Risk Can Be Good: The Tradeoff Between Agency Conflicts, CEO Risk-Taking Incentives, and Credit Risk

Abstract

We explore the trade-off between managerial risk-taking incentives and firm-level credit risk. Assuming that risk-taking incentives do not increase firm value, risk-taking incentives can lead to an asset substitution problem that hurts creditors. However, it is possible that risk-taking incentives will increase firm value, making creditors better off. Empirically, we find that credit rating agencies and credit default swap investors award more favorable credit ratings and credit default swap spreads, respectively, to firms that incentivize managers to engage in greater risk-taking behaviors. Consistent with recent theoretical research, we document a positive relation between managerial risk-taking incentives and firms' market value of assets. In addition, in a difference-in-differences specification, we find that increased risk-taking incentives lead to lower credit risk. Moreover, we document an incremental association between risk-taking incentives and credit risk for firms less likely to exhibit risk-shifting. Our paper is the first to empirically examine the trade-offs predicted by compensation theory from a creditor's perspective. Therefore, we extend prior literature by highlighting that creditors can benefit from risk-taking, suggesting that CEO risk-taking incentives can make both shareholders and bondholders better off. In the process, our results help reconcile conflicting views in the literature. In addition, we provide the first evidence on which firms benefit the most from risk-taking incentives: financially constrained firms. Collectively, our findings refine our understanding of why firms encourage managers to engage in risk-taking behavior.