Inequality and Financial Fragility

I study how the distribution of wealth influences the government’s response to a banking crisis and the fragility of the financial system. Distributional concerns tend to make full government guarantees of deposits in a systemic crisis credible for relatively poor agents, but not for wealthier agents. As a result, wealthier agents will have a stronger incentive to panic and, in equilibrium, the institutions in which they invest will be endogenously more likely to experience a run and receive a partial bailout. Thus, even under a utilitarian policy maker, bailout payments may be directed towards the wealthy at the expense of the general public. Moreover, the shape of the wealth distribution affects the level of fragility in the financial system. The recognition of this fact may alter the government’s desire to redistribute wealth ex ante.