The Reserve Bank of India as the lender of last resort provided various general and sector-specific refinance facilities to the commercial banks such as Export Credit refinance, collateralised lending facility. However in keeping with the recent policy objective of shifting from direct/ regulated/administered instruments to indirect techniques of market-based instruments of monetary control, it became necessary to get rid of all sector-specific and discretionary refinance facilities and to move towards a general policy of refinance facility. The Narsimhan Committee on banking sector reforms in 1998 suggested that for orderly movement of interest rates in interbank call money markets the RBI support to the market should be through the Liquidity Adjustment facility (LAF). Under this, the RBI would periodically, if necessarily daily, resets its repo and reverse repo rate which would in a sense provide a reasonable corridor for market play.
Accordingly the Interim Liquidity Adjustment Facility or ILAF was introduced from 21 April 1999 which was followed by the introduction of final LAF from Jun 5 2000.
In other words under ILAF funds are absorbed by the RBI from the financial system by the Repos at fixed interest rate but injected to the system at multiple rates though the standing refinance facilities and Additional Collateralised Lending Facility.
After the working of Interim LAF for about a year, a full-fledged Liquidity Adjustment Facility came into being in June 2000. The LAF operates through repo auctions, i.e. the sale of government securities from the Reserve Bank of India for absorption of liquidity and reverse repo auctions i.e., 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 rates.
The funds under LAF are expected to be used by the banks for their day-to-day liquidity mismatches. The maturity of repos is from 1 to 14 days. All scheduled banks and primary dealers are eligible to participate in the repo and reverse repo auctions. The minimum bid size for LAF is 8.5 crores and in multiples of 5 crores thereafter. All transferable government dated securities or treasury Bills (except 14 days TBs) can be traded in repo and reverse repo market.
Under LAF the RBI periodically sets/ resets its repo and reverse repo rates, it uses three days or four days repos to siphon off liquidity from the markets. The repos are used for absorbing liquidity at the given rate (floor) and for infusing liquidity, reverse repos at a given ceiling or cap rate is used.
There thus exists an interest rate corridor in the interbank call money market with repo rate as the floor rate and the bank rate acting as the ceiling rate and the call rate acting as the middle rate.
Read More about Repo and Reverse Repo Operations