Unequal and Unstable: Income Inequality and Bank Risk
67 Pages Posted: 20 Jul 2020 Last revised: 12 Feb 2021
Date Written: June 15, 2020
We provide evidence that regions in the U.S. with higher income inequality tend to have a riskier banking sector. However, not all banks are more risky, as reflected in a higher dispersion of bank risk. We show how a model based on risk-shifting incentives where banks channel insured deposits into subprime loans can account for both findings. In equilibrium, a competition to risk-shift emerges, leading to a subprime lending boom in which loans to high-risk borrowers carry negative NPVs. Some banks engage in risk-shifting by lending to high-risk subprime borrowers, while the rest specialize in lending to low-risk prime borrowers.
Keywords: Inequality, bank risk, risk-shifting, mortgage credit, banking competition
JEL Classification: G11, G21, G28, G51
Suggested Citation: Suggested Citation