Ethics and Talent in Banking
This paper develops a theory of optimal ethical standards in banking wherein two types of banks, one being protected by regulatory safety nets ("depositories") and the other not so protected ("shadow banks"), are innovating financial products and competing for managerial talent. Ethical violations take the form of mis-selling" products to customers who would not benefit from them. Ethical violations entail financial losses and regulatory penalties for the miscreant bank. For any given level of penalties, banks choose higher ethical standards (so there are fewer ethical violations) when bank managers are more talented. However, banks adopting higher ethical standards experience managerial talent migration to banks with lower ethical standards. In equilibrium, endogenously-determined penalties are harsher and ethical standards are higher in depositories than in shadow banks, but consequently depositories end up hiring less talented managers and innovate less. Higher capital also induces higher ethical standards in banks.