Liquidity adjustment facility: A primer

The RBI narrowed the 'corridor' of its liquidity adjustment facility (LAF) by 25 basis points (bps)

The Reserve Bank of India (RBI), in its monetary policy on April 6, narrowed the ‘corridor’ of its liquidity adjustment facility (LAF) by 25 basis points (bps). This was done by raising the reverse repo rate to six per cent from 5.75 per cent, while keeping the repo rate intact at 6.25 per cent.

Repo signifies the rate at which liquidity is injected in the banking system by the RBI whereas reverse repo signifies the rate at which the central bank absorbs liquidity from the banks. Both the rates are overnight and create the benchmark for other overnight rates in the market as far as banks are concerned. The LAF is, thus, used to aid banks in adjusting the day-to-day mismatches in liquidity.

The corridor is so called because this is a band in which the overnight call rates (borrowed and lent between banks just for a day) move. Now, the weighted average of these call rates is the target of the central bank policy. This is because in India there is no true term repo market even as the central bank is trying to create one. Between banks, borrowing and lending activities are largely limited to the overnight market only in the call money space.

If the corridor is wide, the RBI’s grip on the rate in the banking system and, thereby, the economy loosens. The narrow corridor instead gives the RBI tighter control and ensures a “finer alignment of the weighted average call rate”. With the same aim in mind, the RBI had narrowed this corridor in its previous annual policy in April 2016 from 100 bps to 50 bps.

Plugging the liquidity tap

• ‘Corridor’ is the difference between repo and reverse repo rates
• It is so called as call rates should move between these two rates
• The RBI’s policy target is the weighted average call rate
• In April 2016, the RBI had lowered the corridor to 50 bps from 100 bps
• In April 2017 policy, the corridor lowered to 25 bps
• Narrow corridor gives tighter control on overnight call rates
• Since banks transact overnight money at call rate, controlling it controls the banks’ rates
• Narrowing of corridor ensures effective policy transmission