https://macropaperwarehouse.com/authors/ulrich-schuwer/Ulrich SchüwerHugo -- gohugo.ioen-ushttps://macropaperwarehouse.com/papers/unequal-and-unstable-income-inequality-and-bank-risk/https://macropaperwarehouse.com/papers/unequal-and-unstable-income-inequality-and-bank-risk/<p>This paper documents that U.S. metropolitan statistical areas with higher income inequality have a larger share of failed banks, higher average bank default probabilities, and greater dispersion of bank risk, using cross-sectional regressions across 178 MSAs and 5,543 banks over 2000–2019 with the Gini coefficient measured from the 2006 American Community Survey. A move from the 25th to the 75th percentile of the Gini distribution (0.429 to 0.460) is associated with a 0.124 percentage point higher share of failed banks, a large effect relative to the 0.3 percent mean failure rate in the sample. To account for these patterns, the paper builds a general equilibrium model in the Allen and Gale (2000) tradition in which banks compete to lend to households that differ by income and finance housing purchases with mortgages; competition and deposit insurance together induce some banks to lend to low-income (subprime) households at rates that carry negative expected present value, creating a segment of endogenously risky banks that fail with positive probability in the bad state. Income inequality expands the subprime borrower pool both directly — by shifting more households below the endogenous income cutoff — and indirectly — by raising the equilibrium cutoff itself via higher housing prices — leading to a larger share of risky banks. A key counterfactual result is that if deposit insurance premiums fully reflected bank-specific risk (eliminating risk-shifting), all banks would be safe regardless of the income distribution, isolating risk-shifting as the necessary friction.</p>