CEO power and corporate risk: The impact of market competition and corporate governance

• Date: 01 September 2019
• Published date: 01 September 2019
• DOI: http://doi.org/10.1111/corg.12285
• Author: Shahbaz Sheikh

ORIGINAL ARTICLE

CEO power and corporate risk: The impact of market

competition and corporate governance

Shahbaz Sheikh

DAN Department of Management and

Organizational Studies, The University of

Western Ontario, London, Ontario, Canada

Correspondence

Shahbaz Sheikh, DAN Department of

Management and Organizational Studies, The

University of Western Ontario, London,

Ontario, Canada.

Email: ssheik2@uwo.ca

Abstract

Research Question/Issue: Although there is no unified theory that can explain the

relationship between CEO power and corporate risk, the empirical evidence generally

finds a positive association. This study argues that market competition and corporate

governance play critical roles in influencing this relationship.

Research Findings/Insights: Using a large panel of nonfinancial U.S. corporations

for the period 1992–2015, I find that CEO power is positively associated with total

and idiosyncratic measures of risk. However, this positive association remains signif-

icant only when market competition is high or corporate governance is strong.

Theoretical/Academic Implications: The research design of this study combines

the predictions of agency theory, the behavioral agency model, and prospect theory

to further our understanding of the relationship between CEO power and corporate

risk, including consideration of how competition and corporate governance influence

this relationship.

Practitioner/Policy Implications: The empirical evidence presented in this study

can help boards to more accurately gauge when CEO power is most beneficial in

terms of optimal levels of corporate risk and to better understand the relationship

between power and risk. The results suggest that boards should grant more power

to their CEOs when their firms operate in high‐competition markets or have strong

corporate governance in place.

KEYWORDS

corporate governance, CEO power, idiosyncratic risk, market competition, total risk

1|INTRODUCTION

The position of CEO is regarded as a source of power (Hamori &

Kakarika, 2009), and CEOs are often perceived as chief planners and

architects of a firm's long‐term strategy (Berger, Dutta, Raffel, & Sam-

uels, 2008). CEOs make key investment and financing decisions that

affect corporate risk and value. CEO ability to influence these decisions

and thus the level of corporate risk depends on how much power they

enjoy relative to their boards and other team members. Although no

unified theory can explain exactly how CEO power affects corporate

risk, there are a few competing views on this relationship. Agency

theory (Jensen & Meckling, 1976), for example, argues that CEOs are

risk averse and poorly diversified, tending to take less risk than the

diversified shareholders would like them to (Amihud & Lev, 1981;

Eisenhardt, 1989; Holmstrom, 1999; Smith & Stulz, 1985). Agency the-

ory further holds that CEOs have incentives to divert corporate

resources to their private benefit by forgoing value‐increasing risky pro-

jects. Because the ability to both divert corporate resources and make

conservative investment decisions increases with power, agency theory

predicts that powerful CEOs tend to reduce corporate risk.

Agency theory focuses only on cases of CEOs who are either risk

averse or risk neutral and ignores cases where they are risk seekers

Received: 2 March 2018 Revised: 26 April 2019 Accepted: 29 April 2019

DOI: 10.1111/corg.12285

358 © 2019 John Wiley & Sons Ltd Corp Govern Int Rev. 2019;27:358–377.wileyonlinelibrary.com/journal/corg

(e.g., Carpenter, Pollock, & Leary, 2003; Sanders & Hambrick, 2007;

Wiseman & Gomez‐Mejia, 1998). Prospect theory (Kahneman &

Tversky, 1979), however, argues that individuals exhibit variable risk

preferences and may avoid or seek risk, depending on a reference

point.

1

It suggests that depending on expected prospects, CEOs may

actually increase risk. Similarly, studies in social psychology (e.g.,

Anderson & Galinsky, 2006) stipulate that powerful CEOs are more

optimistic about the intrinsic payoffs of their decisions and tend to

disregard potential dangers inherent in their decisions. Powerful CEOs

are often overconfident about their skills, with a greater potential for

costly judgment errors while making risky investment decisions

(Adams, Almeida, & Ferreira, 2005; Sah & Stiglitz, 1986, 1991). Conse-

quently, the likelihood of extreme outcomes (either very good or very

bad) and the variability of firm performance (risk) are high when CEOs

have more power (Adams et al., 2005; Hirshleifer, Low, & Teoh, 2012).

Prospect and social psychology theories suggest that powerful CEOs

tend to increase corporate risk.

The empirical evidence on the relationship between CEO power

and corporate risk is also mixed, though a number of studies report a

positive association (e.g., Adams et al., 2005; Lewellyn & Muller‐Kahle,

2012). In this study, I argue that market competition and corporate

governance play critical roles in influencing the relationship between

CEO power and corporate risk. Failure to control for these mechanisms

may have led to the conflicting results in prior literature. Understand-

ing the effects of competition and corporate governance is important

because they impose external discipline and improve quality of moni-

toring, especially when CEOs wield substantial power (Fama, 1980;

Giroud & Mueller, 2010, 2011; Shleifer & Vishney, 1989).

Market competition imposes external discipline by increasing the

probability of failure and by making a firm a more attractive takeover

target (Paligorova & Yang, 2014). Higher competition also increases

the risk of bankruptcy and the likelihood of performance‐related

CEO turnover (Dasgupta, Li, & Wang, 2017). Higher competition thus

motivates managers to make risky but value‐increasing investments to

keep the company competitive and save their jobs (Grossman & Hart,

1983; Hart, 1983; Schmidt, 1997). Higher competition simultaneously

decreases opportunities for “quiet life”by inducing effort‐averse man-

agers to make risky investment decisions.

2

Because powerful CEOs

are often overconfident—and people tend to be more confident about

their performance on difficult rather than easy tasks (Griffin &

Tversky, 1992)—they may make more risky decisions when competi-

tion is high and decision making becomes more challenging.

Strong corporate governance (investor protection) improves quality

of monitoring and restricts managerial ability to expropriate corporate

resources. Strong governance induces powerful CEOs not to forgo

value‐increasing risky investment projects in order to divert corporate

resources to their personal benefit (John, Litov, & Yeung, 2008). Strong

corporate governance also motivates CEOs to give up quiet life and

make difficult and risky investment decisions. Both high market com-

petition and strong corporate governance therefore motivate CEOs

to exercise their power and increase corporate risk.

In order to test how market competition and corporate governance

affect the relationship between CEO power and corporate risk, I

collect data on a large panel of U.S. firms for the period 1992–2015.

Drawing on Finkelstein (1992), I construct a multidimensional index

of CEO power that incorporates six different sources of power. I use

the Herfindahl–Hirschman index (HHI) to measure market competition

and the governance index (G‐index) of Gompers, Ishii, and Metrick

(2003) to measure corporate governance.

3

Results indicate that CEO power is positively associated with two

measures of corporate risk: total risk and idiosyncratic risk. Further

tests show that this relationship is influenced by market competition

and corporate governance. Specifically, CEO power is positively asso-

ciated with corporate risk only when firms operate in high‐competition

markets or have strong corporate governance in place. When market

competition is low or corporate governance is weak, CEO power does

not have a significant impact on corporate risk.

The empirical results in this study are robust to alternative mea-

sures of market competition, corporate governance, and firm risk.

These results remain similar when CEO power is treated as endoge-

nous and the relationship is estimated using instrumental variable

regressions. Finally, results do not change when a 2‐year lag is used

between corporate risk, CEO power, and other control variables; when

CEO power is measured with a categorical variable instead of the

power index; or when the sample is divided into subsamples based

on high market competition and strong corporate governance.

This study contributes to the literature on CEO power and corpo-

rate risk in two distinct ways. First, it shows that powerful CEOs tend

to increase corporate risk only when market competition is high or

corporate governance is strong. Previous studies have separately

examined the relationship between CEO power and corporate risk

(e.g., Chintrakarn, Jiraporn, & Tong, 2015; Pathan, 2009), market com-

petition and corporate risk (Laksmana & Yang, 2015), and corporate

governance and corporate risk (e.g., John et al., 2008). There is no

study to my knowledge that explores the effect of market competition

and corporate governance on the relationship between CEO power

and corporate risk.

Second, it provides further support for the existing stream of

research that demonstrates a positive relationship between CEO

power and corporate risk. It finds a robust positive effect of CEO

power on corporate risk using a measure of CEO power that is differ-

ent from previous studies using a larger panel of firms. In this respect,

it complements the empirical findings of Adams et al. (2005) and

Lewellyn and Muller‐Kahle (2012).

2|THEORETICAL FRAMEWORK AND

RELATED LITERATURE

This study attempts to explain the effects of market competition and

corporate governance on the relationship between CEO power and

corporate risk and not corporate risk taking. Although corporate risk

taking influences corporate risk, they are considered to be distinct

(Palmer & Wiseman, 1999) in the strategic management literature.

Corporate risk is measured by total risk and idiosyncratic risk, which

are calculated from daily stock returns. Corporate risk taking is

SHEIKH 359