Thursday, April 21, 2016

Banking Competition and Shrouded Attributes: Evidence from the US Mortgage Market

Sumit Agarwal, National University of Singapore, Changcheng Song, National University of Singapore, and Vincent W. Yao, Georgia State University - J. Mack Robinson College of Business explore Banking Competition and Shrouded Attributes: Evidence from the US Mortgage Market.

ABSTRACT: Increased competition has a causal effect on banks’ pricing strategies to compete for consumers and profits. We test this conjecture using an exogenous shock due to the interstate banking restriction that has been sequentially lifted across states since 1994. We find strong evidence that increased competition leads banks to reduce initial rates offered on the adjustable-rate mortgages (ARMs) to attract borrowers but increase interest rates after the rate reset and thereby exploit consumer inattention in the pricing terms. Different banks design pricing strategies that are optimal to their own profit structures. Consistent with theoretical predictions, we find that banks shroud more with naïve borrowers or less financially sophisticated borrowers, who are more subject to behavioral bias. Subsequently, banks earn more profits from lower default risk and delayed prepayments.

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