CEO Power and Risk Taking: Evidence from the Subprime Lending Industry

• DOI: http://doi.org/10.1111/j.1467-8683.2011.00903.x
• Author: Krista B. Lewellyn,Maureen I. Muller‐Kahle
• Date: 01 May 2012
• Published date: 01 May 2012

CEO Power and Risk Taking: Evidence from the

Subprime Lending Industry

Krista B. Lewellyn* and Maureen I. Muller-Kahle

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: There is a general consensus that the lack of restraint by US f‌inancial f‌irm executives to engage

in risky subprime mortgage lending practices played a contributing role in both the inf‌lation and def‌lation of the housing

bubble at the heart of the global f‌inancial crisis. Evidence is less clear on whatinf‌luenced the managerial proclivity to ignore

warning signs and take on more and more risk to the detriment of numerous f‌irm stakeholders. Our study examines the

effects of power on Managerial Risk Taking in the context of the subprime mortgage industry.

Research Findings/Insights: We hypothesize that a CEO’s power is positively related to excessive risk taking. We f‌ind

general support for these hypotheses in a matched pair sample of 74 f‌irms and 344 f‌irm years, where half the f‌irms

specialized in subprime lending and the other did not from 1997 to 2005.

Theoretical/Academic Implications: We take a novel theoretical approach to our research by drawing from the social

psychology literature to employ the approach/inhibition theory of power. The use of this theoretical perspective affords the

opportunity to contribute a nuanced understanding of how managerial power within an agency-based governance frame-

work propels managers from taking reasonable risks to engaging in excessive risk taking.

Practitioner/Policy Implications: By presenting evidence of the role that CEO power had in promoting excessive risky

lending practices, corporate directors and policy makers will be empowered and more capable of designing and enacting

governance and regulatory frameworks that result in not only prof‌itable but prudent risk taking.

Keywords: Corporate Governance, Managerial Risk Taking, CEO Power, Subprime Lending, Approach/Inhibition

Theory

INTRODUCTION

The collapse of the subprime mortgage market and the

subsequent f‌inancial shock that rippled across global

markets can be attributed to a combinationof factors, but has

its roots in risky US mortgage lending practices (Wolf, 2010).

The number of subprime mortgage originations grew from

US$65 billion in 1997 to a record level of US$665 billion in

2005 (Schloemer, Li, Ernst, & Keest, 2006). There was never

any doubt about the riskiness of subprime loans, as George

Eshaghian, executive vice president and general counsel of

WMC Mortgage, a major seller of subprime loans, stated

“Everyone in the mortgage industry, whether employed by

the lending companies themselves or by major Wall Street

companies whose investments in mortgages infused the

industry with cash – knew there was risk” (Perry, 2007: para.

12). So why did so many f‌inancial f‌irms not only participate

in such lending practices but choose to specialize in servic-

ing this high risk market? The idea of “reach for yield”, i.e.,

the amplif‌ied willingness by f‌inancial f‌irm executives to take

excessive risks, and specif‌ically what caused it as well as

what might prevent it in the future, are key areas of schol-

arly and public policy debate that have emitted from the

global f‌inancial crisis (Wolf, 2010: 203). The motivation for

our work is to contribute to the debate by seeking to provide

insights into what inf‌luenced the managerial proclivity to

ignore warning signs and take on more and more risk to the

detriment of numerous f‌irm stakeholders.

Despite extensive research, associations between corpo-

rate governance mechanisms and Managerial Risk Taking

remain imprecise and agency theory based predictions have

proven to be weak and inconsistent (Finkelstein, Hambrick,

& Cannella, 2009). Scholars (e.g., Carpenter, Pollock, &

Leary,2003; Sanders & Hambrick, 2007; Wiseman & Gomez-

Mejia, 1996), have suggested that a possible reason for the

lack of distinct relationships may be the agency theory

*Address for correspondence: Krista B. Lewellyn, Department of Management, Old

Dominion University,2029 Constant Hall, Norfolk, VA 23529, USA. E-mail: klewelly@

odu.edu

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© 2012 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00903.x

assumption that managers will have stable risk preferences,

being either risk averse or risk neutral, failing to consider

that there maybe contexts in which they may be risk seekers.

Building on this idea that managers may actually prefer to

take risks and on the notion in the extant agency theory

based governance literature that the distribution of power

between boards of directors and chief executive off‌icers

(CEOs) determines whose interests are likely to be pursued

(Finkelstein et al., 2009; Lane, Cannella, & Lubatkin, 1998),

we develop a conceptual model that seeks to add to the

research stream (e.g., Chatterjee & Hambrick, 2007; Li &

Tang, 2010) that highlights the importance of top managers’

psychological processes and how they inf‌luence f‌irm-level

decisions. By doing so, we seek to answer calls to build

individual level origins, or micro-foundations for f‌irm-level

phenomena (Abell, Felin, & Foss, 2008; Eisenhardt, Furr, &

Bingham, 2010; Felin & Foss, 2005).

Specif‌ically, we seek to generate theory and empirical evi-

dence by taking advantage of the rich and varied extant

knowledge of the role that corporate governance plays in

the development and management of CEO Power, of an

upsurge of recent social psychology research f‌indings on

how power affects psychological processes, and the oppor-

tunity the subprime crisis offers as a natural experimental

setting. Applying insights from social psychology and

agency theory, we hypothesize that CEO Power is positively

related to excessive and unmanaged risk taking. We f‌ind

general support for the hypothesized relationships in a

matched pair sample of 74 f‌irms and 344 f‌irm years, where

half the f‌irms specialized in subprime lending and the

others did not.

Allison (1971: 2) suggests, “what we see and judge to be

important depends not only on the evidence but also on the

conceptual lens through which we look atthe evidence.” We

take a novel theoretical approach to our research by drawing

from the social psychology approach/inhibition theory of

power (Keltner, Gruenfeld, & Anderson, 2003) to explain

why the experience of power may drive a CEO to take risks

others would avoid. We use agency theory logic to examine

the accrual of power and how such power provides the

means by which he or she is able to pursue a penchant for

risk taking, or in other words, why these actions were not

subject to greater evaluation or monitoring by boards of

directors (Finkelstein et al., 2009). The integration of agency

theory and approach/inhibition theory of power, which to

our knowledge has not been done in previous research,

offers the opportunity to extend agency theory and contrib-

ute a unique and nuanced understanding of how power

arising from various governance mechanisms propelled

managers from taking reasonable risks to taking excessive

ones that not only destroyed shareholder value but had det-

rimental effects for a wide range of stakeholders, e.g., home-

owners, community members, and depositors.

THEORETICAL BACKGROUND

The focus in this study is on Managerial Risk Taking as

opposed to organizational risk, which is most often repre-

sented in the literature by income stream uncertainty mea-

sures (Miller & Chen, 2004). Palmer and Wiseman (1999)

suggest Managerial Risk Taking inf‌luences organizational

risk taking but that the two should be considered as distinct

entities. Managerial Risk Taking is described as making

decisions that have highly uncertain and unpredictable out-

comes as well as the potential of generating large losses

(Palmer & Wiseman, 1999). Strategic management scholars

have represented Managerial Risk Taking with a variety of

proxies such as acquisitions (Pablo, Sitkin, & Jemison, 1996),

diversif‌ication changes (Hoskisson, Hitt, & Hill, 1991),

research and development (R&D) expenditures (Palmer &

Wiseman, 1999), f‌irm internationalization (Carpenter et al.,

2003), innovation initiatives (Greve, 2003), and risk related

lending decisions in commercial banking f‌irms (McNamara

& Bromley, 1997). The current study examines risk taking by

f‌inancial f‌irm executives, specif‌ically the decision to pursue

a strategy of specializing in subprime lending. There is

general agreement that subprime loans pose a high risk of

default (Demyanyk & Van Hemert, 2011; Shiller, 2008), thus

focusing a majority of a f‌irm’s business on these types of

products poses a genuine potential for incurring substantial

losses.

In our study of Managerial Risk Taking, the focus is on

CEO risk taking. There is ample precedent in the literature

supporting the notion that the CEO is the most inf‌luential

actor within the f‌irm and likely to be the driver of strategic

choices as well as organizational outcomes (Bigley &

Wiersema, 2002; Child, 1972; Daily & Johnson, 1997). Also,

the CEO, by virtue of the authority of his/her position, has

distinct advantages for inf‌luencing f‌irm decisions and stra-

tegic direction compared to other executives on the top man-

agement team (Bigley & Wiersema, 2002). Therefore, we

focus specif‌ically on factorsassociated with CEO risk taking.

Agency Theory and CEO Risk Taking

Agency theory, underpinned by the potential divergence of

interests when ownership and control of the f‌irm are sepa-

rate, stipulates that, in order to shield their non-diversif‌iable

human capital, managers will be more risk averse than

shareholders would prefer them to be (Amihud & Lev,1981;

Eisenhardt, 1989; Jensen & Meckling, 1976) and that “the

challenge of corporate governance is to set up...mecha-

nisms that alter the risk orientation of agents to align them

with the interests of the principals” (Wiseman & Gomez-

Mejia, 1996: 133). Accordingly, a f‌irm’s board of directors is

expected to enact governance mechanisms that encourage

risk taking (Beatty & Zajac, 1994; Carpenter et al., 2003) as

well as monitor management to mitigate managerial oppor-

tunism which can result from the combination of informa-

tion asymmetry and differences in risk preferences (Boyd,

Haynes, & Zona, 2010). In an agency theory framework,

CEOs with power are predicted to pursue actions and make

decisions, which are in their own personal best interest, and

as such, because of the assumption of risk aversion, will be

not be expected to make choices that are deemed risky.

However, as several scholars have argued, the agency theo-

retic assumption that managers will be either risk averse or

risk neutral, fails to consider that they may actually be risk

seekers (Carpenter et al., 2003; Sanders & Hambrick, 2007;

Wiseman & Gomez-Mejia, 1996), which is a viewpoint con-

sidered within strategic management researchon risk taking

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