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

We document that banking deregulation increases competition, increased competition leads banks to offer lower initial rate on adjustable-rate mortgages (ARMs) to attract borrowers, but they also shroud these contracts by designing them with back-loaded resetting rates. Shrouding helps banks to offset about 73% of their losses from price discount due to competition. Deregulation increases the proportion of naïve borrowers, and banks shroud more where there is higher proportion of naïve borrowers. These results support the theory that sophisticated firms can exploit consumer biases by designing exploitative contracts. Although competition reduces firm revenues and benefits consumers initially, the overall effect is mitigated by the banks shrouding strategy.