Free Banking and Credit Market Competition

Abstract

Why do some countries (e.g. US/UK) have free banking and expensive overdrafts, while others (e.g. France/Germany) do not? Existing models point to naivety amongst consumers – but without evidence that such naivety differs across countries. This paper offers a different explanation. We model the two stages of competition between banks for accounts and then to supply credit. We allow for banks to compete to poach customers in the credit market. We show that free banking results when a country has greater numbers of high credit-risk borrowers. We predict that this leads to borrowers switching less yet paying higher prices for credit.