Increases in firm default risk raise the default probability of banks in US data. We analyse firm risk shocks in a New Keynesian business cycle model, where entrepreneurs and banks engage in a loan contract and both are subject to idiosyncratic default risk. We show that, through a fall in equity, bank owners partly absorb the losses on banks' balance sheets that originate from a wave of corporate defaults. Bank capital buffers help to cushion the contractionary effects of firm risk shocks. We analyze how different combinations of interest rate rules and macroprudential policies can mitigate the adverse consequences of such shocks.