What Is a Liquidity Adjustment Facility?

A liquidity adjustment facility is a business that loans money to banks when banks do not have enough to give out to customers or fall below a certain cash-on-hand limit. Borrowing from a liquidity adjustment facility is only supposed to be a short-term solution, and the amount of money loaned out usually is not as much as in long-term borrowing solutions. When a bank borrows money from this type of facility, it often needs to set up collateral, such as its financial securities. Repurchase agreements are commonly used, so the facility gets its money back with interest.

According to fractional reserve system (FRS) laws, which are used in most countries and regions, a bank has to keep some unused money so withdrawals are possible. If there heavy withdrawals, or if the bank somehow falls below the FRS limit, it needs money. One place a bank can turn for money is a liquidity adjustment facility, a business that loans specifically to banks.

There are long-term solutions for banks that are under-stocked with money, but a liquidity adjustment facility is not one of them. This facility is only set up to handle short-term loans, so the amount of money they give out usually is less than that offered through long-term solutions, and they usually have shorter repayment times. The interest rate placed on the bank’s loan also may be higher, though that isn't always the case.

Much like people often need collateral to borrow money from a bank, a bank needs to offer collateral to receive a liquidity adjustment facility loan. Unlike people, who use property or assets as collateral, banks can only use assets and financial securities, including the interest gained from accounts, bonds and other financial assets the bank owns. If the bank successfully repays its loan, then the collateral will be returned.

When a liquidity adjustment facility and a bank enter a loan agreement, a repurchase agreement is written up. This agreement states the interest rate the bank has to pay back on this short-term loan and describes the securities the bank is putting up for the loan, so both the facility and bank know what securities are going back to the bank after the repurchase. The repurchase agreement also states how much more money the bank has to pay back in late payments if the repayments are not made on time.