CEO Overconfidence,External Governance,and Future Firm Risk

The advocates of behavioral decision theory and upper echelons theory suggest that the psychological traits of executives can substantially affect the firm's decisions.Notwithstanding the fact that overconfidence bias has got a lot of attention from researchers,contemporaneous literature has ignored its impact on firm's future risk.This study endeavors to fill this gap by determining if overconfident CEO's decisions can affect the firm's operational and market risks over the subsequent years.This study further examines the effects of external governance mechanisms,specifically product market competition and institutional investors,on the association between overconfidence and firm's future risk in China.Due to the atypical institutional and ownership structures of Chinese listed firms,this study also investigates how state ownership influences the effect of CEO overconfidence in this context.The initial sample of this study consists of Chinese A-share issuing firms listed on Shanghai and Shenzhen Stock Exchanges during the period starting from 2000 through 2017.However,due to the computational requirements of some variables,final analysis has been performed on a sample period starting from 2003 through 2017.The final sample consists of 2,076 listed firms.Overconfidence classification of CEOs is based on three robust and well-established measures that have been extensively tested in the previous studies.The first measure classifies a CEO as overconfident if the forecasted profits of his firm are greater than the actual profits for majority of the time during his tenure.The second measure recognizes a CEO as overconfident if the forecasted profits of his firm are greater than the analysts' forecasts for majority of the time during his tenure.The third measure identifies a CEO as overconfident if he acquires more stocks of his firm in a year.OLS regression technique has been used as the primary estimation model for generating the results.However,for verifying the robustness of results,fixed effects regression and instrumental variable regression have also been applied due to their advantage of addressing any potential endogeneity issues.Moderating effects of product market competition and institutional investors have been examined by using their respective interaction terms with CEO overconfidence.The results demonstrate that CEO overconfidence leads to an escalation in firm's risk level over the subsequent years.However,the intensity of this escalation is weaker in state-owned firms.It is probably due to the reason that CEOs in these firms have less discretion in decision making.The findings further indicate that competition in the product market negatively moderates the effect of overconfidence on firm s future risk,but this moderation effect only exists in non-state-owned firms.The reason for this negative moderation may be the pressure from competitive environment that restricts CEOs in non-state-owned firms from taking irrational decisions.The findings also provide evidence that different institutional investors have different incentives to monitor the decisions and action of CEOs.Only active institutional investors,specifically mutual funds and foreign institutional investors,play their governance role in reducing the effect of CEO overconfidence on firm's risk level.Additional analysis rev.eals that the moderating effect of active institutional investors is weaker in state-owned firms.All these findings remain qualitatively similar even after using alternative model specifications,and alternative measures of overconfidence and future firm risk.The contributions of this study to the extant literature of behavioral corporate finance are manifold.Firstly,it provides novel empirical findings relating to the effect of CEO overconfidence on firm's future market and operational risks.Secondly,due to an unusual ownership structure of Chinese listed firms,it analyzes the difference in the effect of overconfidence in state-owned versus non-state-owned firms.Thirdly,it identifies whether external governance mechanisms,such as competition in the industry and institutional investors' ownership,can be beneficial for disciplining the overconfident CEOs'actions.Lastly,it investigates variation in the disciplinary effect of external governance in state-owned versus non-state-owned firms.This study provides various policy implications for management,regulators,policy makers,and investors.For management,it provides numerous theoretical and empirical evidences regarding the negative outcomes of overconfidence bias which imply that the executives should exercise extreme diligence in decision making.In order to limit biased and irrational decisions,they must analyze a situation based on realistic facts and figures rather than having misperception about their excessive abilities in controlling the outcomes of a situation.For regulators and policy makers,this study provides insights regarding how product market competition and institutional investors play their role indiminishing the overconfidence-induced risks.The regulators and policy makers,therefore,must formulate strategies for promoting competitive environment,and motivating mutual funds and foreign investors to increase their shareholding in Chinese firms.For investors,this study provides empirical evidence that strong competition in industry has the potential to reduce overconfidence-induced firm risk in non-state-owned firms.This evidence suggests them to invest in those private firms that operate in competitive environment.