Identifying policy determinants of bank default risk during the COVID-19 pandemic: empirical evidence from the U.S. and Canada

This study examines the policy determinants of bank default risk, proxied by credit default swap (CDS) spreads, using quarterly data from the U.S. and Canada for the period 2020 to 2022. The analysis considers four determinant groups: the COVID-19 pandemic shock, aggressive monetary and fiscal policy responses, macroprudential-related bank financial fundamentals, and macroeconomic and market conditions. Utilizing General Least Squares (GLS) and dynamic panel models with system General Method of Moments (GMM), the findings reveal that rising COVID-19 deaths significantly widen CDS spreads. Expansionary monetary policies reduce bank default risk, though the effectiveness under conventional monetary policy is reduced by increasing COVID-19 deaths. In contrast, expansionary fiscal policies and inflation broaden CDS spreads. The combined analysis highlights policy stances as dominant factors, with macroprudential-related fundamentals having minimal impact. The findings are robust using both 5-year and 10-year CDS measures. This study has significant policy implications during health and economic crises. For financial stability, policymakers should prioritize reducing pandemic-related deaths, utilize expansionary monetary policies with health support strategies, balance fiscal support to avoid excessive government spending, and implement measures to control inflation. It is essential to enhance coordination between healthcare, fiscal, and monetary authorities for effective policy implementation.