In the recent time-series of bonds issued by (for example) Germany, Austria and France we see an unfamiliar phenomenon: negative yields. This is mainly the issue on the short end of the yield curve. For a picture see: http://www.ecb.europa.eu/stats/money/yc/html/index.en.html

My question is, why banks or possibly other companies are willing to pay a government for holding their money?

Would it not make more sense to simply hold the cash instead? Stuffing cash under the mattress may be risky and costly for an individual but not for a financial institution. A bank may park money in an ECB account and get a minimal but positive overnight rate for doing so, right?

  • $\begingroup$ Good question ;) $\endgroup$ – Ric Sep 26 '12 at 13:44

Taking the case of companies other than the bank, when you have a large amount of cash, you won't stock it in your backyard as there would be insurance and logistics costs that would cost you more than the negative government yield.

I believe the main reason why people are willing to accept the negative yield is essentially for counterparty risk diversification reasons. Putting your money in a single bank makes you vulnerable to the default risk of that bank (and don't even think it doesn't exist). So you can diversify through several banks but you're still exposed to the overall banking sector risk. So, the next step is to diversify using government bonds, which are likely to be safer than banks. I've seen it used for foreign exchange trades where you don't want to take the risk of a bank for example.

  • $\begingroup$ Naive question: Can a non-financial company buy a bond and hold it by itself? I.e. not being exposed to the credit risk of some bank acting on behalf of that company? $\endgroup$ – Julian Wergieluk Sep 26 '12 at 13:15
  • $\begingroup$ Yes. But you are still exposed to the credit risk of the company issuing the bond. $\endgroup$ – user7056 Sep 28 '12 at 8:25

By holding the bond, you can fund yourself cheaper with repos, so the fair comparison is to check that if you are still negative after taking in account the repo rate you save from the funding rate by posting collateral.

In addition to that, as a bank you may have to hold the securities as a hedge/replication for another trade or you may have to hold a minimum of securities as part of a market making activities.

There are as well many financial institutions which do not have access directly to the ECB, did you factor all of this in your analysis ?

  • $\begingroup$ Your repo market argument sounds interesting. Do you have any references explaining why gov. bonds are better collateral than cash? Thanks! $\endgroup$ – Julian Wergieluk Sep 26 '12 at 12:58
  • $\begingroup$ @Julian Wergieluk: I think the difference is slightly different than what you suggest. The benefit of holding a bond is not only limited to the yield, you can also use secured borrowing to borrow money at a cheaper rate than unsecured funding. I realised that what I said in my reply is not really exact so I will amend it later on. $\endgroup$ – BlueTrin Sep 26 '12 at 17:21

Overnight and repo rates might be even less favorable when counterparty risk, and the hedging that goes with it, is considered. Strange world these days...

  • $\begingroup$ Yes, but what about holding the cash? The interest-rate is 0% but the quality of such a position is superior to everything else. $\endgroup$ – Julian Wergieluk Sep 25 '12 at 20:23
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    $\begingroup$ A T-bill is a security and has a direct right of ownership. Cash deposit is co-mingled with other depositors and thus can be defaulted on. $\endgroup$ – Strange Sep 25 '12 at 23:16
  • $\begingroup$ Exactly. Many banks are still facing hundreds-of-millions in unsettled litigation liabilities related to mortgages, LIBOR, banking w/ un-sanctioned countries, etc. Not to mention the MF Global, Peregrine, and Knight Capital fiascoes that already occurred this year. $\endgroup$ – jeff m Sep 26 '12 at 0:25
  • $\begingroup$ But what about parking money overnight at the central bank? ECB overnight rate is currently 0%. The probability that ECB defaults is less equal the default probability of a government (in case of France, for example). Additionally, you can withdraw your money at any time. $\endgroup$ – Julian Wergieluk Sep 26 '12 at 10:28
  • $\begingroup$ I'm not as familiar with European banking, but I believe that the only banks able to deposit money at the ECB are the national central banks of the member states. $\endgroup$ – jeff m Sep 26 '12 at 12:34

Cash is not unlimited. And, if everybody invested in cash while cash getting unlimited, in the end one is in a world filled with papers, which lose their value.

Secondly, but now last, banks, governmental institutions etc are obliged by (inter)national agreements to keep a percentage of their assets in such type of sure assets (A1 assets as per Basel III definitions). And this percentage has been recently increased, on a background of governments scheduling a decrease in their debt/emmited bonds.

  • $\begingroup$ Regarding your second point, cash counts as an A1 asset too (assuming A1 == level 1 in the reference I found: "Level 1 assets are cash, certain government securities and other 0% risk-weighted assets under Basel II.") $\endgroup$ – Darren Cook Oct 3 '12 at 1:08
  • $\begingroup$ Cash is limited and the monetary mass is not sufficient. Also cash is on its dissapearance road. Here there is the governmental view of the French government, to replace cash with software money, for example economie.gouv.fr/files/rapport-moyens-paiement-2012.pdf. A sort of English-ed version: knowledge.wharton.upenn.edu/article.cfm?articleid=3017 $\endgroup$ – user7056 Oct 4 '12 at 12:10

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