Some Competition Increases Prices

An interesting NY Federal Reserve staff research report, "Price-Increasing Competition: The Curious Case of Overdraft versus Deferred Deposit Credit," September 2009, Number 391, by Brian T. Melzer and Donald P. Morgan, finds that banks charge more for overdrafts when there is a competitive product.

The abstract states:

We find that banks charge more for overdraft credit when depositors have access to a potential substitute: deferred deposit (“payday”) credit. We attribute this rise in prices partly to adverse selection created by banks’ practice of charging a flat fee regardless of the overdraft amount—pricing that favors depositors prone to large overdrafts. When deferred deposit credit priced per dollar borrowed is available, depositors prone to small overdrafts switch to that option. That selection works against banks; large overdrafts cost more to supply and, if depositors default, banks lose more, so prices rise. Consistent with this adverse-selection hypothesis, we document that the average dollar amount per returned check at banks and other depository institutions increases when depositors have access to deferred deposit credit. Beyond documenting another case of price-increasing competition, our findings bear on theories of adverse selection in credit markets and contribute to the debate over the pros and cons of payday credit.

The report concludes:

VI. Conclusion

Faced with competition from deferred deposit, or "payday lenders," mainstream depository institutions charge higher overdraft fees and cut back on "free" checking offers, particularly those without direct deposit.

The auxiliary findings we present suggest that these changes result, at least in part, from adverse selection when payday lenders enter the market. Small dollar overdrafters disadvantaged by the buffet (flat fee) pricing of overdraft credit switch to deferred deposit lenders (when available), saddling banks and other depositories with proportionately more higher cost, possibly riskier large-dollar overdrafts. Depository institutions raise prices and manage the extra risk by reducing the supply of free accounts without direct deposit.

Without a model, the welfare implications of our findings are not entirely clear. It might appear that the depositors who switch to deferred deposit lenders gain, but those who stick with bank overdraft at the new higher price lose. However, Gabaix and Laibson (2006) use overdraft protection as the leading example of a "shrouded attribute," an expensive, overpriced feature of a good or service that is hidden from consumers. "Debiasing," that is, educating consumers by unshrouding hidden attributes is welfare increasing.

The full research report is available here.