In Which Context Is the Option Clause Desirable?

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 [Douglas W. Diamond and Philip H. Dybvig. 1983. "Bank Runs, Deposit Insurance, and Liquidity." Journal of Political Economy 91 (3): 401-419] 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 make the option clause undesirable outside of free banking systems.

Keywords: Financial stability, Bank runs, Free banking, Option clause, Insolvency

JEL Classification: N20, G21, G33