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Review of Quantitative Finance and Accounting

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20.01.2017 | Original Research

CEO ability heterogeneity, board’s recruiting ability and credit risk

verfasst von: Tsung-Kang Chen, Hsien-Hsing Liao, Wen-Hsuan Chen

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 4/2017

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Abstract

This study investigates the effects of the CEO (Chief Executive Officer) ability heterogeneity of an industry and the board’s recruiting capability on firm credit risk by using 26,235 America bond data from the year 2001 to 2014. We find that both CEO ability heterogeneity and board’s recruiting ability enhance a firm’s credit quality when controlling for other well-known determinants of bond yield spreads, implying that high CEO ability heterogeneity and good board’s recruiting ability both encourage a firm to replace the underperformed CEO earlier and improve the firm’s subsequent performance, which enhances firm value and credit quality (Merton in J Finance 29(2):449–470, 1974). We also find that good macroeconomic conditions weaken the effect of CEO ability heterogeneity on bond yield spreads while enhance that of board’s recruiting ability. Moreover, board’s recruiting ability weakens the effect of CEO ability heterogeneity on bond yield spreads, indicating that there may exist a trade-off relationship between the CEO ability heterogeneity effect and the board’s recruiting ability effect. Finally, the results are robust when considering endogeneity issues and other measures of CEO ability heterogeneity.

Vorheriger Artikel Investigating the valuation effects of reverse takeovers: evidence from Europe

Nächster Artikel Value creation and the probability of success in merger and acquisition transactions

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Several previous studies also argue that competition for talent in the CEO labor market is an important determinant of CEO pay, such as Edmans et al. (2009), Gabaix and Landier (2008), and Tervio (2008).

For example, firing costs include the laid-off fee, requirements in pension, and so on.

Cornelli et al. (2013) use three indicators to capture different types of soft information, including the variable that whether or not directors view the CEO as incompetent or think that his skills are a poor match for the firm’s needs, and other two variables.

Cornelli et al. (2013) demonstrate that learning about the CEO’s ability requires that the board can filter out noise when evaluating the CEO.

Merton (1974) and Duffie and Lando (2001) are both belong to stock-based structural credit models. Chen et al. (2011a) develop a flow-based structural credit model and demonstrate the importance of internal liquidity on determining firm credit risk. Chen et al. (2011b) and Douglas et al. (2016) provide the related empirical evidences using internal liquidity volatility and cash flow volatility, respectively.

According to these points of view, the later a firm fires its CEO, the more the firm’s excess profitability drops, the slower the recovery of the firm’s profitability, and, in average, the lower the asset return of the firm than other firms which fire CEO earlier.

As a result, the board will replace its CEO immediately when the cause of bad profitability is the poor ability of CEO. Also, the board can hire a better CEO to improve subsequent performance due to the understanding of other CEOs’ abilities in the CEO market.

The variable of CEO relative pay is defined as the ratio of the CEO’s total pay to the total pay of the other four highest-paid executives in the company.

For the variable of press of CEO (Rajgopal et al. 2006), it needs hand-collected hard work so that this study doesn’t adopt this method in main results.

For the board’s recruiting ability, this study aims to exclude the impacts of external governance rather than those of internal governance. Internal governance is defined as an aggregate measure based on the incentive and ability of key subordinate executives to monitor the CEO (Cheng et al., 2016). Since the internal governance effects are from other major managers, the board recruiting ability should be not affected by the internal governance.

Other similar definitions of institutional ownership could be also referred to Lin (2016) and Lin and Manowan (2012).

The data of these six corporate governance provisions are obtained from Institutional Shareholder Services (ISS; formerly RiskMetrics).

According to the recession period judgement of the National Bureau of Economic Research, the recession period covers year 2001 (March 2001–November 2001), 2007 and 2008 (December 2007-June 2009) during our sample period.

The result of column (2) in Table 5 demonstrate that the interaction term of BU and GDP (BU*GDP) is negatively but insignificantly related to bond yield spreads, implying that the BU effect become weaker when GDP growth rate is higher. Moreover, the result of column (6) in Table 5 shows that the interaction term of BU and RP (BU*RP) is positively related to bond yield spreads, revealing that the BU effect becomes stronger when business cycle is at the recession period.

This study follows Sovey and Green (2011) to employ the lagged variables of CAH and BRA proxies as instrument variables. The lagged CAH and BRA variables have a relatively low correlation with the error term and a greater correlation with current CAH and BRA variables. In addition, the instrument variables for each CAH and BRA proxies are IV_CEO_HET, IV_BU, IV_ISGDR, and IV_SIND, respectively.

This study follows Stock et al. (2002) to examine the validity of the employed instrument variables by conducting the partial F-test with the presence of other control variables (the null hypothesis is that the instrument variables are jointly zero in the first-stage regression). The results of column (1), (3), (5), and (7) of Table 7 show that the partial F-statistics in the first-stage regression are all higher than the critical value of the partial F-statistic (8.96).

This study conducts the over-identifying restrictions test and finds that the model is exactly identified, implying that the instrumental variables are exogenous and valid.

According to the values of partial F-statistics, IV_CAH and IV_BRA satisfy the relevance condition and the exclusion condition (Roberts and Whited 2012) and over-identifying restrictions test, respectively.

If the firm-specific profit volatility is higher, the more difficult the board can learn the ability of CEO. This is because the board cannot be sure that the drop of profitability is caused by the CEO ability or the firm characteristics. Hence, the delay replacement decision makes a bad CEO remain in the firm and therefore raises the firm’s credit risk.

The data of general managerial ability index are directly obtained from Ferreira’s homepage (one of Custo´dio et al. (2013)). The website is http://docentes.fe.unl.pt/~mferreira/. In addition, the provided data period ranges from year 1993–2007.

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Titel: CEO ability heterogeneity, board’s recruiting ability and credit risk
verfasst von: Tsung-Kang Chen
Hsien-Hsing Liao
Wen-Hsuan Chen
Publikationsdatum: 20.01.2017
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 4/2017
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-017-0615-3

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