The Liquidity Adjustment facility(LAF) of RBI-Macro perspective.

Scheme of Liquidity Adjustment Facility: 2001- 02.

The introduction of the Liquidity Adjustment Facility (LAF) was announced in the slack season credit policy by the RBI governor and was made effective on the 5^th of June 2000. The system is being implemented in phases and currently is a daily exercise in which Banks and Primary Dealers (PD) participate.

Objectives of LAF

Amongst its many functions, Reserve Bank of India also acts as the banker of last resort. In this role, the central bank has to ensure that it can inject funds into the system to help participants tide over temporary mismatches of funds. Refinance, as it used to happen earlier was at a fixed rate which was largely divorced from the cost of equivalent short-term funds in the market. This gave rise to a non-egalitarian distribution of interest rates in the short end of the curve. Further, the amounts that could be borrowed were determined by a preset limit. To do away with the deficiencies, RBI moved to an auction system of repos and reverse repos to suck-out and inject liquidity to the market. The three broad objectives of LAF are as follows:

• To give RBI greater flexibility in determining both the quantum of adjustment as also the rates by responding to the system on a daily basis.
  
• To help RBI ensure that the injected funds are being used to fund day-to-day liquidity mismatches and not to finance more permanent assets.
• To help RBI set a corridor for short-term rates, which should ideally be governed by the reverse-repo (top band), and repo (lower band) rates. This would impart greater stability in the markets.

Methodology of LAF

The Financial Markets Committee, consisting of the operational Departmental Heads, which meets every day in the morning to assess market conditions, is responsible for decisions relating to the LAF. The Committee meets again at 12 noon to assess the bids received under LAF. The exact quantum of liquidity to be absorbed or injected and the accompanying repo and reverse repo rates are determined by the Committee after taking into consideration, the liquidity conditions in the market, the interest rate situation and the stance of monetary policy. The decisions are based on a myriad factors including net inflows and outflows on account of forex operations, current account balances of the banks against the CRR requirements, open market operations, redemption of loans and coupon payments, announcement of new issues by the government, un-drawn liquidity support on account of export refinance, collateralised lending facility to banks and level I refinance to PDs and the overall situation of the call money market. The rate of interest however is determined on the basis of the bids received from the market.

Observations in the LAF so far

The experience gathered from witnessing the LAF, which would be three months old soon, can be summed up through a few generalizations.

• RBI has received bids both from lenders as well as borrowers in the market
• Banks and PDs more aggressively do bidding for reverse repos, both in terms of rates and amounts
• The same participant often bids for both repo as well as for reverse repo even on the same date
• There exists a tendency to put in multiple bids, which is normal in any auction process
• On days there have been no bids for either repo, or reverse repo or for both
• On days, RBI has rejected all bids under repo and / or under reverse repo
• On days, RBI has been both injecting as well as taking out liquidity from the markets
• The closing call money rates on days of tighter liquidity conditions seem to have exceeded the rate at which RBI infused liquidity through reverse repos.

Some criticism of the LAF and RBI’s response

As is true with a new system, the LAF too has attracted a fair amount of criticism about the way it works. It is important to note that it is through these criticisms that the system shall evolve as an accepted and a foolproof one.

LAF discriminates between the lending banks and PDs

Reserve Bank of India, or for that matter any central bank is not there to present unlimited liquidity through the reverse repo auctions. While setting cut-off rates and the quantum in reverse repos, RBI keeps in mind the overall liquidity condition of the market and not bank-wise liquidity positions. RBI can monitor the bids submitted by the banks to identify the chronic borrowers and whether the reverse repo is being used as a "back-door" refinance for other more permanent assets.

The uniform price auction should be replaced with a discriminatory price auction

The main argument in favour of this being that given a uniform price auction which eliminates the "winner’s curse", the tendency is to submit higher bids to ensure success. This in turn leads to higher cut-off rates. The argument can be countered by the proposition that the uniform price auction leads to a single clearing rate, which sets a benchmark for the market. Also RBI feels that this form of auction is better for the post-auction market.

Counter arguments have it that a weighted average rate can emerge from a discriminatory price auction, which can serve as a benchmark and yet serve the purpose of fine-tuning the bids. RBI feels that there is no settled wisdom, even internationally, as to the ideal auction system and that it is open to a situation review from time to time.

LAF has increased interest rates, as call rates tend to follow the reverse repo cut-off

This would inevitably happen as the market players read from the actions of the central bank. The ultimate objective of the LAF is to adjust short-term liquidity situation to the overall policy stance. The LAF is still in the early protean stages of development and further fine-tuning is bound to improve the system.

PDs argue that they should be given assured liquidity at reasonable rates so that they are not hit on the carry

Higher cost of carry for PDs get transmitted to the market by higher bond yields. Also PDs face uncertainty that all bids might get rejected and they are left with nothing. It is important to remember that Level I refinance is still available to the PDs and that the LAF currently operates at the margin in replacement of Level II refinance. Thus to view the impact of the LAF on PDs, the reverse repo cut-off rate has to be seen in conjunction with the liquidity availed under Level I refinance and a weighted average will have a far greater relevance. As has been stated earlier, the objective of the LAF is with overall liquidity and not with the needs of individual market players.

Moving ahead

It is without doubt that the considerations on which the concept of LAF is based are extremely sound and that it has been able to make an impact on the market in a very short period of time. The mechanism has also come in handy for RBI to monitor and control short-term liquidity in the current volatility in the forex market. During the next one year, RBI intends to move into a system of a full-fledged LAF with multiple auctions, based on electronic dealing, and replacing traditional assured sources of liquidity at fixed interest rates.

The main features of the revised Scheme, known as LAF Scheme 2001-2002, are as under:

The Scheme

Under the scheme,
(i) Repo auctions (for absorption of liquidity) and
(ii) Reverse Repo auctions (for injection of liquidity)

will be conducted on a daily basis (except Saturdays). But for the intervening holidays and Fridays, the Repo tenor will be one day. On Fridays, the auctions will be held for three days maturity to cover the following Saturday and Sunday. The funds under LAF are expected to be used by the banks for their day-to-day mismatches in liquidity.

Fixed rate Repo auction

RBI will henceforth have an additional option to switchover to fixed rate Repos on overnight basis; but this option is expected to be sparingly used. For the purpose of such Repos, the rates of interest intended to be offered would be announced as part of auction announcement on the previous evening or before 10.00 a.m. on the day of auction, if necessary.

Long term Repo

• In addition to overnight Repos, RBI will also have the discretion to introduce longer-term Repos up to 14 day period as and when required.

Rate of Interest

Till recently, auctions under LAF were conducted on ''uniform price'' basis. It was decided to introduce ''multiple price'' auction, in place of existing uniform price auction on an experimental basis and after evaluation of the experience, the RBI in consultation with the market participants has decided to continue with the system of multiple price method of repo and reverse repo auctions until further notice.

Interest rates in respect of both Repos and Reverse Repos will be, accordingly, based on the bids quoted by participants and subject to the cut-off rates as decided by the Reserve Bank of India, at Mumbai. The Repo/Reverse Repo rate in per cent per annum expected by the tenderer will be expressed up to two decimal points rounded off to the nearest 5 basis points. As there will be no adjustment for accrued coupon, the cash flow will depend upon the Repo rate emerging on day-to-day basis.

Back - Stop Facility

For a smooth transition to full-fledged operation of LAF, banks and PDs are being provided a back-stop facility at variable rate of interest, as a cushion over the normal liquidity facility at Bank Rate. Basically, the standing liquidity facilities available from RBI is split into two parts, viz.,

1. normal facility and
2. back-stop facility.

The normal facility will be provided at the Bank Rate. The back-stop facility will be provided at a variable daily rate. The variable rate would be linked to cut-off rates emerging in regular LAF auctions and in the absence of such rates, to National Stock Exchange - Mumbai - Inter-bank Offer Rate (NSE-MIBOR) as detailed below

1. The variable rate for the back-stop facility, to be fixed on a daily basis would be 1.0 percentage point over the reverse repo cut-off rate at which funds were injected earlier during the day in the regular LAF repos auctions.
2. Where no reverse repo bid was accepted as part of LAF auction, the rate will be 2.0 to 3.0 percentage points over the repo cut-off rate of the day emerged in LAF auction as may be decided by RBI.
3. In case no bids were accepted earlier during the day at either repo or reverse repo auctions, the rate will be 2.0 to 3.0 percentage points over NSE-MIBOR as may be decided by RBI.

The Back-stop facility would be operated till close of banking hours. And of the total limits of liquidity support available to PDs and banks, the normal facility would initially constitute about two-thirds and the back-stop facility about one-third. PD-wise and bank-wise limits will be announced separately.

Further, to facilitate better bidding by the participants, additional information on the aggregate cash balances of scheduled commercial banks maintained with RBI, during the fortnight, on a cumulative basis with a lag of two days as also weighted average cut-off yield will also be released as a part of the Press Release on money market operations.

Mechanics of operations

1. The LAF auction timing is being advanced by 30 minutes. Bids will be received in tender forms at IDM Cell before 10.30 a.m., as against 11.00 a.m. at present. A separate box for the purpose will be kept at the reception on the Ground floor of the Central Office Building, RBI, Mumbai. Processing of the bids will be done at IDMC. The auction results will be displayed by Mumbai Office by 12.00 noon as against 12.30 p.m. at present.
2. The Repo will be conducted as "Hold in Custody" type, wherein the Reserve Bank of India will act as a custodian for the participants and hold the securities on their behalf in the Repo/Reverse Repo Constituents’ Accounts. In pursuant to this, the participants will have to give an undertaking as given in the respective tender forms authorizing RBI to act on behalf of them. Reserve Bank of India shall not, however be responsible for any loss, damage or liability on account of acting as the Custodian on behalf of the participants. A Repo Constituents’ SGL Account (RC SGL Account) and Reverse Repo Constituents’ SGL Account (RRC SGL Account) will be opened and held in the Securities Department in Mumbai Office for this purpose which will have institution-wise subsidiary records of the securities sold under Repo and securities bought under Reverse Repo. RBI will have Subsidiary Accounts in the case of both of these Accounts.
3. On success in auction in respect of Repos, the tenderer’s RC SGL Account will be credited with the required quantum of securities debiting Bank’s subsidiary account/Investment Account. Likewise, the tenderer’s Current Account will be debited for the resultant cash flows and credited to the Bank’s Account. The transaction will be reversed in the second leg.
4. In the case of Reverse Repos, on acceptance of bid, the tenderer's SGL account/ RRC SGL Account will be debited with the required quantum of securities and credited to Bank’s Investment Account/Subsidiary RRC SGL Account. Accordingly, the tenderer’s Current Account will be credited with the Reverse Repo amount, debiting the Bank's account. The transactions will be reversed in the second leg.
5. Transactions between RBI and counter parties including operation of the RC SGL Account and RRC SGL Account would not require separate SGL forms as provision will be made in the application form for the purpose. Likewise, transfer of securities from/to RBI’s Investment Account and Subsidiary Accounts in the Repo and Reverse Repo SGL account will not require signing of SGL transfer forms. However, transfer from tenderer’s SGL Account to the RRC SGL Account will require completion of SGL form. In the case of Reverse Repos, tenderers will have the option to either use the RRC SGL Account route or getting their SGL Accounts debited for the purpose of transferring securities to RBI.
6. Pricing of all securities including Treasury Bills will be at face value for Repo/Reverse Repo operations by RBI. Accrued interest as on the date of transaction will be ignored for the purpose of pricing of securities. Coupon, if any, will be transferred to RBI in the case of Repos, and RBI will collect the coupon, if any, on the due date and credit the same to the party’s Current Account in the case of Reverse Repos.

Eligibility

All Scheduled Commercial Banks (excluding Regional Rural Banks) and Primary Dealers (PDs) having Current Account and SGL Account with RBI, Mumbai will be eligible to participate in the Repo and Reverse Repo auctions.

Minimum bid size

To enable participation of small level operators in LAF and also to add further operational flexibility to the scheme, the minimum bid size for LAF is being reduced from the existing Rs.10 crore to Rs.5 crore and in multiples of Rs.5 crore thereafter.

Margin Requirement

A margin will be uniformly applied in respect of the above collateral securities comprising the Government of India dated securities/ Treasury bills. The amount of securities offered or tendered on acceptance of a bid for Rs.100 will be Rs.105 in terms of face value.

Settlement of Transactions

The settlement of transactions in the auction will take place on the same day.

SLR and Securities held in Repo SGL Account

Securities held by RBI on behalf of banks' Repo Constituents’ SGL account and credit balance in the RRC SGL Account will be counted for SLR purpose and a certificate will be issued to banks by RBI on a fortnightly basis. As far as valuation etc. for SLR purpose is concerned, extant DBOD instructions will apply.