CEO Optimism and the Cost of Bank Debt

• Published date: 01 August 2020
• Author: Hyun‐Dong Kim,Kyojik “Roy” Song,Yura Kim
• DOI: http://doi.org/10.1111/ajfs.12309
• Date: 01 August 2020

CEO Optimism and the Cost of Bank Debt

Yura Kim

Business School, University of Seoul, Republic of Korea

Hyun-Dong Kim

Graduate School of International Studies, Sogang University, Republic of Korea

Kyojik “Roy” Song*

Business School, Sungkyunkwan University, Republic of Korea

Received 23 July 2019; Received in current form (1

st

revision) 29 March 2020; Accepted 30 April 2020

Abstract

This paper examines the effect of the level of CEO optimism on loan spread and number of

covenants using 4869 loan facilities (tranches) made to 1271 U.S. industrial firms over the

period 1992–2011. We find that banks charge significantly lower spreads and impose a smal-

ler number of covenants on loans made to firms with moderately optimistic CEOs. However,

banks tend to charge higher costs on loans made to firms with low- or high-optimism CEOs.

The results suggest that the level of CEO optimism and the costs of bank loans have a convex

relation.

Keywords CEO optimism; Bank loan; Loan spread; Covenant

JEL Classification: G3, G21

1. Introduction

Recent literature in corporate finance and accounting examines how managers’ psy-

chological biases or characteristics affect corporate policies.

1

Specifically, the

research has extensively studied the effect of prevalent traits in managers, manage-

rial optimism, or overconfidence, on corporate policies such as investment, financ-

ing, payout, and mergers and acquisitions (M&As). Highly optimistic managers

overestimate their ability to affect their financial performance and/or underestimate

the probability of their failures. Since they overestimate the expected cash flows

from a project, they tend to incorrectly perceive negative NPV projects as profitable,

to overinvest, and to make value-destroying acquisitions accordingly. Prior studies

have generally focused on the harmful effect of managerial optimism on corporate

*Corresponding author: Business School, Sungkyunkwan University, 25-2 Sungkyunkwan-ro,

Jongno-gu, Seoul 03063, Republic of Korea. Tel: +82-2-760-0497, email: roysong@skku.edu.

1

For a summary of behavioral corporate finance, refer to Baker et al. (2007).

Asia-Pacific Journal of Financial Studies (2020) 49, 548–580 doi:10.1111/ajfs.12309

548 ©2020 Korean Securities Association

policies. They have investigated how managerial optimism affects the investing and

financing activities of firms and how optimism affects financial reporting. In a series

of influential research, Malmendier and Tate (2005, 2008) and Malmendier et al.

(2011) develop measures of executive overconfidence based on their options exer-

cise behavior and document that overconfident managers tend to overinvest and

make value-destroying acquisitions. They also find that overconfident managers

avoid equity financing and rely on internal cash and debt to fund projects since

they think the equities of their firms are undervalued in the market. Banerjee

et al.’s (2018) findings also support the hypothesis that overconfident executives are

more likely to engage in reckless or intentional actions that increases the likelihood

of securities class actions (SCA).

Whereas previous literature tends to focus on the adverse effect of managerial

optimism on corporate policies, we examine how the level of managerial optimism

is related to financing costs. Managerial risk aversion imposes agency costs if man-

agers give up new projects with positive NPVs when the outstanding debt holders

capture most of the benefits from the new projects without incurring the invest-

ment costs (Myers, 1977). Based on the assumption that shareholders observe nei-

ther cash flows nor management’s investment decisions, Stulz (1990) shows that

managerial discretion can lead to underinvestment or overinvestment. Even without

information asymmetry and agency problems, a level of managerial optimism can

create overinvestment or underinvestment. Highly optimistic managers tend to

overestimate expected cash flows from a project and invest in the project that

otherwise might have been rejected by a risk-averse manager. In contrast, overly

conservative or risk-averse managers may forego risky but value-adding projects.

Also, there is some evidence that a moderate level of managerial optimism con-

tributes to the innovative activities of firms (Galasso and Simcoe, 2011; Hirsh leifer

et al., 2012), which can increase firm value. Therefore, a level of managerial opti-

mism and firm value can have a concave relation. Goel and Thakor (2008) theoreti-

cally show that moderate optimism diminishes underinvestment and increases firm

value. Campbell et al. (2011) also show in their theoretical model that a moderate

level of optimism causes the CEO to invest at the first-best level that maximizes

firm value.

However, Campbell et al. (2011) argue that it is difficult for researchers to

examine the concave relation between CEO optimism and firm value empirically

because highly optimistic CEOs are likely to experience forced turnovers. Then, for

a firm with a high-optimism CEO, firm value depends on both a current high-opti-

mism CEO who makes value-decreasing decisions and a newly joined CEO who

implements better corporate policies and enhances firm value. Therefore, it is diffi-

cult for researchers to separate the effect of CEO optimism from firm value. We

attempt to overcome the difficulty of testing the relation between CEO optimism

and firm value by examining the effect of CEO optimism on the cost of bank debt.

Banks are considered information producers and effective monitors and they should

be able to evaluate the implications of CEO optimism. Since banks lend capital to

CEO Optimism and the Cost of Bank Debt

©2020 Korean Securities Association 549

firms over the short term, they would reflect the potential benefits and costs of the

current CEO’s trait in loan contracts. Few empirical studies have examined how

capital providers value the benefits and costs of CEO optimism. How banks evalu-

ate the beneficial versus detrimental effect of CEO optimism on firm value when

they design loan contracts is an empirical question. We attempt to fill this gap and

contribute to extant literature by investigating the relation between CEO optimism

and the spread and covenants of bank loans.

Managerial optimism can be more relevant to debt holders rather than outside

shareholders since optimistic CEOs are more likely to raise debt to cover financing

deficits, rather than equity (Malmendier and Tate, 2005). Highly optimistic CEOs

tend to make riskier investments and invest even in negative NPV projects (Mal-

mendier and Tate, 2008; Malmendier et al., 2011). Merton (1973) shows that equity

is considered a call option when firms use risky debt to raise capital. If firm man-

agers behave in the interests of equity holders, they have incentives to invest in risk-

ier projects and take even negative NPV projects, which can lead to wealth transfer

from debt holders to equity holders. Therefore, it can be detrimental to debt hold-

ers if executives manage firms with a high level of optimism. In our analysis, we

focus on bank loans since banks, compared to other financial intermediaries, are

special in their ability to gather and process information and in their ability to cer-

tify firm value to outsiders (Fama, 1985). Banks typically build repeated lending

relations and access to the borrowing firm’s private information through their mon-

itoring role. Thus the intimate relation with the borrowing firm makes bank debt

different from “arm’s length” debt, which is diffusely owned by numerous public

debt holders. If banks recognize the potentially negative effect inherent in the

investing decisions of highly optimistic managers, they should reflect their concern

in the loan spread and covenants. In contrast, banks might perceive the managerial

optimism to be beneficial if they recognize that the moderate level of CEO opti-

mism offsets the CEO’s risk aversion and leads to better innovation. Accordingly,

we hypothesize that the level of CEO optimism and the cost of bank debt have a

convex relation.

To test our hypotheses, we use the data on bank loans made to U.S. industrial

firms over the period 1992–2011. Our sample consists of 4869 loan facilities

(tranches) made to 1271 unique firms. Following Campbell et al. (2011), we classify

CEOs into low-, moderate-, and high-optimism CEOs based on the in-the-money

ratios. In multivariate regressions, we find that banks charge significantly lower

spreads on loans made to firms operated by moderately optimistic CEOs even after

controlling for other determinants. The results are consistent with our argument

that the level of managerial optimism and the loan spread have a convex relation.

Further, we examine the relation between the level of CEO optimism and the num-

ber of covenants used in bank loans using ordered logit regressions. We find that

banks increase the covenant intensity index when they make loans to firms with

low- and high-optimism CEOs. The results also confirm that banks recognize the

positive effect of a moderate level of CEO optimism on firm policies ex ante.

Y. Kim et al.

550 ©2020 Korean Securities Association