Credit ratings are a key check on CEO overconfidence in corporate acquisitions
Heriot-Watt University
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Research co-author Professor Patrycja Klusak, an expert in credit ratings agencies at Heriot-Watt University.
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Overconfident chief executives and their risky behaviours can be partly restrained through credit ratings, new research finds.
Researchers led by Bangor University in Wales in the United Kingdom and other institutions including Heriot-Watt University in Edinburgh, Scotland, Vlerick Business School in Brussels, Belgium and The University of Aberdeen in Scotland found that the creditworthiness of a company can hugely influence how its chief executive behaves – especially during corporate mergers and acquisitions (M&A).
The research, which is published in the journal, European Financial Management, is based on data from 916 firms in the United States who were rated by American credit ratings agency S&P (previously Standard & Poor’s) between 2006 and 2019. Credit rating agencies are companies that assess the creditworthiness of financial institutions, companies and governments.
The researchers say their paper is the first to suggest that credit ratings agencies, through their rating actions and outlooks, can effectively restrain chief executive overconfidence, thereby serving as external monitors of managerial behaviour.
Paper lead author Dr Shee-Yee Khoo, a Lecturer in Finance at Bangor University’s Bangor Business School, said: “Our research shows that when companies risk a credit downgrade, even overly confident chief executives are more likely to think twice before making risky acquisitions.
“This highlights the important role credit ratings play in corporate governance. Rather than simply reflecting a firm’s financial health, credit ratings can influence strategic decisions by curbing excessive risk-taking. Faced with the potential loss of access to low-cost debt, even the most self-assured chief executives become more cautious, demonstrating that credit rating agencies can effectively reshape corporate behaviour beyond financial metrics alone.”
The researchers found that overconfident chief executives increase their acquisition activity more than their rational peers when their company’s credit rating is rising from lower levels, making the cost of debt cheaper. But conversely, when their company has a high credit rating that could be downgraded, overconfident chief executives become more cautious than their rational peers, fearing loss of access to low-cost debt.
Specifically, firms managed by overconfident chief executives that were facing a potential downgrade from an ‘investment grade’ credit rating – which signifies a relatively low risk of default – to a ‘speculative grade’ credit rating – which indicates a higher risk of default – saw a 15.7 percentage point drop in the likelihood of acquisition activity, compared to their rationale counterparts.
Co-author Patrycja Klusak, an expert in credit ratings agencies and Professor of Accounting and Finance at Heriot-Watt University’s Edinburgh Business School, explained: “This behavioural shift underscores the monitoring power of rating agencies: the threat of a downgrade appears to temper even the boldest executive impulses.
“Overconfidence in leadership is a double-edged sword. On one hand, bold decision-making by chief executives can lead to visionary strategies and drive innovation. On the other hand, unchecked confidence often results in poor judgement, misjudged acquisitions and long-term value destruction.”
Despite the high levels of responsibility they carry and high expectations around their decision-making, chief executives are “just as likely to succumb to irrational behaviour as anyone else,” Professor Klusak adds.
Professor Thanos Verousis, Professor of Sustainable Finance at Vlerick Business School in Belgium, said: “Our research demonstrates that credit ratings do more than just signal financial health to investors – they actively shape executive decision-making.
“This external control mechanism is particularly important given that traditional corporate governance structures may not always effectively curb the risks associated with chief executive overconfidence.”
Dr Huong Vu, Lecturer in Finance at the University of Aberdeen, said credit ratings have been found to be a crucial consideration in shaping most corporate executives’ debt policies, alongside financial flexibility. She added: “Our study offers a more nuanced perspective. It shows that rating agencies, through their rating decisions, send a clear signal that even overconfident chief executives cannot ignore – steering them toward more value-enhancing investment policies that protect long-term shareholder value.”
Overconfident managers tend to overestimate the value they can create; underestimate risks and engage in highly complex transactions that can destroy a firm’s value, the researchers explain. Overconfident managers also prefer to use cash or low-cost debt than equity to finance investments. This reflects their belief that their company’s own equity – its shares – are undervalued by the stock market. Their preference for debt also explains the sensitivity of overconfident managers to negative credit ratings – which can limit their access to low-cost debt.
As M&A decisions continue to be a key lever for corporate growth – and potential risk – understanding executive psychology, and the subtle tools that can influence it, is more important than ever, the researchers say.
The research team also includes Bennett Institute for Public Policy at the University of Cambridge; the ClimaTRACES Lab in Judge Business School at the University of Cambridge and the Bennett Institute for Innovation and Policy Acceleration at the University of Sussex.
The research is entitled Restraining overconfident CEOs through credit ratings.
Journal
European Financial Management
Method of Research
Meta-analysis
Article Title
Restraining overconfident CEOs through credit ratings
Article Publication Date
12-May-2025
