Recent research has highlighted the powerful influence of credit ratings on the behaviour of overconfident chief executives, particularly when making high-stakes corporate decisions like mergers and acquisitions (M&A). The study, led by Bangor University in collaboration with Heriot-Watt University, Vlerick Business School, and the University of Aberdeen, reveals that a company’s creditworthiness can significantly shape how its leaders act, especially when faced with the prospect of significant financial transactions. This comprehensive analysis, based on data from 916 US firms rated by S&P (previously Standard & Poor’s) between 2006 and 2019, underscores the critical role of credit rating agencies as external monitors of executive behaviour.

Unlike traditional governance structures, which often struggle to rein in the risk-taking tendencies of powerful CEOs, credit ratings offer a more direct and financially impactful form of oversight. Lead author Dr Shee-Yee Khoo, a Lecturer in Finance at Bangor University, explained that the potential threat of a downgrade can make even the most self-assured executives pause before committing to aggressive acquisitions. “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,” she said. This reflects that credit ratings influence the cost of borrowing and the strategic calculus behind major corporate decisions.

The study found a clear pattern: overconfident CEOs tend to increase acquisition activity when their companies enjoy rising credit ratings, taking advantage of cheaper debt. However, these same leaders become noticeably more cautious when faced with a downgrade. Specifically, firms led by overconfident CEOs that risked a downgrade from ‘investment grade’ – indicating relatively low default risk – to ‘speculative grade’ – suggesting a higher risk of default – experienced a 15.7 percentage point drop in the likelihood of pursuing acquisitions compared to their more cautious counterparts. This dramatic shift highlights the powerful psychological impact of potentially losing access to low-cost financing.

Co-author Patrycja Klusak, a Professor of Accounting and Finance at Heriot-Watt University, emphasised that this behavioural change underscores the unique role of credit ratings in corporate governance. “The threat of a doubt tempers even the boldest executive impulses,” she noted, pointing out that while overconfidence can drive innovation and bold strategy, it also increases the risk of poorly timed or misjudged acquisitions. For these leaders, the fear of losing their firm’s favourable credit status can be a crucial brake, encouraging more measured decision-making.

Professor Thanos Verousis of Vlerick Business School further noted that credit ratings do more than reflect a company’s financial health—they actively shape executive strategy. “Credit ratings are more than passive indicators for investors,” he explained. They serve as a form of external control that can show how executives think about risk and opportunity, particularly when traditional corporate governance mechanisms fall short. This insight is critical given that many standard governance structures are often insufficient to contain the risks associated with overconfident leadership.

Dr Huong Vu, a Lecturer in Finance at the University of Aberdeen, added that this study provides a more nuanced perspective on how credit ratings influence executive decision-making. “Our research shows that even overconfident CEOs cannot ignore the signals sent by credit rating agencies,” she said, noting that this external pressure can steer them towards more sustainable, value-enhancing investments. This is crucial, as overconfident managers often overestimate their ability to create value, underestimate risks, and favour debt over equity, making them especially sensitive to changes in their firm’s credit status. As M&A remains a vital but risky avenue for corporate growth, understanding these psychological and financial dynamics is more important than ever.

More information: Shee-Yee Khoo et al, Restraining Overconfident CEOs Through Credit Ratings, European Financial Management. DOI: 10.1111/eufm.12557

Journal information: European Financial Management Provided by Heriot-Watt University