Trust Busting: The Effect of Fraud on Investor Behavior

We study the importance of trust in the financial intermediation industry by exploiting the geographic dispersion of victims of the Madoff Ponzi scheme to estimate the effects of trust on asset flows. Investors in communities that were more exposed to the fraud subsequently withdrew assets from investment advisers and increased cash deposits at banks. Additionally, exposed advisers were more likely to close. Advisers who provided services that can build trust experienced lower withdrawals, while those with the ability to steal from their clients experienced greater withdrawals. Our evidence suggests that the trust shock was transmitted through social networks. Taken together, our results show that trust plays a critical role in financial intermediation.