Competition and Adverse Selection in Consumer Credit Markets:

We investigate the relationship between payday lenders, which offer small, short-term consumer loans, and traditional depository institutions using a national survey on the provision and pricing of checking account services. Somewhat surprisingly, we find that payday loan competition leads to higher prices for overdraft credit and bounced check transactions at traditional depositories. In addition, we find that banks and credit unions are less likely to offer free checking accounts when payday loans are available. We hypothesize that customer sorting and adverse selection are responsible for these effects. Price sensitive, low risk borrowers substitute cheaper payday credit for overdraft credit, leaving depositories with a riskier and less price elastic clientele. Accordingly, depositories raise rates to cover higher costs and maximize profits, and they cut back on free checking accounts to mitigate increased risk.