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In Which Context is the Option Clause Desirable?

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Abstract

The option clause is a contractual device from free banking experiences meant to prevent banknote redemption duels. It has been used within the Diamond and Dybvig (J Pol Econ 91: 401–419, 1983) framework to suggest that very simple contractual solutions can act as an alternative to deposit insurance. This literature has, however, been ambiguous on whether the option clause can replace deposit insurance outside of those two contexts. It will be argued that the theoretical clause does not generally affect the likelihood that a solvent bank goes bankrupt because of a bank run, as empirical evidence suggests it is already near null, and that the exercise of the clause will have the effect of diminishing the size of creditor claims on bank assets because it exacerbates the agency problem of bank debt. It will therefore be argued that the clause is only desirable in (a) free banking systems that are historically devoid of bank runs in the first place and have other means of managing debt-related agency problems and (b) under the unrealistic assumption that bank runs are self-fulfilling prophecies. It will be argued that the agency problem of bank debt makes the option clause undesirable outside of free banking systems.

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Notes

  1. This theoretical literature essentially comprised Dowd (1988), Dowd (1991, 1993, 1996), Cowen and Kroszner (1989), Schuler (1992b), Selgin (1993, 1988), White (1999), Selgin and White (1987, 1994), and Selgin and White (1997).

  2. Henceforth cited as “the clause” for the sake of brevity.

  3. For other examples of option clauses in free banking systems, see Jonung (2000) for 1864–1903 Sweden and Schuler (1992a) for nineteenth century Canada. See also Hammond (1957, p. 174) for one known case in 1804–1809 Boston.

  4. A contemporary anonymous comment cited in White (1995, p. 143) is particularly revealing “A run upon any bank, such as happens in England sometimes or a panic, are terms the meaning of which is hardly understood in Scotland.”

  5. For a critique of point (3.a), namely that the clause reduces the incentives to run, see Yeager (1993), Gherity (1995), and Shah (1997). However, note that it would seem like simple modifications in the payoff and interest accumulation, not involving additional transaction costs, could solve this problem.

  6. More specifically, in a context of competing money issuance and extended liability of shareholders.

  7. Diamond and Dybvig suggest ‘sunspots’ as a reason for this instant change in expectations. It is a way of saying that the source for these beliefs is exogenous to the model, and can be any belief, right, or wrong, about anything that might affect banking even in the most remote and indirect way, further emphasizing the bank’s fragility. This is why it is sometimes called the random withdrawal theory of bank runs.

  8. For a review of the critical literature on Diamond and Dybvig see White (1999, pp. 127–133).

  9. Selgin mentions a third type of bank runs, simply suspending the activities of the clearing house. There is, however, no room for a clearing house in the Diamond and Dybvig framework, as there is only one bank.

  10. The Bank of Scotland was forced to do so because it was the only one to include in its bylaws the right to summary diligence upon convertibility of its notes (Gherity 1995, pp. 717–718), in contradiction with the informal ad hoc use of the clause.

  11. Goodspeed (2014, pp. 38–39) explains the mechanism through which individuals could write bills of exchange on a dummy in London, change it for bank notes including a premium, redeem the bank notes and quickly send the specie to the dummy in London before the bills’ term. He likens the actual use of the clause to a private capital control measure to sterilize “hot money” flows.

  12. Either Diamond and Dybvig (1983) “deposit insurance” or genuine deposit insurance.

  13. This does not mean that problems on the liability side cannot accelerate these difficulties.

  14. Note that in Schwartz’s table over the period studied by Bordo (1990), the U.S. had three panics, while France, Germany, and Sweden had one. Canada and Britain had none.

  15. For an argumentation that costs of banking crises are in fact attributable to the prudential regulation supposed to limit these crises, see Kaufman (1987), Selgin (1994) and Calomiris (2010). See Demirgüç-Kunt and Detragiache (2002) for empirical evidence that it makes banking crises more likely.

  16. In the Diamond and Dybvig (1983) model, the deposit contract relates to a debt/equity hybrid which is very different from traditional banking contracts (Dowd 1992, pp. 111–112). The absence of a clear and distinctive class of equity supposes that the bank has no capital reserve. Long-term agents are therefore never protected by equity. Also consider that even in the good equilibrium the bank’s liabilities always exceed its assets in the interim period. As this section will attempt to demonstrate, there is nothing mysterious or harmful in an insolvent bank experiencing bank runs.

  17. See supra note 3.

  18. While gold and/or silver were the units of account, individual banks issued bank notes payable to bearer. The banking profit on this type of activity was based on the acceptability and use of its banknotes. The more they were accepted and used, the more banknotes took time to come back to the issuing bank for conversion to base currency. The bank then had a vested interest that its notes be widely and generally accepted, as it allowed it to allocate assets to more lucrative venues than reserves.

  19. See Goodspeed (2014, pp. 99–135) and White (1995, pp. 27–29) for the Ayr Bank failure, the “exception that confirms the rule” in the loose rhetorical sense.

  20. Under a regime of multiple banks of issue, a run on deposits is generally not a problem. The bank can respond by transforming deposits into bank notes without affecting its solvency or even requiring to sell assets, and there are no a priori reasons that a run on bank money should transform to a run on the base currency (see Selgin 1988, p. 134). In comparison, monopolies of issue like our modern central banking systems eliminate the possibility of offering banknotes to depositors because it requires central bank cash on hand. So while modern central banking systems have no use for the option clause on banknotes, the case has been made that option clauses might be applicable to deposits in those systems.

  21. For responses to this literature using the clause, see Selgin and White (1996), Cachanosky (2011), Evans (2013), and Evans (2014).

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Acknowledgments

The author would like to acknowledge that this research was partially conducted with the support of a Bradley Foundation Doctoral Fellowship for a visit at New York University.

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  1. Toulouse School of Economics, Manufacture des Tabacs, Aile Jean-Jacques Laffont, 21 Allée de Brienne, 31015, Toulouse Cedex 6, France

    Mathieu Bédard

  2. Aix-Marseille School of Economics, CNRS and EHESS, Centre de la Vieille Charité, 2, rue de la Charité, 13002, Marseille, France

    Mathieu Bédard

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Bédard, M. In Which Context is the Option Clause Desirable?. J Bus Ethics 139, 287–297 (2016). https://doi.org/10.1007/s10551-015-2611-7

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