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ARTICLES

The Option Clause in Free-Banking
Theory and History: A Reappraisal

Parth J. Shah

anks under a free-banking system, like banks with frac-

tional reserves under any other system, are susceptible

to runs. Free-banking theorists maintain that the option

clause would be one effective means of dealing with runs

on banks. The option clause, printed on banknotes, would allow

banks to defer redemption of their notes provided they pay interest

for the period of deferment. The clause would enable banks to

protect their liquidity in the face of an unexpected increase in de-

mands for redemption, and allow them time to adjust their portfo-

lios. To make the clause notes acceptable to the public, banks would

likely promise to pay interest at a rate higher than the market rate for

the period of deferment. This penalty rate would dissuade banks

from misusing the option clause. The clause therefore could serve as
a crucial stabilizing mechanism for a free-banking system.

Historically, eighteenth- and nineteenth-century Scotland

(White 1984), Sweden (Jonung 1985), and Canada (Schuler 1988)

serve as examples of free-banking systems that have employed option

Parth J. Shah is assistant professor of economics at the University of Michi-
gan, Dearborn. I would like to thank the students of my monetary theory class
for their insightful questions about the workings of the option clause. They were
the inspiration for this paper. Detailed comments on an earlier draft by George
Selgin are gratefully acknowledged. Leland Yeager helped make the paper more

readable. All remaining errors of substance and style are my own doing.

Review of Austrian Economics 10, no. 2 (1997): 1-25
ISSN:0889-3047


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2 Review of Austrian Economics 10, No. 2 (1997)

clauses. Among the three, the Scottish free-banking experience fur-
nishes the most detailed information on the use of the clause (Dowd
1988, 1991; Gherity 1995). In Scotland, the clause was first adopted
in 1730 by the Bank of Scotland to protect itself against “note duels”
initiated by its new rival, the Royal Bank of Scotland. It was, however,
outlawed in 1765." Despite its short duration, the Scottish experi-
ence is generally cited as an illustrious example of the operation of
the option clause in a free-banking system.

Modern free-banking theorists who view the overall Scottish
experience as exemplary, consider the option clause a desirable
market solution to the problem of unexpected demands for redemp-
tion (White 1984, pp. 28-29; Selgin 1988, pp. 161-62; Selgin and
White 1994, p. 1726; Dowd 1988). Cowen and Kroszner (1989) and
Sechrest (1993, pp. 79-93; 1988) have been skeptical in interpreting the
Scottish experience as that of “genuine” free banking.” They do, how-
ever, share with the previous group the view that the option clause was
an important, effective, and desirable innovation. There seems to be a
consensus among the free-banking theorists on both issues: one, of
the historical usefulness of the option clause in protecting the Scottish
banks from runs and “note duels,” and two, of its desirability in any
future free-banking system as a stabilizing mechanism.

Despite the consensus, a description of the exact working of the
option clause either theoretically (logically) or historically is missing.
A focus on the mechanics of the option clause raises doubts about its
alleged historical usefulness and its desirability in any future free-

'Even though the option clause was outlawed in 1765, the free-banking
system in Scotland lasted until 1844.

2A list of skeptics should also include Rothbard (1988). But he neither
discusses the option clause nor advocates free banking.

3A notable exception is Yeager (1993). In his review of Dowd’s Laissez-Faire
Banking, Yeager raises concerns about the workings of the option clause. Gherity
(1995) evaluates the Scottish experience with the option clause using contem-
porary magazines and newspapers. He does not deal with the logic of the
operation of the option clause.


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Shah: The Option Clause in Free-Banking Theory and History: A Reappraisal 3

banking system. When one tries to work out what exactly happens
after a bank invokes the clause—the mechanics of the clause—sev-
eral questions arise that the proponents have so far left largely
unanswered. How would a bank distinguish notes presented for
redemption from ones that were not? Would invocation of the clause
apply only to notes or also to deposits? Would the bank refuse conversion
of deposits into notes? If the bank allows customers to convert their
deposits into notes, wouldn’t all customers convert to earn the penalty
rate of interest? Would the bank then be compelled to pay the penalty
rate on all its notes and deposits? In order to earn that rate, people would
have to hold on to the notes and deposits. What would they then use to
carry out transactions?

An understanding of the mechanics of the option clause brings
the costs of using it into sharper focus. These costs must then be
balanced against the benefits of the clause.

Benefits of the Option Clause

The origin of the option clause points directly to its use in making “note
duels” ineffective, thus largely eliminating a potential source of instabil-
ity in a free-banking system. When a rival bank presents large amounts
of notes for redemption, exercise of the clause would foil its attack.
Moreover, anticipation of its use would prevent any rival bank from even
attempting a note duel.

The clause elicits a stabilizing response not just from rival banks but
also from the public. Dowd (1991, p. 763) argues that the clause would
“reduce the pressure on the public to participate in bank runs, and make
bank runs both less likely and less damaging (to everyone concerned) if
they do occur.” Without the clause, any strong fear of a bank run would
induce noteholders to start a run as they would suffer losses by not being
first in line. The option clause, in fact, gives “an interest ‘bonus’ for not
being first in line” (Cowen and Kroszner 1989, p. 5). If others demand
redemption and force the bank to invoke the clause, the noteholders back
in line would earn a penalty rate of interest. “Hence, the option clause helps
to convert speculative demands for redemption from the destabilizing force


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4 Review of Austrian Economics 10, No. 2 (1997)

they are under full convertibility to a stabilizing force that protects the
banks’ reserves when they are run down” (Dowd 1991, p. 764).

By aiding individual banks in handling runs on their base money, the
option clause also contains a bank run from spreading to other
banks—the contagion effect. Banks’ exercise of the clause prevents
any system-wide liquidity crisis; bank runs do not turn into banking
panics. The clause therefore diminishes the need for a lender of last
resort.

Use of the clause also strengthens the bank’s liquidity position by
a process that has been overlooked in the literature. Notes issued by
the bank that has invoked the clause would bear a penalty rate of
interest. But given the difficulties in calculating interest at each
transaction, those notes would not circulate freely as media of ex-
change. People would hold on to those notes to earn interest and the
bank would enjoy reduced demands on its reserves. The bank would
also experience a more favorable clearing against other banks at the
clearinghouse, since its notes would be held and not passed on to the
customers of its rival banks. Notes of the rival banks would be in use
as before, so the bank would acquire more than the usual quantity of
them. By redeeming those notes, it would be able to acquire specie
from other banks in the system. This would help strengthen the
bank’s liquidity position.

Henry Meulen (1934, pp. 77-81) argued that the use of the option
clause would lead to more efficient financial intermediation by the
banking system. The clause would allow banks to replace the specie
in circulation by paper, and would enable banks to further expand credit
by releasing funds tied up in reserves.’ By reducing the threat of sudden
demands for redemption, the clause would permit banks to hold
proportionately less specie, or to expand their liabilities proportion-
ately more.

Dowd (1991) contends that the clause plays a stabilizing role in

*One is struck by the similarities between Meulen (1934) and Schumpeter
(1955) on the role of bankers and credit creation in economic development.


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Shah: The Option Clause in Free-Banking Theory and History: A Reappraisal 5

the market for “gold bills,” which are promises to pay gold in the
future. Banks would initially demand gold on the spot market to
meet the large redemption demands.

As the demand for spot gold continues to rise, the price of [gold] bills
would fall to encourage holders to lend it and to discourage spot
demands. . . . If it continued to fall and banks had the option clause,
there would come a threshold point at which banks would suspend
convertibility. The falling price of bills implies a rising gold interest rate,
and the banks would suspend when that interest rate began to increase
beyond the interest rate they would have to pay if they suspended
the convertibility. Once that point has been passed, the banks could
make a profit by suspending and effectively borrowing from the
public at a fixed interest rate (i.e., the compensatory rate they would
have to pay to noteholders), and then lending out their gold reserves.
The public would be able to calculate when the banks would inter-
vene, and rational speculators would appreciate that this intervention
would almost certainly stop the price of gold bills from falling
further. . . . [T]he banks’ anticipated intervention when bill prices
hit the threshold point ought to be more than sufficient to break the
price fall. The bear speculators would almost certainly cut and run
before the banks intervened, and the price of gold bills would fall to
normal. It would be the threat of intervention, rather than the
intervention itself, that would stabilize the market. This shows how
effective option clauses can be even if they are never invoked. (Dowd

1991, pp. 764—65)

The effectiveness of the clause in reducing the threats of note
duels, bank runs and panics, and adverse speculation in the market
for gold bills leads Dowd (1993, p. 25) to consider the clause as one
of three distinctive features of “a highly sophisticated free-banking
system.” He further maintains that the theoretical advantages of the
clause are borne out by the Scottish free-banking experience before


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6 Review of Austrian Economics 10, No. 2 (1997)

1765 (1988, pp. 330-31). In their survey article on free banking, Selgin
and White (1994, p. 1729) conclude that the option clause is a “type of

: 5
run-proofing” contractual arrangement.

Incentives for Being First in the Redemption Line

The option clause, as the proponents maintain, allows for “orderly
suspension” and lessens the need for noteholders to be first in line
during any liquidity crisis. It actually pays an “interest bonus” for not
being first in line. These incentives are crucial for the alleged benefits
of the clause. . |

The incentives for not being first in line must be counterbalanced
by two other concerns: one, the default risk, and two, the price of
“waiting.” Notes on which the clause is invoked would earn an interest
compensation, but payment of the principal or the interest is not
guaranteed. The clause does not promise that the bank would not
declare bankruptcy during the deferment period. In fact, by invoking
the clause, the bank has already signaled difficulties regarding its
portfolio. Noteholders must then weigh the prospects of the bank’s
closure—the default risk—against the promise of interest payment.

Moreover, the whole of the interest payment is not a “bonus” to
noteholders. They would have to wait for a period of time before
receiving the specie. The price of “waiting” is generally posi-
tive—specie today is worth more than specie later. The market rate
of interest can be taken as reflecting the price of waiting. So only that
part of the interest payment that is more than the market rate of
interest is a “bonus” to noteholders.

Noteholders would take into account the default risk and the
price of waiting in deciding whether they want to be first or last in
the redemption line. The sum of the default risk premium and the
market rate of interest (the price of waiting) must be smaller than
the interest rate offered on the clause, in order to keep noteholders

For their recent statement of support for the clause, see Selgin and White
(1996, pp. 91-92).


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Shah: The Option Clause in Free-Banking Theory and History: A Reappraisal 7

away from the line. One could know the market rate of interest and
the clause rate, but the default risk premium is determined subjec-
tively by individual noteholders. In light of these issues, it is not
obvious that the clause would always dissuade noteholders from ever
being first in the redemption line.®

Mechanics of the Option Clause Use

The proponents of the clause do not describe what chain of events
actually occurs after it is invoked. To understand the mechanics of the
clause or the logic of its operation, it is instructive to consult some actual
experience of its use.

Banknotes Turn into Bonds

Consider first the actual text of a typical option clause used in
Scotland: “pay the bearer one pound sterling on demand or, in the
option of the Directors, one pound sixpence sterling at the end of six
months after the day of the demand & for ascertaining the demand
& option of the Directors, the accomptant & one of the tellers of the
Bank are hereby ordered to mark & sign this note on the back of the
same” (Checkland 1975, p. 67; printed on Bank of Scotland notes,
capitalization adjusted). This description indicates that the typical
deferment period on the clause was six months with an interest
payment of 2.5 percent (annual rate of 5 percent). It also tells us that
the notes on which the clause was invoked were marked and signed
individually.

The text does not tell us whether the notes on which the clause
was invoked were returned to the holders or kept by the bank and
returned with interest at the end of the deferment period. In any case,
the notes were effectively turned into interest-bearing bonds. “Calcu-
lating the gradual accrual of interest on a stamped note would entail

6s will be discussed later, the option clause was rarely used to suspend
convertibility of all notes as envisioned by its proponents. Banks used it selec-
tively against particular redemption demanders. In that case, the public had the
incentive to be first in line because that would start early accrual of interest.


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8 Review of Austrian Economics 10, No. 2 (1997)

transactions costs probably disqualifying it from continued use as an
ordinary medium of exchange. . . . [T]he note would disappear as
part of the active circulating medium” (Yeager 1993, p. 322). As
argued earlier, this would help the bank achieve favorable clearing at
the clearinghouse against other banks. By the same token, the note-
holders would begin to use other banks’ notes as media of exchange,
and the invoking bank would lose its share in the market for
banknotes. This could turn out to be a permanent loss if the bank’s
customers decide to continue with other banks’ notes. The cure
could become worse than the disease.

Yeager (1993, p. 322) also raises concerns about the macroeconomic
consequences of whether and how the sudden increase in the de-
mand for other banks’ notes would be met. Alternatively, one must
consider the macroeconomic consequences of the sudden fall in the
quantity of transaction media. Invocation of the clause turns
banknotes into bonds, thus effectively removing them from their use
as media of exchange.

Announcement Effect

A bank’s exercise of the clause serves as a public announcement of
its liquidity problems. In the old days, the announcement might not have
spread too far from its headquarters, but today it would be an invitation to
all its noteholders to make a run—a run, not to redeem their notes for
specie (“note run,” as conventionally labeled), but to convert the notes
into bonds (“bond run”). They would run to get their notes “stamped”
as quickly as possible to trigger the accrual of interest.

The bank can avoid this “bond run” if it simultaneously announces
that all outstanding notes would accrue interest. The bank then converts
its non-interest-bearing liability (notes) into an interest-bearing li-
ability (bonds). In other words, the bank reborrows from its note-
holders the full amount of its note liability at the penalty rate of
interest. The size of this borrowing may or may not be optimal. The
announcement effect of the use of the clause does not allow the bank

flexibility in choosing the optimal amount on which to pay the penalty


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Shah: The Option Clause in Free-Banking Theory and History: A Reappraisal 9

rate. It is compelled to pay that rate on all its outstanding notes.
Yeager rightly observes:

Modern conditions differ from those of eighteenth-century Scotland.
Banks in a temporary liquidity bind have better opportunities for raising
funds, as by borrowing on the interbank market, selling liquid securities, and
attracting deposits by increasing the interest rate offered. The possibility
of obtaining semi-forced loans from noteholders is less important than

it once might have been. (1993, p. 322)

Note Runs Turn into Deposit Runs

A note run is an attempt to convert notes into specie, and a
deposit run is an attempt to convert deposits into notes. In a free-
banking system with private issue of notes, a deposit run generally
does not present any significant problem; banks could easily change
the form of their liability from deposits to notes. Ultimately what
matters is the size, not the composition, of banks’ liabilities.

A bank’s use of the option clause to control a note run would most
likely create a deposit run. The uncertainty about the bank’s soundness
that caused the note run would also infect its deposits, since people
would not want to hold a suspected bank’s liabilities in any form.
They could withdraw their deposits either by transferring them to
other banks or by converting them into notes (which would then
become bonds). The transfer of deposits to other banks would lead
to severe adverse clearings at the clearinghouse, eventually increasing
demands for specie by the other banks. The clause would probably not
help the bank at the clearinghouse.” If people convert their deposits
into notes, the bank would incur the costs of printing new notes and
of “stamping” them. The bank could avoid these costs, and thereby
the deposit run, by agreeing to pay the penalty rate on both notes and
deposits.

"The literature is not clear about whether banks would be able to exercise
the clause against other banks at the clearinghouse or whether they did so during
the Scottish episode.


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10 Review of Austrian Economics 10, No. 2 (1997)

The bank ultimately ends up suspending redemption of all its liabili-
ties and paying a penalty rate on them. If the bank had borrowed funds
from somewhere else, then it could possibly have met the crisis by
reborrowing less than its total liabilities. However, the clause com-
pels it to reborrow the full amount of its liabilities at a penalty
interest rate. It is an all-or-nothing decision; the bank cannot make
adjustments at the margin.

The proponents seem to think that after invoking the clause and
thereby containing the crisis, the bank would continue to carry out
its business as usual.’ But the logic of the clause would actually
require the bank to suspend its transaction services. This suspension
puts its customers at great inconvenience by requiring them to find
substitute media of exchange on short notice.

Payment of Interest on the Option-Clause Notes

How does a bank actually pay interest at the end of the deferment
period on the notes on which it had invoked the clause? The Bank of
Scotland was supposed to have paid interest to its noteholders at least
three times for the suspensions in 1704, 1715, and 1728. Details on
these payments ‘are difficult to find. In the absence of branches,
collection of the payment must have been a rather difficult task for
noteholders, unless they were located relatively close to the Bank.
The overall transaction costs in paying the interest seem substantial
in comparison to the average amount of interest payment involved.
The costs to the bank are of verifying the notes, counting them, and
calculating interest; costs for the noteholders are of safe-keeping of
the notes, and then of the travel to the bank. To put some reasonable
numbers on this scenario, suppose that an average noteholder with £100
of notes would earn interest of £2.50 for a six-month deferment at 5

8n discussing the difference between a bank “holiday” and a limited “re-
striction” of the type of the option clause, Selgin (1993, p. 358) maintains that
“a bank restriction permits the continued use of bank money—checks or
notes—in payments, whereas a holiday shuts down the bank-money payments
mechanism entirely.”


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Shah: The Option Clause in Free-Banking Theory and History: A Reappraisal } 11

_ percent. How favorably does this sum compare with the transaction
costs?

Moreover, noteholders (or rather bond holders) would have little
incentive to present notes (bonds) to collect interest payment. The
notes earn above-market interest, and customers would certainly
have found other transaction media during the deferment period.
How would the bank “de-stamp” the notes? Why would the custom-
ers convert the bonds back into notes?

All these practical problems with the workings of the clause lead
one to inquire about the details of its operation during its historic
use. Modern free-banking literature is rather silent on the mechanics
of the clause in Scotland; it merely asserts its historic usefulness. Was
the clause ever actually used as intended by its modern proponents?

The Option Clause in Scotland

The Scottish parliament chartered the Bank of Scotland in 1695 with
a legal monopoly in banking and note issue. The monopoly powers
expired in 1716 and the business of banking became open to new
entrants. The Royal Bank of Scotland acquired its charter in 1727,
and from the first day both banks “opened a brisk duel in which the
combatants used each other’s notes as missiles” (Munro, quoted in
White 1984, p. 25). The Royal Bank collected Bank of Scotland
notes against its own and then presented them for redemption. The
Old Bank—the Bank of Scotland—suspended convertibility for
eight months to put its finances in order. During this time, allies of
the Royal Bank brought a suit against the Old Bank for its failure to
honor the promise to pay specie. “After much legal wrangling the
note holder’s right of ‘summary diligence’ or immediate payment on
Bank of Scotland notes—a right stipulated in the bank’s char-
ter—was upheld” (White 1984, p. 26). In response to this new legal
environment, the Old Bank for the first time inserted an option clause
on its notes in 1730.

The innovation of the option clause was due to a legal and not an
economic necessity. Beginning with the first run in 1704, the Old Bank


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12 Review of Austrian Economics 10, No. 2 (1997)

had acted as if it had the option clause. The Bank suspended convert- |
ibility and “set an important precedent by announcing at the time of
suspension that all notes would be granted 5 percent annual interest for
the period of the delay . . . The same policy was adopted for the
eight-month suspension following a run during the civil unrest of 1715,
and again for the eight-month suspension of 1728” (White 1984, pp.
25-26; see also, Gherity 1995, p. 718). The introduction of the
clause in 1730 simply legalized what had been a standard practice.

The legal-necessity interpretation of the origin of the option
clause gets further support from the case of the Banking Company of
Aberdeen. It was established in 1747 and did not include any option
clause on its notes (Gherity 1995, pp. 717-18). It suffered a liquidity
crisis as it had greatly expanded its note supply. As the bank sus-
pended convertibility, a noteholder petitioned for “summary dili-
gence.” The court denied the petition on the grounds that summary
diligence “was enforceable on bills but not on promissory notes such
as bank notes” (White 1984, p. 28). The court pointed out that the
charter of the Bank of Scotland specified summary diligence on its
notes but that requirement did not automatically extend to other
banks. In Scotland, according to the court, all banks but the Bank of
Scotland could legally suspend convertibility without an option clause.
This also explains why no other bank included the clause on its notes
until the 1750s.

Gherity, who has consulted contemporary sources, states:

From 1730 until 1752, the Bank of Scotland’s notes were the only ones
bearing the option clause, and it remained uninvoked. At that time, two
banks that had recently been established in Glasgow, under attack by
their Edinburgh rivals, added the clause to their notes where it remained
uninvoked until 1756. . . . This was during the period of the Seven Years
War, when higher taxes imposed to finance the war increased remit-
tances to London. . . . Remittances abroad were further increased by
an exceptionally poor harvest in 1756 leading to the importation of

£200,000 of foreign grain. (1995, p. 716, emphasis added)


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Shah: The Option Clause in Free-Banking Theory and History: A Reappraisal 13

It was only because of the shocks of the Seven Years War and poor
harvests that the option clause came into wider use. Even the Royal
Bank of Scotland did not imitate its rival’s insertion of the clause
until the 1750s. This raises an important question: why did banks
abstain from including the clause on their notes if it was useful and
effective against unexpected demands for redemption?

Shortages of specie and coins in the early 1760s led to a “small
note mania”; a large number of smaller banks began issuing small-
denomination notes with option clauses. Until then, “most, and
perhaps all, of the Scottish banks included no option clause on their
smallest notes” (Gherity 1995, p. 717). These “beggarly bankers,”
as Adam Smith called them, recklessly invoked option clauses, even
on small-denomination notes, against routine redemption demands
by the public. Mistrust of banknotes increased among the public and
it demanded abolition of option clauses.

Outside the turbulent period of the late 1750s and early 1760s,
there are few episodes of note duels or bank runs where the clause
was actually used as supposed by its modern proponents. The first
note duel was in 1727-28, but the Bank of Scotland successfully
survived it without the clause. The second major battle was fought in
the mid-1750s by the Edinburgh banks (the Bank of Scotland and
the Royal Bank) against the Glasgow banks. White summarizes the
episode: “The chartered [Edinburgh] banks then allegedly turned
jointly to the tactic of note dueling, but their Glasgow rivals
survived the assault by a series of evasive maneuvers” (1984, p. 28, emphasis
added).

Scottish history indicates that these “evasive maneuvers” were actu-
ally used regularly and probably effectively. Adam Smith (1911 [1776],
pp- 290-91), Meulen (1934, pp. 129-36), and Checkland (1975, pp.
184-86) provide ample evidence on Scottish banks paying only a
fraction of the redemption demand in specie, questioning loyalty and
patriotism of redemption demanders, using stalling tactics like
checking each note and coin methodically, counting them deliber-
ately slowly, giving tellers long and frequent breaks during counting,


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14 Review of Austrian Economics 10, No. 2 (1997)

and at times, simply refusing to pay specie.” All these maneuvers
together seem to have been effective in protecting banks’ liquidity. It
was better to raise “redemption costs” for noteholders by “evasive
maneuvers” than to use the clause. Scottish banks certainly relied on
them more commonly and frequently than they relied on the clause.

The Scottish experience leads one to conclude that the option
clause “worked” as long as it was rarely included on notes or invoked
by banks. When a large number of banks adopted and used it, the
banks’ customers demanded that it be abolished. Surprisingly, the
Scottish banks, the alleged beneficiaries of the option clause, joined
the public in demanding recision of the clause.” Gherity (1995, p.
722) states:

By early 1763, the chartered banks had indicated to the government
their willingness to give up the option clause in exchange for the
exclusive right to issue bank notes in Scotland. . . . Shortly thereafter,
the Glasgow bankers submitted a memorial to the Lord Privy Seal
advocating the prohibition of the clause and had drafted a pamphlet or
article, apparently for publication, blaming all of Scotland’s monetary

11
problems on the clause.

®For more details and citations, see Sechrest (1993, pp. 87-88), Dowd
(1988, pp. 328-29), and White (1984, pp. 29-31). Gherity (1995, p. 721)
informs us that at times banks threatened to call in loans to people who made
“unreasonable” demands for specie.

1%\eulen blamed the “paternalistic attitude” of the government for the
abolition of the option clause; in order to protect some “fools,” the government
sacrificed a great innovation in banking (1934, pp. 131ff). Boase charged
“exaggerated assertions, fallacious inferences, and ridiculous fears” (quoted in
White 1984, p. 30).

"1G herity (1995, pp. 722-24) details the different rationales that led the
Edinburgh banks and the provincial (mainly Glasgow) banks to the same conclu-
sion. Notes of the Edinburgh banks were the least suspected by the public since
they were the oldest and the largest banks, they acted as the government’s bank
as taxes and disbursement were channeled through them, and they had the
strongest ties with London. They were therefore ready to give up the option
clause in exchange for monopoly in the issue of notes. Notes of the provincial


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Shah: The Option Clause in Free-Banking Theory and History: A Reappraisal 15

It was argued earlier that the option clause not only helps indi-
vidual banks during a run but also mitigates the contagion effect. A
counterfactual test of the mitigating effect of the clause on the
contagion effect came in 1772, after the option clause was banned in
1765. One of the major banks in Scotland, the Ayr Bank, collapsed
in 1772. Its crash,

spectacular as it was for its day, did not imperil the Scottish banking
system as a whole. . . . Only those private banking houses involved with
the Ayr Bank’s circulation of bills were brought down. . . . Even this
brief run was a new and unexpected circumstance, for nothing of the
kind had “occurred” following the failure of one private bank in 1764
or another in 1769. (White 1984, p. 32)

The Scottish free-banking system apparently had mechanisms other
than the option clause to effectively handle bank runs and contagion
effects.

The option clause, as is evident, was never used by any of the
Scottish banks to suspend convertibility of all its notes simultane-
ously, as is envisioned by its modern proponents. The clause was
useful precisely to the extent that banks did not use it for a general
suspension of convertibility. The clause allowed banks to discriminate
among their customers on the basis of their motives for redemption
demand. Banks gave specie to “bona fide” noteholders but refused it to
speculators, and agents of rival banks. Ironically, the

”

“specie lifters,

banks generally suffered more distrust from the public, but more importantly,
they were concerned that in times of crisis, the chartered banks would exercise
the option clause and put more strain on their reserves. Some of the provincial
banks actually had made their notes payable in notes of the chartered banks. The
latter, it seems, were acting as “bankers’ banks.” The provincial banks were more
than happy to take away the right of the chartered banks to use the option clause.
Incidently, these rationales of the banks seem to provide support for the thesis
of Rothbard (1988) and Sechrest (1988) that the chartered banks acted as the
“bankers’ banks” for the smaller banks in Scotland, and the Bank of England
performed similary for the chartered banks.


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16 Review of Austrian Economics 10, No. 2 (1997)

Bank of Scotland acted as the option-clause proponents expected
before the inclusion of the clause in 1730; it suspended convertibility
of all its notes in 1704, 1715, and 1728.

Acceptance of the Option-Clause Notes

When the Bank of Scotland first offered notes with the option clause in
1730, people readily accepted them. The rival Royal Bank’s reminders
that its notes were convertible on demand did not affect the demand
for Bank of Scotland notes. This is usually interpreted as evidence
that the option-clause notes would be generally acceptable to the
public (see Dowd 1988, for example). '? But is the inference valid?
If a bank that has the clause printed on its notes offers a greater
protection to its noteholders, as the modern proponents argue, then
one would expect the public to switch from notes of the Royal Bank
(without the clause) to those of the Old Bank (with the clause). This,
however, did not happen. Notes of both banks were in such demand
that the two banks were the largest in Scotland. One must conclude
that the public did not hold notes of the Old Bank because of any
perceived advantage of those notes over notes of the Royal Bank.
What then does explain the public’s holding of Old Bank notes?
Until the early 1750s, the Old Bank was the only major bank that had
the option clause. The public accepted its notes because the clause
did not really concern them one way or the other. The Old Bank had a
long-standing reputation and the clout of a major bank with close ties to
London, and it had faithfully paid interest compensation in earlier
suspensions even without the clause. During those suspensions, Old
Bank notes actually circulated at par. To its noteholders, the intro-
duction of the clause was merely a legal issue, not an economic

concern. When other banks without a good reputation adopted and used
the clause in the early 1760s, the public demanded it be outlawed. Was

127he only question left, according to Dowd, is for banks and the public to
figure out a mutually acceptable deferment period and interest compensation.


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Shah: The Option Clause in Free-Banking Theory and History: A Reappraisal 17

the public rational in 1730 but irrational in the 1760s? Its response,
one must conjecture, was based not on the presence or absence of
the clause, but on the reputation and integrity of note-issuing banks.
The Scottish experience does not suggest that the option-clause
notes were preferable or acceptable because of their advantages. The
public, it seems, did not find much benefit in the option-clause notes
of reputable banks, but suffered gravely at the hands of irreputable
banks. The experience does tell us that during most of the period in
which option clauses were legal, they were rarely invoked, and were
never used as envisioned by the modern proponents of the clause.

The Option Clause and the Market for Specie

Dowd (1991, pp. 764-66) argues that the existence of the option
clause results in a stabilizing speculation in the market for gold bills.
When the spot demand for gold increases, the price of gold bills falls,
raising the gold interest rate. As the gold interest rate gets close to the
interest rate specified in the clause, banks would invoke the clause and
suspend convertibility. At a gold interest rate above the clause rate, banks
would start “lending out their gold reserves.” Banks, Dowd main-
tains, would become sellers of gold instead of buyers, and thus would
prevent any further fall in the price of gold bills. The anticipation of
a banks’ intervention would limit the divergence of the interest rates
and would stabilize the market for gold bills.

Dowd’s argument is internally consistent. One must wonder,
though, how banks would become sellers instead of buyers of gold.
The price of gold bills begins to fall initially precisely because of the
increased demand for gold by banks to meet their redemption needs.
Whether the increased demand for gold by a bank would lower the
price of gold bills depends on the size of the bank’s demand vis-a-vis
the size of the market for gold. A single bank’s demand for gold is
unlikely to raise the gold interest rate above the option-clause rate.
If the whole banking system were facing a run, suspension of con-
vertibility would dampen the immediate demand for gold. Even if the
gold interest rate had risen above the option-clause rate before the


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18 Review of Austrian Economics 10, No. 2 (1997)

suspension, it is hard to understand why banks would become net
sellers of gold after the suspension. To whom would they be selling
gold?

One is obliged to question this whole framework of analysis. It is
historically accurate to think in terms of gold bills and gold interest
rate, but one doubts whether that framework is relevant for any future
free-banking system or the current free-banking theory. It seems more
useful to think in terms of the market for gold and the market for
loanable funds in exact parallel with banks’ increased demand for gold
to meet redemptions and for funds to purchase gold. Banks could sell
their securities or borrow directly on the market, both of which would
raise market rates of interest (not just the gold interest rate). 13 If market
rates of interest rise above the clause rate, banks would most likely
invoke the clause. In this framework, suspension of convertibility
does not make banks net sellers of gold; rather it makes them less
urgent demanders of gold and funds to purchase gold.

Potential Misuses of the Option Clause

A bank could invoke the option clause to protect itself not only against
temporary illiquidity but also against insolvency. It could defer redemp-
tion to “buy time” and invest in risky but more profitable assets to rescue
itself from insolvency. * How could noteholders protect themselves
against this type of misuse of the clause? Dowd (1991, p. 767)
suggests that “if potential noteholders felt that this was a sufficiently
serious danger, they could simply refuse to accept the notes, and the
banks would have to continue providing fully convertible notes in-
stead.” This response begs the question. A noteholder is not choos-
ing between notes with and without the clause, but has already
chosen the option-clause notes. The question now is about distin-

guishing proper from improper use of the clause by banks. How does

134 “fire sale” of securities to generate funds for the purchase of gold would

lower their prices and raise the interest rate.

140ne is reminded of “zombie” savings and loans of the 1980s.


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Shah: The Option Clause in Free-Banking Theory and History: A Reappraisal 19

a noteholder differentiate between illiquidity and potential insol-
vency of a bank?

Dowd (1991) does. suggest a solution: The bank’s shareholders
accept “extended liability” whenever the clause is invoked. The
acceptance of “extended liability” would indicate that the bank does
not face insolvency, and would thereby calm the wary noteholders.
This solution demands too much from shareholders in order to make
noteholders accept the clause. If shareholders are willing to accept
“extended liability,” and are able to handle the “principal-agent
problem” with banks’ managers, then they would be far better off by
offering “extended liability” generally, and thus providing an overall
competitive advantage to their bank.

Difficulties in differentiating situations of illiquidity and insol-
vency necessitate a more transparent clause. Gorton (1985) explores
the possibility of whether any suspension clause would be incentive
compatible, that is, a bank would invoke the clause only when it is
illiquid but not when it is insolvent. He designs a suspension clause
that is incentive compatible by having independent verification of the
bank’s portfolio. Because of verification costs, banks do not choose
to suspend in situations of insolvency but only in those of illiquidity.
The traditional option clause, however, does not include this type of
verification. Nonethless, Gorton’s analysis indicates that interven-
tions by third parties who can verify the bank’s portfolio (clearing-
houses, for example) would be more suitable than two-party con-
tracts like the option clause.

Modifications of and Alternatives
to the Option Clause

The difficulties with the clause, brought out by analyzing the mechanics
of the clause, necessitate consideration of alternative mechanisms to
protect banks against temporary liquidity crises. The viable and
more effective modifications of the traditional option clause (the
one suggested by its modern proponents) will be discussed and
then some alternatives to the clause will be offered.


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20 Review of Austrian Economics 10, No. 2 (1997)

The traditional option clause focuses only on specie and
banknotes and on banks and noteholders, and tries to solve the
problem without involving any other party. As discussed earlier, a
simple suspension of the convertibility of notes into specie does not
solve the problem; it causes bond runs and deposit runs, and thwarts
people’s attempts to convert their notes and deposits into higher
interest-bearing assets, and to transfer their deposits to other banks.
A better way to deal with sudden large demands for redemption is
not to suspend convertibility, but to offer more options to notehold-
ers and to transfer the problem from its door—with hordes of poorly
informed, clamoring customers—to a place where the bank is better
able to negotiate and decide among its various alternatives.

In a bank run, customers of a bank are not particularly interested
in specie but in avoiding capital losses. The bank should do every-
thing possible to make it easy for its customers to avoid those losses.
The bank could offer to convert its notes into notes of other banks
that are convenient and acceptable to its customers. A better modi-
fication would be to promise conversion of its notes into transferable
deposits with other reputable and convenient banks. There is no
reason to limit these new types of option clauses to notes. They can
apply this equally to deposits. Inclusion of deposits would diminish any
chance of bond runs and deposit runs.

The modified option clause is a promise to convert any and all
liabilities into any asset, other than specie, that the bank’s customers
desire. The modified clause may be labeled as the “comprehensive
option clause.” It does not suffer from the drawbacks of the tradi-
tional option clause. There is no need to mark and sign the notes, no
need to worry about the transactions costs of paying interest at the end
of the deferment period, and no inconvenience to noteholders of finding
alternative media of exchange on short notice. The comprehensive
option clause does not require noteholders to differentiate between
banks’ proper and improper use of the clause. Irrespective of the
banks’ intentions in using the clause, noteholders would be able to
protect themselves with little effort.


===== PAGE 21 =====

Shah: The Option Clause in Free-Banking Theory and History: A Reappraisal 21

More importantly, by exchanging notes with those of other banks
and by transferring deposits to them, the bank would divert the
problem from its door to the clearinghouse. It would be easier and
better for the bank to deal with the clearinghouse, other prominent
banks, or finance companies rather than with large numbers of
scantly informed and suspicious customers. The comprehensive op-
tion clause is also incentive-compatible in the sense of Gorton (1985).
It necessitates intervention and verification by third parties to solve the
problem of redemption between the bank and its customers.

The comprehensive clause would not have to be printed on notes;
it could simply be included in the bank’s charter. One may even view
it not as a modification, but as an alternative to the traditional option
clause. The necessity of third-party involvement makes it categori-
cally different from the traditional clause, and it provides a more
effective means to deal with liquidity crises.

A crucial element in the comprehensive clause is the clearing-
house. Even under a mature free-banking system, noteholders and
depositors would generally find it difficult to quickly distinguish
between problems of illiquidity and insolvency confronting a bank.
Reputable third parties could help customers distinguish between
those two problems, and thereby provide an orderly resolution of the
crises. Clearinghouses are obvious candidates since they are the most
likely third parties to possess the necessary information about the
bank in trouble. As Timberlake (1984) and Gorton and Mullineaux
(1987) document, clearinghouses in the recent past have engaged in
“the joint production of confidence” by providing guarantees, loans,
and their own currencies (certificates). Clearinghouses, however,
would not be the sole source of such information in a mature free-
banking system. Bank-rating agencies which would render overall
“soundness rating” of banks, or agencies rating banks’ ability to
redeem their liabilities— “liquidity rating”—would also provide in-
dependent information to the banks’ customers.

The issue of liquidity crisis arises only in a system with directly
convertible notes, convertible either on demand or with deferment.


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22 Review of Austrian Economics 10, No. 2 (1997)

The alternative system of “indirect convertibility” obviously avoids

the whole problem (Yeager 1985; Greenfield and Yeager 1983).

A Conjectural History of the Option Clause

Introduction of the option clause in eighteenth-century Scotland
was a good initial response to unexpected, large increases in redemp-
tion demands. Until the turbulent years of the mid-1750s, the Bank
of Scotland was the only major bank with the clause on its notes. The
fact that rival banks did not use it and the public did not shy away
from those rival banks strongly suggests that the clause was consid-
ered of little value by banks and the public. The modern proponents
assume that after suspending convertibility of notes, the bank would
be able to continue to provide its transaction services—notes and
deposits of the bank would continue to be used as media of exchange.
At least in Scotland, the clause was never used for general suspension
of convertibility. As shown earlier, liabilities of the bank that invoked
the clause would hardly stay in circulation. The little protection the
clause provided to Scottish banks was because it allowed banks to
discriminate among redemption demanders.

How would the clause have evolved if the free-banking system
had been allowed to mature under laissez-faire? It would have be-
come difficult for banks to invoke the clause discriminately. As more
banks adopted the clause and as it came into use as envisioned by the
modern proponents, the drawbacks that have been emphasized in
this paper would have come into play. Banks would have looked for
more viable alternatives and would have adopted any of the modified
versions of the traditional clause, including ultimately, the compre-
hensive option clause. To implement the comprehensive clause,
banks would have made prior arrangements and agreements with
other banks and financial institutions. Such stipulated cooperation
would have played an important role in the banks’ efforts to earn the
public’s confidence. During a time of crisis, banks would ask their
partners to publicly reiterate the commitments and such reiteration,
or the lack thereof, would provide useful information to customers.


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Shah: The Option Clause in Free-Banking Theory and History: A Reappraisal 23

In discussing how banks in the United States prior to the War
Between the States dealt with liquidity crises, Selgin (1993) points
out that not only did banks agree to accept each other’s notes at par,
but that they also made agreements which involved

provisions for regular note exchange with interest charged on accu-
mulated balances in lieu of immediate settlement as well as stipula-
tions limiting loan expansion for the duration of the restriction. In
some cases new deposits were accepted on the understanding that the
depositor could receive payment of checks or drafts in notes but not
in specie, and merchants formally agreed to continue receiving bank

notes at par. (p. 357)

A system with mutual commitments among individual banks
certainly seems sustainable. But intense rivalry, moral hazard problems,
difficulties in enforcing such commitments, and a fear of the emergence
of a dominant bank would necessitate a move toward a joint responsi-
bility of all banks in producing confidence. '® Clearinghouses would
then come to play an important independent role in mitigating
temporary liquidity crises of their members. Guarantees and loan
certificates by clearinghouses would prevent the aggravation of bank
runs and banking panics.

Whether the laissez-faire evolution would have ultimately re-
sulted in a system of indirect convertibility is an interesting question.
The evolution of the traditional option clause into the comprehen-
sive clause does suggest a way through which a system with direct
convertibility could move toward one with indirect convertibility.
The comprehensive clause allows banks to redeem their liabili-
ties—notes and deposits—for other banks’ liabilities or for any
other financial asset that is acceptable to their customers. General

13Goodhart (1988) elaborates on these types of arguments. His focus is on
explaining the “evolution” of central banking, where the arguments do not
completely succeed. His arguments nevertheless are relevant to the point that is

being developed here.


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24 Review of Austrian Economics 10, No. 2 (1997)

acceptance of the practice of redeeming the banks’ liabilities for
other financial assets could become a first step toward the evolution
of a banking system with indirect convertibility. An expanded role of
independent clearinghouses in dealing with liquidity crises would
help continue that evolution.

In conclusion, several drawbacks undermine the claim that the
option clause is an effective and desirable mechanism for creating a
stable free-banking system. Though it is important for fractional
reserve banks to develop a means to tackle sudden demands for
redemption, the traditional clause does not meet the challenge.
Modifications of the traditional clause, clearinghouse guarantees and
certificates, and a system with indirect convertibility seem to provide
more suitable mechanisms and arrangements.

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