CEO Overconfidence and the Cost of Private Debt: Evidences from Bank Loan Contracting

Abstract

This paper studies whether banks charge higher or lower interest rates on loans to firms with overconfident CEOs. It establishes a theoretical model to show the relationship between the loan rate and overconfidence of the borrowing firm’s CEO. It also conducts empirical analyses to test the predictions of the model. As predicted in the model, with a hedge against the downside risk of the loan payments, banks favor firms with overconfident CEOs such that these firms enjoy lower loan rates and higher loan approval rates, especially when firms have rich firm-specific growth opportunities or during prosperous periods. Furthermore, there is evidence showing that firms with overconfident CEOs bring more future business opportunities to banks than other firms. Hence, this paper implies that banks may prefer high-risk borrowers if the future benefits from doing businesses with these borrowers are sufficiently high.

Keywords: CEO overconfidence, bank loan contract, growth opportunities, downside risk.

JEL Classification: G21, G32, G33, G34