Liquidity Adjustment Facility

Also called: LAF · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Beyond NCERT

Meaning

The Liquidity Adjustment Facility (LAF) is the RBI's system of repo, reverse repo and standing facilities, at fixed and variable rates. The RBI uses it to manage day-to-day liquidity (how much ready cash banks have) in the banking system.

It matters because announcing a repo rate (the interest rate at which the RBI lends money to banks for a short time, against government bonds) does not make market rates follow it. The LAF adds or removes cash so that the Weighted Average Call Rate (WACR) stays close to the repo rate. Only then does a rate change reach the rest of the financial system [1].

Explanation

How the LAF works: two directions

• Repo adds liquidity.
• A bank sells government securities to the RBI and agrees to buy them back later.

• The bank gets cash now, so more money flows into the market.

• Reverse repo / SDF takes liquidity out.

• Banks park their extra cash with the RBI and earn interest on it.

• That cash leaves the market.

• Current components: overnight and term repo/reverse repo, at fixed and variable rates, plus the Standing Deposit Facility (SDF) and the Marginal Standing Facility (MSF) [1].

Components: auctions and standing windows

• Variable Rate Repo (VRR): an auction where banks bid for RBI funds at or above the repo rate. The RBI adds cash this way.
• Variable Rate Reverse Repo (VRRR): an auction where banks bid to park extra funds with the RBI. The RBI takes cash out this way.
• The rate is called "variable" because it comes from the banks' bids, not from a fixed number. So the auction shows how much banks really need cash, or how much they want to park it.

• Tenor (how long the deal lasts): overnight to 14 days.

• Standing facilities are windows that are always open. Banks can use them on their own, without waiting for an RBI auction.

• MSF (May 2011): an overnight emergency borrowing window at a penal rate (a rate set above repo to discourage use), repo + 25 bps [1]. (100 bps = 1 percentage point.)
• SDF (April 2022): a collateral-free overnight window where banks park extra funds, at repo − 25 bps [1].

The corridor: the band the LAF keeps rates inside

• Ceiling = MSF rate. No bank will borrow in the market above MSF, because it can borrow from the RBI at MSF instead.
• Floor = SDF rate. No bank will lend in the market below SDF, because it can park money with the RBI at SDF instead.
• Middle = repo rate [1][2].
• Worked example: corridor width (December 2025 rates) [3]
• MSF 5.50% − SDF 5.00% = 0.50 percentage points = 50 bps.

• The corridor is symmetric: 25 bps on each side of the 5.25% repo rate.

• Worked example: WACR, the rate the LAF steers

• Formula: WACR = Σ (rateᵢ × volumeᵢ) ÷ Σ volumeᵢ
• Deal A: ₹6,000 crore at 5.20%. Deal B: ₹4,000 crore at 5.35%.
• WACR = (31,200 + 21,400) ÷ 10,000 = 5.26%. This is close to the 5.25% repo rate, so the target is being met.

What pushes liquidity up or down

• Net LAF position = money taken in by the RBI − money lent out by the RBI.
• Surplus (banks are parking net funds with the RBI) → WACR is pulled toward the SDF floor → the RBI runs a VRRR to take out the extra cash and lift WACR back toward repo [1].

• Deficit (banks are borrowing net funds from the RBI) → WACR is pushed toward the MSF ceiling → the RBI runs a VRR to add cash.

• Autonomous drivers (things that change liquidity without any RBI decision):

• Festivals and elections → people withdraw cash from banks → liquidity falls.
• Tax dates → money moves from bank accounts to the government's account with the RBI → liquidity falls. Government spending → liquidity rises.

• RBI sells dollars to support the rupee → banks pay rupees to the RBI → liquidity falls. RBI buys dollars → liquidity rises.

• Transient vs durable liquidity:

• Transient (short-lived) imbalances are handled by the LAF's 7-day and fine-tuning VRR/VRRR [1].
• Durable (long-lasting) imbalances need other tools: open market operations (outright purchase or sale of government bonds) and CRR changes.

In India

• Start: the RBI began the LAF in June 2000, following the Narasimham Committee II (Committee on Banking Sector Reforms).
• Who runs it: the Reserve Bank of India. Its operating target is the WACR, which is the volume-weighted average rate in the overnight call money market (where banks lend to and borrow from each other for one day) [1].
• Main operation over time:
• Feb 2020 framework (announced 6 February 2020): the 14-day VRR/VRRR was the main operation. It was timed to match the fortnightly CRR maintenance cycle [4][2]. The CRR (cash reserve ratio) is the share of NDTL (net demand and time liabilities, roughly a bank's deposits) that a bank must keep as cash with the RBI [1].
  • Example: a 14-day VRRR on 15 January 2021 had a notified amount of ₹2,00,000 crore [4].

• Current framework (after the 2025 review): short-lived liquidity is managed mainly through the 7-day VRR/VRRR. The RBI can also run other operations, from overnight to 14 days, when it chooses [1].

• MSF SLR dip: under MSF, a bank can borrow using government securities it holds for its Statutory Liquidity Ratio (SLR) (the minimum share of deposits it must keep in safe liquid assets), even if this takes it below the SLR requirement, up to 2% of NDTL [1].

• Example: NDTL of ₹1,00,000 crore → SLR dip of ₹2,000 crore. At 5.50%, one night costs about 2,000 × 5.50% ÷ 365 ≈ ₹30 lakh.

• Law behind SDF: Section 17(2A) of the RBI Act, 1934, inserted by the Finance Act 2018. The SDF replaced the fixed-rate reverse repo (3.35% at the time) as the floor. The fixed-rate reverse repo is now used only when the RBI chooses [1].

• Latest rates (5 December 2025 policy, neutral stance): SDF 5.00%, repo 5.25%, MSF = Bank Rate 5.50% [3]. (Check current rates before the exam. Later MPC meetings may have changed them.)

Don't confuse with

• Repo rate vs WACR: the repo rate is the policy rate that the RBI announces. The WACR is the operating target, the market rate that the LAF tries to keep near repo [1].
• Reverse repo vs SDF: under a reverse repo, the RBI must give banks government bonds as collateral (security). The SDF needs no collateral, so the RBI does not run short of bonds when it takes in very large surpluses.
• LAF vs Open Market Operations (OMOs): the LAF handles transient (short-lived) liquidity through repo/reverse repo deals that reverse after a fixed time. OMOs are outright purchases or sales of bonds and handle durable (long-lasting) liquidity.
• MSF vs repo: repo is the normal borrowing window at the policy rate. MSF is an emergency overnight window at a penal rate (repo + 25 bps) and allows an SLR dip [1].

Prelims Hooks

• The LAF began in June 2000, on the recommendation of the Narasimham Committee II.
• Corridor: floor = SDF (repo − 25 bps), ceiling = MSF (repo + 25 bps), width = 50 bps. MSF rate = Bank Rate (5.50% in Dec 2025) [3].
• Trap: the operating target of monetary policy is the WACR, not the repo rate. Repo is the policy rate [1].
• SDF (April 2022) is collateral-free. Its legal basis is s.17(2A) of the RBI Act, inserted by the Finance Act 2018. It replaced the fixed-rate reverse repo (3.35%) as the floor.
• Current main LAF operation: the 7-day VRR/VRRR [1]. Under the Feb 2020 framework it was the 14-day VRR/VRRR, timed to the CRR cycle [2][4].
• Liquidity surplus → WACR moves toward SDF. Deficit → WACR moves toward MSF. RBI selling dollars and tax payments drain liquidity. Government spending adds liquidity.

Mains Points

• Rate cuts work only if liquidity allows them to:
• A repo cut helps borrowers only if the WACR and other market rates also fall.
• If the system is short of cash, the WACR stays near MSF and the cut does not reach borrowers.

• So managing liquidity through the LAF (VRR/VRRR), OMOs and CRR is as important as the rate decision itself [1].

• SDF as a structural reform:

• A floor that needs no collateral lets the RBI take in very large surpluses, for example after heavy dollar buying or big government spending, without running out of government bonds.

• This makes the corridor more reliable. It also shows how a change in law (Finance Act 2018) can create a new monetary-policy tool.

• Trade-off between defending the rupee and keeping liquidity steady (GS-III):

• When the RBI sells dollars to support the rupee, rupee liquidity falls and the WACR rises toward MSF.
• This can make credit tighter at a time when the RBI may want easier money. The RBI then has to refill liquidity through VRR or OMO purchases.
• A narrow, symmetric 50 bps corridor, one target (WACR) and a short main operation (7-day, earlier 14-day) make the RBI's signals clearer. The cost is that the RBI has to act in the market more often.

Related concepts

• Variable Rate Repo
• Variable Rate Reverse Repo
• Marginal Standing Facility
• Standing Deposit Facility
• Policy rate corridor
• Weighted Average Call Rate
• Banking system liquidity

Read more

• The operating framework: LAF, the corridor and WACR