurance Companies with Subsidiary General Ledger Account with the RBI. Under the LAF, these entities are allowed to repo government securities, including SDLs and Treasury Bills, acquired under reverse repo, subject to various conditions and guidelines prescribed by RBI from time to time. The liquidity adjustment facility is used by RBI to manage high levels of inflation. Banks use repo to borrow money from the RBI when they need liquidity to satisfy their daily requirements. Banks can park with the RBI using the reverse repo process at the reverse repo rate when they have plenty of cash. RBI introduced a new tool, a standing deposit facility (SDF), to suck out excess liquidity in the system. Under the new facility, banks can park their surplus money with RBI at a higher rate of 5.65%. Thus adjusting the money supply can control inflation in the economy.
Let’s say a bank is experiencing a temporary cash shortfall due to a recession in the Indian economy. To use the RBI’s liquidity adjustment facility, the bank would execute a repo agreement, selling the RBI government assets in exchange for a loan and an agreement to repurchase those securities later. Let’s take an example: the bank signs a repo arrangement at 6.5% to obtain a ₹1crore ten days loan. The bank is responsible for paying interest ₹17800.82 for that loan. According to RBI data, banks borrowed ₹73,297 crores from the central banks through various LAFs, which is a significant improvement over the previous scenario. A few months ago (in May 2022), ₹3.10 lakh crore was kept with the central bank in excess liquidity. But, the rising demand for loans has made banks borrow from the central bank. Credit growth is close to 18%, almost double the 10% deposit growth. Hence, banks rush to raise deposits by spiking interest rates on deposits for the short term. RBI injected Rs 72,860.7 crore of liquidity into the banking system in October 2022, the highest since April 2019 after liquidity conditions tightened on higher demand for credit during the festival season. Banks such as SBI, HDFC, and Axis have raised deposit rates in some tenures by up to about 80 basis points as they go all out to take more funds to keep pace with strong credit growth. To reduce its huge balance sheet and control inflation, the European Central Bank announced changes to the terms of its ultra-cheap loans to commercial banks and increased interest rates. The ECB raised its deposit rate by another 75 basis points to 1.5%, the highest rate since 2009. The higher international interest rate would pressure the RBI to maintain high rates to keep the currency from further depreciation. Thank you.
Well written!
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