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I know commercial banks need to meet liquidity requirements, but why would they choose to invest their money in an instrument that is guaranteed to give them a negative return, instead of just keeping their clients' money in "cash"?

Is there some legislation forcing them to use government bonds?

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For a bank , the basic choice of assets is between (a) loans to customers (b) invest in financial asset such as government bond (c) deposits with the central bank. Note that (c) may return a negative interest rate, so (b) may be better than (c). Holding a large amount of physical cash in the vault is not practical for a bank of any decent size, due to the cost of storage and insurance. It would also be discouraged by the bank regulators , because it would frustrate the negative interest rate policy the central bank is trying to apply.

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  • $\begingroup$ A few issues with this. 1) Government pays printing cost, not private sector. 2) Central bank does not have the legal ability to “ban” such an activity. At best, bank regulators could make it known that they are unhappy. However, this would not deter non-banks. 3) There were discussions around a cash-backed ETF in the euro area. Not sure why it was never launched, but security concerns seemed to be the biggest problem. Very hard to get insurance, $\endgroup$ – Brian Romanchuk Oct 11 '20 at 12:08
  • $\begingroup$ Editing to take into account @Brian Romanchuk comments $\endgroup$ – dm63 Oct 11 '20 at 23:33

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