CEO Overconfidence and Financial Crisis

Chih-Yung Lin is Associate Professor of Finance at Yuan Ze University. This post is based on an article authored by Professor Lin; Po-Hsin Ho of National Taipei University; Chia-Wei Huang, Associate Professor of Finance at Yuan Ze University; and Ju-Fang Yen of the Department of Statistics at National Taipei University.

Bank financial contagion is cited as a key feature of the financial crises, as problems at specific financial institutions rapidly morphed into a crisis for the entire financial system. Shocks to bank health have played a systematic role in worsening financial stability. Yet not all financial institutions suffered during these crisis years. In our article, CEO Overconfidence and Financial Crisis: Evidence from Bank Lending and Leverage, which was recently published in the Journal of Financial Economics, we propose a new perspective that manager overconfidence could explain the substantial heterogeneity in bank risk-taking behaviors during a boom, as well as the performance of these banks during the ensuing crisis years.

The chief executive officers (CEOs), as the top decision maker in the bank, are the primary influence on bank investment and financing decisions, CEO attitudes toward borrower prospects thus could affect their banks’ lending standards and leverage levels. An overly optimistic assessment of borrower prospects during a credit boom could make banks more vulnerable when a credit boom is followed by a crisis.

Overconfident CEOs generally think they have more precise knowledge about future events than they actually have and that they are more likely to experience favorable future outcomes than they actually are. Such biased perceptions cause them overestimate their ability to generate higher returns on their investment projects, often resulting in overinvestment. During an economic upswing, an overconfident CEO who is more bullish than others on prospects for the economy could relax lending standards and increase bank leverage more than other banks while they take exposures believed to be the most profitable for current shareholders. Yet, by taking greater risk, overconfident CEOs make their banks more vulnerable to an external shock such as a financial crisis.

To identify overconfident CEOs, we use the stock option-based overconfidence measure from Campbell, Gallmeyer, Johnson, Rutherford, and Stanley (2011). We collect CEO overconfidence data from publicly listed US banks over 1994–2009, a period that includes the 1998 Russian financial crisis and the most recent worldwide financial crisis of 2007–2009. Both crises followed a period of lending growth and are among the worst financial crises in the last 50 years. We take 1998 as the start of the Russian crisis and 2007 as the start of the most recent financial crisis. We then define 1998 and 2007–2009 as crisis years and other years as non-crisis years.

We find that banks with overconfident CEOs (who we refer to them as just “overconfident banks” henceforth) were more aggressive in lending than non-overconfident banks in the non-crisis years, particularly in lending to real estate borrowers. Overconfident banks on average increased their loans (real estate loans) by about 14.98% annually (18.06%), which is 4.60 (11.42) percentage points higher than the increase for non-overconfident banks. We also find that overconfident banks showed greater growth in leverage in the non-crisis years. For example, the annual rate of change in market leverage for overconfident banks was on average about 5.37 percentage points higher than for non-overconfident banks during the non-crisis years, again indicating greater risk-taking behavior.

After a crisis developed, our results show that many loans extended by overconfident banks in non-crisis years were in default or near default. It indicates that overconfident banks were more prone to have originated low-quality loans that experienced higher future default rates than non-overconfident banks before a crisis, creating large capital losses after a crisis occurred. Such unanticipated losses for overconfident banks, accompanied with high leverage, diminished their net worth considerably, prompting some depositor withdrawals and fire sales and thereby reducing these banks’ net worth still further.

We find that overconfident banks generally experienced more severe worsening of operating and stock return performance, along with greater increases in expected default probability. Many of these banks replaced their CEOs and even failed during the crisis years. In our sample during crisis years, 25.93% of overconfident banks experienced CEO turnover, compared with only 15.83% of non-overconfident banks, and 10.37% of overconfident banks failed, compared with 4.17% of non-overconfident banks during the period. Our results thus indicate that overconfidence can lead risk-averse CEOs to take exposures that they perceive are the most profitable for current shareholders ex ante but that could harm their banks and themselves ex post.

We further explore whether a bank CEO’s attitude toward risk before the 1998 crisis could help predict the bank CEO’s attitude before the most recent crisis. We find that, instead of learning from their experience in the 1998 crisis, banks with overconfident CEOs in 1997 were still likely to have overconfident CEOs prior to the most recent financial crisis, even though overconfident managers incurred heavy losses in the 1998 Russian crisis. This is consistent with the finding of Fahlenbrach, Prilmeier, and Stulz (2012) that the same firms that suffered significant losses in the 1998 crisis then incurred the heaviest losses in the most recent crisis. This result provides evidence to support persistence in a bank’s risk culture.

Our analyses help us to better understand the kinds of banks that perform poorly during a financial crisis by relating managerial overconfidence to bank misfortunes during crisis years. Overall, our empirical evidence shows that the aggressive risk culture of some banks makes them more likely to hire overconfident CEOs who take risks when the economy is in an upturn. CEO overconfidence, prompting greater lending and higher leverage during the boom preceding a crisis, could have contributed to banks’ woes during the ensuing crisis years.

The full article is available for download here.

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