The Option Clause in Scottish Banking

Abstract

A key question raised by the modern literature on laissez-faire money and banking is whether unregulated fractional-reserve banks could protect themselves from bank runs by purely contractual means. If so, banking stability would not require government to provide deposit insurance or to act as a lender of last resort. One possible run-proofing device discussed in the literature is an or notice of withdrawal allowing a bank temporarily to suspend the redeemability of some or all of its liabilities (notes or demand deposits) provided the bank pays a prespecified (penalty) rate of interest on the suspended liabilities. Before the practice was outlawed in 1765, many Scottish banks issued notes bearing option clauses. In an informative reappraisal of the option clause in Scottish banking, James A. Gherity (1995) suggests that his findings contradict other recent discussions. In particular, Gherity disputes three propositions that he attributes to us and others: 1. that option clauses were vital to preventing runs in Scotland; 2. that run-proofing was the purpose that motivated Scottish banks to employ option clauses; and 3. that option-clause notes were accepted by the public without prejudice. To set the record straight, we note here that we and several other authors Gherity cites have in fact avoided making claims 1 and 2. The conflict between Gherity's view and ours is thus much smaller than he suggests. We would defend claim 3, however, and argue that the evidence Gherity offers against it does not suffice to refute that claim. 1. The Potential and Historical Roles of the Option Clause An option clause can keep a solvent bank from being run upon by providing a contractual circuit breaker. By allowing an illiquid bank to suspend for enough time to liquidate assets without fire-sale losses, it prevents a run from forcing a sol-

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