I study how the distribution of wealth influences the government's response to a banking crisis and the fragility of the financial system. When the wealth distribution is unequal, the government's bailout policy during a systemic crisis will be shaped in part by distributional concerns. In particular, government guarantees of deposits will tend to be credible for relatively poor investors, but may not be credible for wealthier investors. As a result, wealthier investors will have a stronger incentive to panic and, in equilibrium, the institutions in which they invest are more likely to experience a run and receive a bailout. Thus, without political frictions and under a government that is both benevolent and utilitarian, bailouts will tend to benefit wealthy investors at the expense of the general public. Rising inequality can strengthen this pattern. In some cases, more progressive taxation reduces financial fragility and can even raise equilibrium welfare for all agents.

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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.

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