COVID-19, bank risk, and capital regulation: The aggregate shock and social distancing

Abstract

In this study, we introduce a novel spatial framework to examine the impact of the aggregate shock and social distancing policies stemming from the COVID-19 pandemic on banks' incentives to monitor entrepreneurs. Our findings reveal that banks raise their loan rates to compensate for losses caused by the aggregate shock, which, in turn, enhances their monitoring efforts. However, the default probability still rises. The government's expansionary monetary policy, implemented in response to the COVID-19 crisis, can help mitigate these effects. Additionally, social distancing measures have led to either increased customer service or higher preparation costs for entrepreneurs seeking loans, both of which ultimately benefit the banks' monitoring efforts. We further explore social welfare analysis, the role of capital regulation, and several other relevant extensions.