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Zhiming Ma is an associate professor from Guanghua School of Management, Peking University. In this study, Ma and his co-authors examine whether credit rating agencies consider a CEO’s attributes when evaluating an entity’s overall creditworthiness and its ability to satisfy financial obligations. They conduct several tests and their findings suggest that CEOs’ general skills are a significant factor in the credit rating evaluation process and have incremental power to predict firms’ credit risk over firm fundamentals and other CEO attributes. This paper was published in Contemporary Accounting Research.

BACKGROUND

A firm’s credit ratings represent rating agencies’ assessments of its overall creditworthiness and ability to meet its financial obligations. However, the role of a firm’s management concerning credit ratings has been largely unexplored, and only a few recent papers have examined the effect of CEO attributes on firms’ credit ratings.

According to previous studies, CEOs can be divided into two types: generalist ones whose skills are transferable across firms or industries, and specialist ones whose skills are firm-or industry-specific. Empirical results show that generalist CEOs are likely to outperform specialist CEOs in addressing complex modern business issues and adapting to an evolving economic environment. However, the presence of outside options may encourage generalist CEOs to take excessive risks, which may lead to more severe agency problems. It is unclear whether a generalist CEO is desirable from bondholders’ perspective. An empirical investigation is therefore warranted to directly examine whether rating agencies perceive generalist CEOs positively or negatively.

Moreover, the considerable increase in the corporate bond market calls for a better understanding of the factors that debt market participants consider in assessing default risk. However, until now, market participants have not fully understood which factors credit rating agencies use to determine and issue credit ratings. Existing literature also suggests that the attributes of a CEO influence a firm’s capital structure and default risks and thus should be considered by rating agencies in their assessments.

In this study, Zhiming Ma and his co-authors extend the research by examining whether credit rating agencies also consider CEOs’ general skills in their rating assessments.

RESEARCH DESIGN

The research is designed to explore the relationship between a firm’s credit ratings and a CEO’s general skills. First, Ma and his co-authors made hypothesize 1 that generalist CEOs are negatively associated with credit ratings. The samples in this paper come from 12,675 firm-year observations for 1,272 unique US firms from 1992 to 2015.

Second, they use measures to proxy both CEO’s general skills and credit rating. They use a model to explore the relationship between the two. In the model, variables that are found to affect a firm’s credit ratings were controlled.

Third, they conduct multiple robustness tests with different alternative empirical specifications and identification strategies to mitigate potential endogeneity concerns. In addition, they conduct cross-sectional tests to examine whether the negative relationship between credit ratings and CEOs’ general skills is heterogeneous across different types of firms.

RESEARCH FINDINGS AND ANALYSIS

First, for the test of Hypothesis 1, results indicate that credit agencies are likely to view CEOs’ general skills as a negative factor. They also find more financially transparent firms, larger firms, more financially stable firms, more profitable firms, and more capital-intensive firms are more likely to have higher credit ratings anfirms with less growth potential, more volatile performance and/or stock returns, and higher leverage tend to have higher default risksThese results are generally consistent with the related literature.

Second, the results of the investigation of ex-post risk-taking behavior and future performance are consistent with the expectation that CEOs’ general skills are associated with higher future leverage, intangible investments, probability of loss, and earnings volatility. Besides, those firms exhibit more volatile future performance measured by the standard deviation of return on assets (ROA) in the next three years. These findings further support the agency problem argument that generalist CEOs’ risk-taking incentives might increase firms’ chances of default.

Third, path analyses also confirm a highly significant mediated link (by default risks) between credit ratings and CEOs’ general skills, suggesting that the risk of default is a mediator variable influenced by CEOs’ general skills that, in turn, influences firms’ credit ratings.

What’s more, the results of robustness tests demonstrate that the effect of a CEO’s general skills on the firm’s credit rating is unlikely to be captured by other CEO attributes or corporate governance. In addition, safer (riskier) firms tend to avoid (favor) generalist CEOs, who are usually less risk-averse. Forced CEO turnover subsample analyses show that ratings worsen when firms hire new CEOs with relatively higher general skills than those of the forced-out CEOs.

Last, cross-sectional analyses of firm characteristics suggest that firms’ innovation intensity mitigates the negative relationship between credit ratings and CEOs’ general skills. Broader debt market effects analyses prove that firms with generalist CEOs face higher borrowing costs, which is consistent with the main finding that CEOs’ general skills are a significantly negative factor in risk assessments for debtholders.

APPLICATION

This paper examines whether credit rating agencies consider a CEO’s attributes when evaluating an entity’s overall creditworthiness and its ability to satisfy financial obligations. This study contributes to the literature in two ways. First, it enriches the literature on credit rating assessment —specifically, the relationship between a CEO’s attributes and the firm’s credit rating. Second, this paper extends the literature on the value of hiring generalist and specialist CEOs by providing evidence that both credit agencies and debtholders are likely to view the presence of a generalist CEO as a negative factor. Their findings contribute to the literature by providing evidence that firms with generalist CEOs tend to take more risks ex post and exhibit more volatile future performance, which may hurt debtholders’ interests. These results are also consistent with the argument in prior literature that the existence of generalist CEOs’ outside options naturally provides them with more risk-taking incentives. Therefore, they provide a full picture of why hiring a generalist CEO may be desirable from shareholders’ perspectives but still lead to less favorable credit ratings and higher debt costs.

About the author:

Zhiming Ma received his Ph.D. from the Hong Kong University of Science and Technology in 2014. The same year, he joined the Guanghua School of Management and served as an assistant professor and associate professor. His research interests include information disclosure, debt, auditing, corporate governance, and government accounting. He has published in leading international journals, such as the Journal of Accounting and Economicsthe Journal of Financial EconomicsAccounting, Organizations and SocietyContemporary Accounting Research, Academy of Management JournalJournal of Financial and Quantitative Analysis and Review of Accounting Studies.