# What Is a Liquidity Adjustment Facility in Monetary Policy?

![Liquidity Adjustment Facility (LAF): A way for banks and financial institutions to raise funds to meet capital requirements.](https://www.investopedia.com/thmb/PK9MTzTvt0CnsGzWhYvXphijJ54=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Liquidity_adjustment_facility_final-8de263f14f034a3d9a92ef0e6ac93a77.png)

*— Investopedia / Michela Buttignol*

> **Definition**
>
> A liquidity adjustment facility is a monetary tool used by a country’s central bank to help commercial banks manage short-term cash shortages or surpluses by borrowing or lending money, typically overnight.

## What Is a Liquidity Adjustment Facility?

A liquidity adjustment facility (LAF) is a tool used in [monetary policy](https://www.investopedia.com/terms/m/monetarypolicy.asp), primarily by the [Reserve Bank of India](https://www.investopedia.com/terms/r/rbi.asp) (RBI), that allows banks to borrow money through repurchase agreements (repos) or to make loans to the RBI through reverse repo agreements. This arrangement is effective in managing liquidity pressures and assuring basic stability in the financial markets. In the United States, the Federal Reserve transacts repos and reverse repos under its open market operations.

The RBI introduced the LAF as a result of the Narasimham Committee on Banking Sector Reforms (1998). 

### Key Takeaways

*   A liquidity adjustment facility is a monetary policy tool used in India by the Reserve Bank of India or RBI.
*   The RBI introduced the LAF as part of the outcome of the Narasimham Committee on Banking Sector Reforms of 1998. 
*   LAFs help the RBI manage liquidity and provide economic stability by offering banks the opportunity to borrow money through repurchase agreements or repos or to make loans to the RBI via reverse repo agreements.
*   LAFs can manage inflation in the economy by increasing and reducing the money supply.

## Basics of a Liquidity Adjustment Facility

Liquidity adjustment facilities are used to aid banks in resolving any short-term cash [shortages](https://www.investopedia.com/terms/s/shortage.asp) during periods of economic instability or from any other form of stress caused by forces beyond their control. Various banks use eligible securities as [collateral](https://www.investopedia.com/terms/c/collateral.asp) through a repo agreement and use the funds to alleviate their short-term requirements, thus remaining stable.

The facilities are implemented on a day-to-day basis as banks and other financial institutions ensure they have enough capital in the overnight market. The transacting of liquidity adjustment facilities takes place via an [auction](https://www.investopedia.com/terms/a/auction.asp) at a set time of the day. An entity wishing to raise [capital](https://www.investopedia.com/terms/c/capital.asp) to fulfill a shortfall engages in repo agreements, while one with excess capital does the opposite and executes a reverse repo. 

## Liquidity Adjustment Facility and the Economy

The RBI can use the liquidity adjustment facility to manage high levels of [inflation](https://www.investopedia.com/terms/i/inflation.asp). It does so by increasing the repo rate, which raises the cost of servicing debt. This, in turn, reduces investment and [money supply](https://www.investopedia.com/terms/m/moneysupply.asp) in India’s economy.

Conversely, if the RBI is trying to stimulate the economy after a period of slow economic growth, it can lower the repo rate to encourage businesses to borrow, thus increasing the money supply. For example, the RBI increased the repo rate by 40 [basis points](https://www.investopedia.com/ask/answers/what-basis-point-bps/) in May 2022 to 4.40% from 4.00%. In another example, the reverse repo rate was cut to 3.35% from 3.75% in 2020.

> **Fast Fact**
>
> As of May 2025, the repo rate is 6.00%.

## Liquidity Adjustment Facility Example

Let’s assume a bank has a short-term cash shortage due to a [recession](https://www.investopedia.com/terms/r/recession.asp) gripping the Indian economy. The bank would use the RBI's liquidity adjustment facility by executing a repo agreement by selling [government securities](https://www.investopedia.com/terms/g/governmentsecurity.asp) to the RBI in return for a loan with an agreement to repurchase those securities. For example, say the bank needs a one-day loan for 50,000,000 [Indian rupees](https://www.investopedia.com/terms/i/inr.asp) and executes a repo agreement at 6.25%. The bank's payable interest on the loan is ₹8,561.64 (₹50,000,000 x 6.25% / 365).

Now, let’s suppose the economy is expanding, and a bank has excess cash on hand. In this case, the bank would execute a reverse repo agreement by making a loan to the RBI in exchange for government securities, in which it agrees to repurchase those securities. For example, the bank may have ₹25,000,000 available to loan the RBI and decide to execute a one-day reverse repo agreement at 6%. The bank would receive ₹4109.59 in interest from the RBI (₹25,000,000 x 6% / 365).

## What Is a Liquidity Adjustment Facility?

A liquidity adjustment facility is a monetary policy tool used by the Reserve Bank of India that allows banks to borrow money through repurchase agreements or lend to the RBI via reverse repo agreements. This mechanism helps manage liquidity pressures and maintain stability in the financial markets.

## Why Was the LAF Introduced?

The RBI introduced the LAF following recommendations from the Narasimham Committee on Banking Sector Reforms in 1998.The primary goal was to provide banks with a mechanism to manage short-term liquidity mismatches.

## How Do Repo and Reverse Repo Operations Function in LAF?

In a repo operation, banks borrow funds from the RBI by selling securities with an agreement to repurchase them later, thus injecting liquidity into the banking system. On the other hand, in a reverse repo operation, banks lend funds to the RBI by purchasing securities, which helps absorb excess liquidity.

## What Is the Purpose of the Repo Rate?

The repo rate is the interest rate at which the RBI lends money to commercial banks under the LAF. Adjusting the repo rate influences borrowing costs for banks, thereby impacting the money supply and inflation in the economy.

## The Bottom Line

The liquidity adjustment facility is a tool used by the Reserve Bank of India to regulate short-term liquidity in the banking system through repurchase and reverse repurchase agreements. Introduced after the Narasimham Committee’s recommendations, it helps banks manage temporary cash flow shortages. By changing the repo and reverse repo rates, the RBI can steer credit availability, money supply, and inflation levels in the economy.

> **Article Sources**
>
> 1.  Federal Reserve Bank of New York. “[Repo and Reverse Repo Agreements](https://www.newyorkfed.org/markets/domestic-market-operations/monetary-policy-implementation/repo-reverse-repo-agreements).”
>     
> 2.  Reserve Bank of India. “[Report of the Committee on Banking Sector Reforms – A Summary](https://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/july98-bul5.pdf).” Pages 571-572.
>     
> 3.  Reserve Bank of India. “[Report on Trend and Progress of Banking in India, 2003-04](https://www.rbi.org.in/upload/Publications/PDFs/58851.pdf).” Page 175.
>     
> 4.  Reserve Bank of India. "[Monetary Policy Statement, 2022-23 Resolution of the Monetary Policy Committee (MPC) May 2 and 4, 2022](https://www.rbi.org.in/commonperson/english/Scripts/PressReleases.aspx?Id=3356)."
>     
> 5.  Reserve Bank of India. “[Monetary Policy Statement, 2020-21: Resolution of the Monetary Policy Committee (MPC) May 20 to 22, 2020](https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49843).”
>     
> 6.  Reserve Bank of India. "[Money Market Operation](https://www.rbi.org.in/scripts/BS_ViewMMO.aspx)."