Unequal and Unstable: Income Inequality and Bank Risk

We present a model in which income inequality interacts with banks' risk-taking incentives, generating financial instability. Competition and deposit insurance cause some banks to lend to lower-income borrowers at underpriced rates, creating “risky banks” that fail in downturns, while others lend to higher-income borrowers and avoid default. Rising inequality affects stability by expanding the underpriced loan segment and increasing the share of risky banks. Moreover, borrower risk does not automatically imply bank risk: without risk-shifting, no bank fails, even as borrowers become riskier. The model identifies when inequality heightens bank risk and clarifies the mechanisms connecting inequality, lending behavior, and financial fragility.