Published on 4 July 2022
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Economics  •  Regulation

Credit ratings and capital structure: New evidence from overconfident CFOs

For the first time, a new study by Shee-Yee Khoo, Huong Vu, Panagiotis Andrikopoulos and Patrycja Klusak, links two research areas – CFO overconfidence and credit rating - contributing useful insights to board of directors of firms where CFOs are subject to overconfidence bias.

Having a good corporate credit rating assigned by an external credit rating agency (e.g. Standard & Poor’s, Moody’s, Fitch) is often what a company strives for. Similar to a personal credit score, a corporate credit rating determines how likely a company is to pay its debts in full and on time.  Because of information asymmetry in the capital markets – credit ratings are crucial privately produced information upon which lenders rely to assess a company’s creditworthiness and hence how much interest to charge. Put simply, the higher the credit rating, the easier it is for issuers to tap the capital market for funding and the cheaper their cost of borrowing.

Changes in credit ratings might have a significant impact on corporate managers’ debt decisions because of their effects on the cost of borrowing. Rating upgrades signal a stronger capability of generating positive cash flows, hence making it easier for firms to borrow at a relatively low cost. On the other hand, rating downgrades increase the cost of borrowing. In certain extreme cases, downgrades can activate rating triggers in financial contracts and impose further constraints on borrowers. Therefore, there is an incentive for managers to increase debt in response to upgrades due to the relaxation brought about by the improved creditworthiness. However, this might not be the case for overconfident managers (i.e. CFOs, CEOs) as they display debt conservatism due to excessive preference for internal capital to external capital (Malmendier, Tate and Yan 2011).

The trait of overconfidence is commonly found among corporate executives, particularly in individualistic countries such as the United States. Confidence is arguably one of the virtues that outstanding leaders possess. But too much of it can be devastating, particularly when it comes to judgment and decision-making. Overconfident managers generally believe their firms are less risky and/or more profitable than they actually are under their leadership, which subsequently has substantial impact on their capital structure decisions. Overconfident managers prefer to fund investment opportunities first with retained earnings, then by debt financing and only tap equity as a last resort. The excessive preference for internal capital to external capital could lead to debt conservatism towards risky debts. As a result, firms with overconfident managers, that underutilise debt, could not fully enjoy the tax benefits of debt (Malmendier, Tate and Yan 2011).

Although there has been strongly documented empirical evidence for the impact of CEO overconfidence on firms’ financing decisions, the studies on the impact of CFO traits on firms’ financial policies remain scarce. Given that CFOs are primarily responsible for financial policies, and credit ratings are a very important consideration when making capital structure decisions (Graham and Harvey, 2001), an interesting question to ask here is whether credit ratings matter to overconfident CFOs when shaping financial policies.

Given the particularly strong preference for internal financing over external financing, we argue that overconfident CFOs would not issue more debt after rating upgrades, unless they have the access to low-cost debt. Relaxing the assumption that executives are rational (in the sense in which economists use the term), we find that firms with overconfident CFOs reduce debt by 1.33% following a rating upgrade from the previous year. Consistent with our expectations, the reduction of net debt following rating upgrades is only prevalent when firms do not have access to low-cost debt (i.e. firms with speculative-grade credit ratings). In case of rating downgrades, overconfident CFOs reduce net debt by 3.7% more than their rational counterparts. Upon closer scrutiny, we also find that overconfident CEOs carry influence on firms’ financing policies as they multiply the effect of debt conservatism arising from overconfidence bias.

The executives’ bias literature has been growing alongside the credit rating literature, yet little is known about how they relate to each other. We link the two areas of research for the first time, contributing insights that could be particularly useful to board of directors of firms where CFOs are subject to overconfidence bias. Our study reaffirms that overconfidence bias is the root of pecking order distortions, and debt conservatism may be a result of excessive preference for internal capital to external capital. As a consequence, overconfident CFOs are more likely to pursue excessively conservative debt policies when ratings change, especially when firms have no access to low-cost debt (they are in the speculative grade ratings). In such cases, the board could encourage overconfident CFOs to utilise debt in order to take full advantage of tax benefit (of debt), particularly after a rating upgrade.

Reading working paper: Credit ratings and capital structure: New evidence from overconfident CFOs


Graham, J. R., and C. R. Harvey. 2001. “The theory and practice of corporate finance: evidence from the field.” Journal of Financial Economics 60: 187-243.

Malmendier, U., G. Tate, and J. Yan. 2011. “Overconfidence and early-life experiences: The effect of managerial traits on corporate financial policies.” Journal of Finance 66: 1687-1733.

Read: “The Credit Rating-Capital Structure Hypothesis – Does CEO Overconfidence Matter?” by Shee-Yee Khooa, (University of Aberdeen), Huong Vua  (University of Aberdeen), Panagiotis Andrikopoulos (Centre for Financial and Corporate Integrity) and Patrycja Klusak (Norwich Business School, UEA; Bennett Institute for Public Policy).


Patrycja Klusak

Dr Patrycja Klusak

Affiliated Researcher

Dr Patrycja Klusak is an Associate Professor at Norwich Business School at University of East Anglia and an Affiliated Researcher at Bennett Institute for Public Policy at the University of...

Shee Yee Khoo

Shee Yee Khoo is a Lecturer in Finance at Bangor University. Her research areas of interest are corporate finance, behavioural finance and credit ratings.

Dr Huong Vu

Dr Huong Vu is a Lecturer in Finance at University of Aberdeen. She joined the University of Aberdeen in September 2018. Prior to that, Dr Huong Vu had three years...

Dr Panagiotis Andrikopoulos

Panagiotis Andrikopoulos is the Executive Director of the Centre for Financial and Corporate Integrity (CFCI) at Coventry Business School and a Professor of Finance. Prior to joining the CFCI, he...

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