Liquidity adjustment facility

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.