The risk of financial crises: Is there a role for income inequality?

•Our results are based on a dataset of 14 developed countries over the 1870–2008 period.•We use both in-sample and out-of-sample analyses.•Income inequality is found to have the highest individual predictive power of financial crises.•The role of bank loans diminishes considerably when controlling for other factors.•Income inequality is found to be a relevant predictor of financial crises especially when it is at a relatively high level.

Could macroeconomic factors such as income inequality be the real root cause of financial crises? We explore a broad variety of financial and macroeconomic variables and employ a general-to-specific model selection process to find the most reliable predictors of financial crises in developed countries over a period of more than 100 years. Our in-sample results indicate that income inequality has predictive power beyond loan growth and several other financial variables. Out-of-sample forecasts for individual predictors show that their predictive power tends to vary considerably over time, but income inequality has predictive power in each forecasting period.