On the credibility of ethical banking

Abstract

Motivated entrepreneurs investing in ethical projects financed by ethical banks seems a virtuous albeit rather fragile outcome of the credit market. The credibility of ethical banking is in fact the result of a subtle balance of delicate ingredients supporting each other. To obtain the better credit deals that could be offered when (truly) motivated entrepreneurs and ethical lenders match, non-motivated entrepreneurs may easily pretend to be socially responsible by investing in ethical projects. In a model with moral-hazard (in the credit relationship) and adverse-selection (for the types of entrepreneurs, motivated or not), we show that the market for ethical projects thrives. Market segmentation occurs as a virtuous and unique equilibrium that features standard entrepreneurs and lenders trading in the market for standard projects only, while motivated entrepreneurs deal with ethical banks in the market for ethical projects. In line with the empirical evidence on ethical banking, the model predicts that ethical lenders require lower collateral than commercial banks.