This paper investigates the effects of the novel coronavirus (COVID-19) outbreak and government capital injections on the bank's optimal interest margin and the efficiency gain/loss from the shadow banking operations. The down-and-out call option approach is adapted to model the structural break in volatility to capture the COVID-19 outbreak. Results show that the COVID-19 outbreak reduces the optimal bank interest margin, government capital injections enhance the margin, and both the outbreak and capital injections harm the efficiency gain from shadow banking. COVID-19, as such, makes the bank more prone to risk-taking, thereby adversely affecting banking stability.

Highlights A life insurer capped by the borrower's credit risk and COVID-19 outbreak is modeled. The COVID-19 outbreak, hedging, and capital regulation are considered explicitly. The effect of COVID-19 outbreak on borrowing firm deteriorates insurance activities. The COVID-19 outbreak and insurer hedging harm policyholder protection. Stringent regulation reinforces insurance instability during COVID-19 outbreak period.