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

Abstract

ABSTRACTManuscript Type: EmpiricalResearch 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 what influenced 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 framework 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.