Authors

Economics

A Note on the Notice of Withdrawal Clause

Regular readers of this site may be aware of a debate relating to the contractual devices that banks might use to ensure that they are solvent. One of the terms that has been used is a “notice of withdrawal clause”, but what is this?

It might be argued that a notice of withdrawal clause (or a “withdrawal clause”) is merely another term for the more often invoked “option clause”. This has received extensive treatment in the “free banking” literature (for example Dowd (1988), Selgin & White (1994, 1997)), and we can use the following definition:

option clauses… give banks the option of deferring redemption of their notes provided that they later pay compensation to the noteholders whose demands for redemption are deferred” (Dowd, 1998, p.319)

The confusion may stem from the fact that in some instances option clauses and withdrawal clauses are used interchangeably. For example Selgin & White (1997) say:

one possible run-proofing device discussed in the literature is an “option clause” or “notice of withdrawal clause” allowing a bank temporarily to suspend the redeemability of some or all of its liabilities (notes or demand deposits) provided the bank pays a pre-specified (penalty) rate of interest on the suspended liabilities

However, I believe there is stronger textual support for the idea that they are distinct devices. In an earlier article Selgin & White (1994) say the following:

a bank might contractually reserve the option to suspend for a limited time the redeemability of its notes or demand deposits, as Scottish banks did with banknotes before 1765 (when the practice was outlawed) and as banks do today when they include “notices of withdrawal” clauses in deposit contracts

My reading is that they are often used interchangeably (or perhaps as though a withdrawal clause is a type of option clause), because they perform the same economic function. But a detailed reading would reveal them to be different.

In my working paper on the sound money debate I define a withdrawal clause as follows:

In addition to the option clause banks might also offer (and historically did offer) a “notice of withdrawal” clause, specifying that their customers were required to give 























































30 days notice prior to making a redemption claim. The fact that this clause existed (to protect the bank from a legal point of view if it were ever to suffer a liquidity crisis) does not mean it is always invoked, and banks could routinely not enforce this rule and satisfy immediate redemption requests.

Firstly, note that this is presented as a different clause to the option clause. But secondly, we can see that it differs from the option clause in terms of the default nature of the contract.

Recollect that an option clause allows banks – under certain conditions – to convert a demand deposit into a timed deposit (thus giving them time to generate liquidity whilst avoiding firesale losses). This is seen to be good for the banks (obviously!) but also good for the customers (since it’s better to receive the deposit plus interest at some point in the future than to see the bank being wiped out).

However in the case of the withdrawal clause there is a notice period written into the contract – it is technically a timed deposit (where the notice period serves as a minimum term). But if the bank wanted to offer an instant access account it can simply publicise the fact that it does not routinely enforce this notice period and that it satisfies redemptions on demand.

I suspect the reason withdrawal clauses received less explicit attention in the literature is that unlike the option clause they are not a uniquely “free banking” concept. Indeed, notices of withdrawal are routinely used in contemporary banking. Investopedia define it as follows:

A notice given to a bank by a depositor. As its name implies, a notice of withdrawal states the depositor’s intention to withdraw funds from an account. This notice applies to both time-deposit and NOW accounts

In short, the option clause means that a de jure demand deposit can be treated as a de facto timed deposit. The withdrawal clause means that a de jure timed deposit can be treated as a de facto demand deposit. They are two sides of the same coin – both allow instant access fractional reserve accounts, the only difference is the default position.

So perhaps provisions such as option clauses and withdrawal clauses allow banks to offer fractional reserve accounts that aren’t fraudulent or reliant on legal privilege, but does that make the 100% reserve argument wrong? Not necessarily. The withdrawal clause in particular “works” precisely because it changes the de jure status of the account. A counter argument might be “if a withdrawal clause applies to a timed deposit then you are admitting that fractional reserve banking is irreconcilable with demand deposits”. From the view of legal theory (and depending on your definitions), this may well be correct. However the de facto status of this account is instant access and redeemable “on demand”. In terms of the economic function of the account it exists exactly as “free bankers” envisage.

References

5 comments to A Note on the Notice of Withdrawal Clause

  • Toby Baxendale

    I have long held that economists should ground themselves more with the common law of our nation. Hayek and Mises were both educated in law and their attention to jurisprudential matters shows in their writing. The law can often be a great friend of Liberty in setting the ground rules for conduct between parties.

    If a bank has an option clause on a note, lets update by 250 years since they were outlawed, and say on your demand deposit, you have accepted conditionality on your demand deposit and you may be forced into becoming a timed depositor / creditor of your bank. So this statement is not totally right “In short, the option clause means that a de jure demand deposit can be treated as a de facto timed deposit.” One needs to say “that a de jure demand deposit can be changed into a timed deposit by the creditor at its wish and not that it can be treated as a de facto timed deposit.”

    FRFB do not address the consequences of this happening to a person and address why they were outlawed as far as I am aware. I may be wrong. If I had deposited with the full knowledge that I may have an option clause exercised against me, then so be it. I presume it was banned due to misuse.

    If you have a NOW account , or any notice of withdrawal, you are a timed deposit de jure . The point of law is to make things very clear. You now have to give 30 days notice as per the example in this illustration of AJE. Should your creditor waive his notice period habitually, you may think that you have a de facto demand deposit and in a court of law a lawyer make take up the case and argue that by the previous actions of the creditor , this notice period by act of custom is unenforceable and the deposit, timed though it says is in fact on demand. This blurring of legal clarity is most unhelpful and is shunned upon as it does not lead to the smooth and peaceful working of the capitalist system, which is a key purpose of our law. So this statement also needs refining, “The withdrawal clause means that a de jure timed deposit can be treated as a de facto demand deposit. They are two sides of the same coin – both allow instant access fractional reserve accounts, the only difference is the default position.” They are not two sides of the same coin, they are very similar in economic outcome from the point of view of the bank, it knows for a short period of time , 30 days, it can enforce a redemption notice and for the option clause it can enforce suspension of any on demand rights. Both can facilitate the smoother running of a FR account. If the bank gives you the impression that they will not evoke a withdrawal clause then they are committing a contract law infringement of misrepresentation. This of course is dishonest.

    An instant access account can exist in a 100%-RFB environment lawfully if BY EXCEPTION a timed depositor is told he will be allowed instant access with a right for the bank and no notice to revert to the original contract. You can only offer this on timed deposits as a demand deposit is either cash itself of 100% backed by cash and or some commodity money on most schemes I have seen it applied to.

    Instant access account do exist in the current FRB system and can exist with no infringement of contract, on the face of it, as the deposit, demand or timed, has with the option and/or the withdrawal clause clearly spelled out and banking practice being clearly consistent, got the ability to offer this. This does not address the argument that some people actually think they have a clear property entitlement to their money and the legal system say ‘no you do not’.

    • Current

      If the bank gives you the impression that they will not evoke a withdrawal clause then they are committing a contract law infringement of misrepresentation.

      This is a complicated issue. Computer companies promise that they can answer support calls within a certain time. In reality it’s possible that they can’t live up to this promise.

      Does this mean that they shouldn’t be able to make the contractual promise legally?

      Further, should they not even by able to give the impression that they can answer support calls within a certain time?

      This is a very difficult area because all of life is uncertain. Very little is 100% probable. As I understand it the law doesn’t regard any contract that has a probability of not being met as being illegal to make. As I understand it the position is that a contract can be made but if the contract isn’t met then the party that fails is in breach.

  • George Selgin

    I think there’s a misunderstanding here: when Larry and I refer to “an ‘option’ or ‘notice of withdrawal’ clause,” we aren’t treating the terms as synonyms: we are referring to two distinct things, either of which can serve the described purpose. We understand ‘option’ clauses to be clauses on banknotes, and ‘notice of withdrawal’ clauses to be clauses on demand-deposit accounts, as that is what the two things have meant historically.

  • George Selgin

    I should make clear that in my previous comment I merely meant to suggest that Anthony misinterpreted the first quote he gives from my and Larry’s work. I did not mean to suggest by this any serious criticism of his overall point.

    In fat, the one substantial disagreement I have with the piece is when Anthony writes: “perhaps provisions such as option clauses and withdrawal clauses allow banks to offer fractional reserve accounts that aren’t fraudulent or reliant on legal privileges.” I object to it because I believe that banks can and historically generally did offer fractional accounts (and notes) that weren’t fraudulent even when the contracts in question did not involve any special option or NOW clauses. They were in that case simple demandable debts, rather than demandable/time debts (depending on whether a special option was invoked). I personally doubt in any case that including option clauses and such that would allow normally demandable to be turned under certain contingencies into timed debts would satisfy the 100-percenters: my guess is that Toby’s response is more generous than what we can expect from Hans, or Philipp or Walter etc. But if it would win some of them over and that’s the only way to make them happy than I consider the compromise a (politically!) reasonable one.

  • conclusion part from the Parth (1997) paper

    ..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.

    http://mises.org/journals/rae/pdf/rae10_2_1.pdf