Why Ban the Option Clause?

An option clause allows banks to postpone repayment of deposits while imposing a penalty interest rate.   It requires depositors to sometimes wait longer for their money than agreed while providing compensating bonus interest.

The option clause was outlawed by the 19th century.   Rather than having banknotes and deposits usually payable on demand, but with the possibility of a delay with penalty interest, they were required to be payable on demand at all times.

What does payable on demand at all times mean?   What happens when a bank fails to make payment when required?   The usual "punishment" for default was liquidation.

Since paying some agreed penalty interest rate is less costly than liquidation and closure, banks would likely respond by holding more reserves.   They would probably hold more liquid assets relative to illiquid assets like bank loans.   They would probably match maturities better, funding loans with deposits of similar maturities.  They would probably hold more capital (be less leveraged,) because that would protect their ability to obtain funds by borrowing.

To reverse this, "allowing" the option clause is likely to result in banks that hold fewer reserves, fewer liquid assets, fund more loans with short or demand deposits, and hold less capital (have more leverage.)    The option clause would allow banks to be less safe and sound.

However, all of these "good" consequences require that when a bank defaults, it is closed and liquidated.    Unfortunately, there is a severe problem of time inconsistency.   When push comes to shove, closing and liquidating banks imposes great costs on both the owners of the bank but also its customers, both depositors and those who borrow from it.

In the U.S., banks that were unable to make payments when required were allowed to remain open.   Rather than being closed and liquidated, the banks "suspended" payments.

When bank are allowed to suspend payments, all of the supposed problems created by the option clause exist and in a more severe manner.   The agreed penalty interest rate is replaced with nothing.

Interestingly, if the banks expect that they will be allowed to suspend payment, a "ban" on the option clause has advantages.   Suppose all the banks got together and agreed to reduce the interest promised depositors during periods of suspension?   Surely, this would be beneficial to the banks relative to a competitive outcome?   Perhaps a zero promised interest rate enforced by government is better for the banks than the competitive outcome?

Of course, even better for the banks is to have a central bank willing to lend to them so that they don't have to worry about default.   Better yet, if the government guarantees deposits, then banks should be able to borrow from the private sector whenever necessary.   With those rules, there is no need for an option clause.

And, of course, with these government guarantees, the incentive of banks to hold minimal reserves, hold minimal amounts of other liquid assets, fund loans with short term deposits, and hold little capital (have high leverage,) can be expected to rise to new heights.   Of course, if you trust politicians and bureaucrats, these incentives can be prevented by wise regulation.

In my view, the option clause is a better alternative than the time inconsistent policy of immediate closure and liquidation.    If a bank is solvent, but illiquid, it should have an option clause and exercise it.   Of course, if a bank is insolvent, then it should be closed and reorganized--rapidly.