The LAF has emerged as one of the most important instruments of monetary policy in recent years. The RBI, as the lender of the last resort, was providing various general and sector-specific refinance facilities to the banks.
In keeping with the recent policy objective of shifting from direct to indirect techniques of monetary control. It became a general refinance facility.
The LAF operates through repo auctions,that is, the sale of Government securities from the RBI portfolio for absorption of liquidity, and reserve repo auctions, that is, buying of Government securities for injection of liquidity on a daily basis, thereby creating a corridor for the call money rates and other short-term interest rates.
The funds under LAF are expected to be used by banks for their day-to-day mismatches in liquidity. The maturity of repos is form one day to fourteen days. All scheduled banks are eligible to participate in the repo and reverse repo auctions.
The minimum bid size for LAF is rs.5 crore and in multiples of Rs. 5 crore thereafter. All transferable Government of India dated securities/T-bills (expect 14-day T-bills) can be traded in the repo and reverse repo markets.
The DL is the sum of the RBI balance sheet flows that arise out of its money market operation.It represent a change in the total liquidity in the system which occurs due to monetary policy action. It comprise policy-induced flows from the RBI to banks. It is the sum of the following i) net repos and OMOs of the RBI and ii) RBI credit to banks.
The LAF technique is based on the view that the RBI balance sheet can be partitioned into autonomous and discretionary components.The Autonomous liquudity(AL) and DL bear an inverse relationship with the change in the change in the inter-bank call money rate.
The AL is the sum of RBI’s net incremental claims on the following.
i) the Government adjusted for OMOs and repo operation.
ii) Banks(other than credit to schedule banks)
iii) Commercial sector.
iv) Foreign assets net of liabilities (Other than schedule bank deposit with RBI.
Under LAF the RBI periodically daily if necessary, sets/rests its repos and reverse repo rate.It uses 3-day repos to siphon of liquidity from the market. The repos are used for absorbing liquidity at a given rate (floor) ,and for infusing liquidity through reverse repos, at a given rate( ceiling).
Merits of LAF
i) The LAF is a new short-term liquidity management technique.
ii)It is a flexible instrument in the hands of the RBI to modulate, even out, adjust or manage short-term market.
iii) Liquidity fluctuation on a daily basis and to help create stable or orderly conditions in the overnight/call money markets.
iv)It is meant to help monetary authorities to transmit short-term interest rate signals to other money markets, financial markets, and the long-end of the yield curve.
V) The repos operations also provide liquidity and breadth to the underlying treasury securities markets.
The LAF operations combined with OMOs and B/R changes, have become the major technique (operating procedure) of the monetary policy in INDIA.