Why the LAF?
The central bank is responsible in facilitating the smooth functioning of the financial system. An important distorting phenomenon associated with the operation of the financial system is illiquidity. Liquidity means adequate and timely cash in the system for financial institutions to carry out their functions. Liquidity situation in the economy as a whole may fluctuate highly due to many factors. Excess liquidity may transfer itself into price rise. Simultaneously, liquidity shortages lead to havoc in the financial system especially in the banking system. The responsibility of the RBI is to keep liquidity in a daily manner.
How it works?
The LAF as its name suggests is a liquidity adjustment mechanism for the banking system. It is aimed to inject liquidity into the system when there occurs liquidity shortages. Simultaneously, it absorbs liquidity when there is excess liquidity. For all these purposes, the LAF is working in an automatic manner based on repo and reverse repo operations. The LAF is operating on a daily basis. The central point of LAF is that liquidity injection is done through Repo operations and liquidity (absorption from banks to the RBI) is done through Reverse repo operations.
The working of repo and reverse repo operations under LAF is simple. Banks which have liquidity shortages, approach the RBI and gives government securities to it while obtaining loans. During the time of liquidity stringency, most of the commercial banks will be resorting to repo operations. On the other hand, during the time of excess liquidity, the commercial banks will be parking money with the RBI and thus will be earning an interest rate (at reverse repo rate).
The reverse repo rate is fixed at 1% lower than the repo rate. This means whenever the repo rate changes, the reverse repo rate also changes equally. For example, if the RBI increases repo rate by 25 basis points, the reverse repo rate also is increased by 25 bps.
The LAF, though is working on the basis of repo and repo mainly, it is also supported by other instruments such as the CRR (Cash Reserve Ratio), OMO (Open Market Operations) and MSS (Market Stabilization Scheme).