A new study “Restraining overconfident CEOs through credit ratings” published by European Financial Management Journal by a cross-institutional team of researchers including Pati Klusak, Affiliated Researcher at the Bennett Institute for Public Policy, sheds light on the critical role credit ratings play in restraining the risky behaviours of overconfident CEOs—especially during corporate mergers and acquisitions (M&A).
Overconfidence in leadership is a double-edged sword. On one hand, bold decision-making by CEOs can lead to visionary strategies and drive innovation. On the other, unchecked confidence often results in poor judgement, misjudged acquisitions, and long-term value destruction.
“Human minds are overconfidence machines,” David Brooks once wrote, and as Professor Pati Klusak and colleagues explain in their latest study, even CEOs are not immune. “Despite the level of responsibility and expectations regarding their decision-making process, CEOs are just as likely to succumb to irrational behaviour as anyone else,” Klusak explains.
“Overconfident CEOs may not only take riskier business decisions, but also they may downplay the riskiness of investments and overestimate their potential future value. Such (mis)judgements might result in overinvestment behaviour that could be detrimental to a company’s value and its long-term success, particularly if the company has access to large internal capital and debt capacity.”
The research explores how credit ratings—typically seen as tools for communicating financial health—can serve a more nuanced function: acting as external checks on CEO behaviour. Based on data from 916 US firms rated between 2006 and 2019, the study finds that overconfident CEOs behave very differently depending on their firm’s credit standing.
When firms enjoy high credit ratings, overconfident CEOs become more cautious, reducing M&A activity—more so than their rational peers. Conversely, at lower rating levels, the same CEOs engage in more acquisitions, often overleveraging resources. This behavioural shift underscores the monitoring power of rating agencies: the threat of a downgrade appears to temper even the boldest executive impulses.
“Our research shows that when companies risk a credit downgrade, even overly confident CEOs are more likely to think twice before making risky acquisitions,” says lead author Dr Shee Yee-Khoo.
These findings highlight the Learning Effect identified in the study—where a firm’s proximity to a downgrade leads to self-correction in CEO behaviour. In fact, firms at the boundary between investment grade and speculative grade saw a 15.7 percentage point drop in acquisition likelihood when their outlook was downgraded.
Yet the role of credit ratings remains controversial.
“Credit ratings are often portrayed with a negative connotation, as they can constrain a firm’s financial flexibility and signal risk to investors,” notes Dr Huong Vu, Aberdeen University.
Nevertheless, the study offers a more nuanced perspective: ratings not only affect financial terms but also generate positive externalities, such as curbing overinvestment, promoting better governance, and helping protect long-term shareholder value.
As M&A decisions continue to be a key lever for corporate growth—and potential risk—this research shows that understanding executive psychology, and the subtle tools that can influence it, is more important than ever.
Read the blog: Restraining overconfident CEOs through credit ratings
The views and opinions expressed in this post are those of the author(s) and not necessarily those of the Bennett Institute for Public Policy.
