Ethics and Talent in Banking

This paper develops a theory of optimal ethical standards, capital requirements and talent allocation in banking wherein two types of banks, one being protected by regulatory safety nets ("depositories") and the other not so protected ("shadow banks"), innovate financial products and compete for managerial talent. Ethical violations are "mis-selling" products to customers who would not benefit from them, and they entail financial losses and regulatory penalties for the miscreant bank. Bank capital is shown to be more efficient than a penalty for implementing ethical standards. For any capital level, banks choose higher ethical standards and experience fewer ethical violations when bank managers are more talented. However, banks adopting higher ethical standards experience managerial talent migration to banks with lower standards. In equilibrium, endogenously-determined regulatory capital and ethical standards are higher in depositories than in shadow banks, and this difference is bigger with talent competition than without. Consequently, depositories hire less talented managers and innovate less, implying that prudential bank regulation has unavoidable labor market consequences in financial services