RISK TAKING BEHAVIOR:
MANAGERS & DIRECTORS
BY
KEN PAUL DE GUZMAN
University of Groningen
Faculty of Economics and Business
MSC – International Business & Management
RISK TAKING BEHAVIOR: MANAGERS & DIRECTORS
TABLE OF CONTENTS Page
ABSTRACT 2
INTRODUCTION 3
THEORY AND PROPOSITIONS 5 Introduction to Risk 5 Towards a Model of Risk Taking Behavior 7 MANAGERIAL DISCRETION & RISK TAKING 17
Managerial Discretion - Organizational Level 19 THE BOARD & RISK TAKING 23 Independence 23
Expertise 26
Board Tenure 28
CEO Duality 31
DISCUSSION 32
Implications for Practice 35 Implications for Research 36
Conclusions 37
REFERENCES 38
APPENDIX 53
ABSTRACT
The late 2000s financial crisis attracted more attention to managerial risk taking. Risk is widely recognized to be an essential element of strategic management hence the interest of researchers in finding its determinants. From an agency theory perspective, corporate governance failed to provide a safe guard to excessive risk taking which resulted in the financial crisis. But risk taking warrants attention from other fields such as psychology or econometrics. In this thesis, the concept of risk will be unpacked and a model for risk behavior is proposed. Furthermore other factors, which are related to the risk taking by firms, will be elaborated. The thesis can serve as a foundation for more a holistic research in risk taking behavior.
Keywords: risk taking behavior, managerial discretion, upper-echelon theories, corporate governance, supervisory board
Research theme: Risk Taking Behavior
INTRODUCTION
This thesis finds its motivation in the criticism of the corporate governance practices of the boards of financial institutions during and after the financial crisis. While the scrutiny of the boards ex-ante the crisis is limited, the aftermath shows a common perspective pointing at excessive risk-taking as the main problem. Moreover excessive risk-taking as a result of management action coherently ratified by the board, with the shareholders or governments bearing the costs of bailouts or decreased share value in the end. Plath (2008) points out lax board oversight of risk management, executive compensation promoting excessive risk taking, or simply corporate governance deficiencies as the main reason for the banks failure. The papers of Erkens, Hung and Matos (2009) as well as Wymeersch (2008) are in line with these conclusions, identifying corporate governance as the root of the problem.
The previously mentioned authors approached corporate governance from an agency perspective. The definition of corporate governance for that context is well defined by Shleifer and Vishny (1997) who argues that corporate governance deals with the way in which the capital suppliers (principals) expect returns of the money invested from the agents, who are the management in this case. This notion of separation between
(2009) confirms, corporate governance mechanism failed to prevent excessive risk-taking. For the previous researches mentioned before the overlapping theme is to examine
whether the agency problems are correctly addressed by looking at key elements present in the board of directors, compensation and ownership structure. When certain elements are present it is assumed that these will lead to a certain outcome. For example an independent board of director should lead to less risk taking as monitoring will be more effective and an independent board will be more difficult to be captivated by management (Larker, Richardson and Tuna, 2005). As the mentioned researches investigated this area, a gap still exists for the executive side as the focus is on the supervisory board or CEO only. Moreover a larger gap exists when exploring factors below the surface-level demographics and the relation to risk-taking. Coherently researches concerning risk
taking mostly examine a particular area at a time, providing opportunity for improvement. Consequently exploring how risk-taking behavior comes to existence is one
contribution of this thesis. Firstly, by utilizing previous theories about risk decisions, a model of risk taking behavior will be proposed. This will provide insight why individuals act as they do. Secondly, areas, which affect risk taking such as theories about managerial discretion and director’s characteristics, will be explored. As these outside factors also shapes an individual behavior. The main goal is to provide propositions concerning the main question of:
What are the elements involved in risk taking and which board characteristics can be attributed to excessive risk taking?
thesis will only investigate the dynamics at the highest level (board) and will therefore not address the extended agency problem (Thomas, 2008). Finally, the aim is to provide the reader with an overview of elements, which matters concerning the risk taking in organizations. The paper will prove to be useful to shareholders when electing their representatives and provides a different perspective to understanding risk taking in firms.
THEORY AND PROPOSITIONS Introduction to Risk
In order to understand why certain management or board characteristic affects risk one must first understand the concept of risk. Financial research papers’ concerning risk taking in banks often does not specifically define risk but use the operationalization of risk as its definition (Laeven & Levine, 2009; Jiménez, Lopez, & Saurina, 2007; Mehran & Rosenberg, 2007; Erkens et al, 2009). Therefore in these papers, indicators for the degree of bank stability define the level of risk in the banks. Lowering of capital levels, increasing of financial leverage, or taking on more credit risk in the product portfolio are examples of riskier bank policies. Another measure for risk taking exploited before (Laeven & Levine, 2009; Erkens et al, 2009) is for example the equity to assets ratio (higher equity to assets ratio indicating lower default risk) as it captures leverage, which is one of the prime often used measure of risk taking in financial and economics papers.
course disagree with this usage of the word risk, as risk in his point of view refers to actions (or ventures) with consequences, which are virtually unknown. That is, when speaking of ventures, could either succeed or fail dependent on effort, and skills but less on chance. Like there is different risk by looking at semantics, one can argue for the existence of different type of risk. For example the previously mentioned risk as a probability is the so-called absolute risk, i.e. risk without any context. Clearly to examine how management characteristics are related to the risk taking in bank there is a need to identify risk first. What is risk taking? How does it come to existence? The following section addresses the concept of risk in context and risk taking by elaborating it from other field of studies besides the previously discussed risk taking in finance. The common notion across the different disciplines is that risk is a function of choices, decisions, and consequences made under uncertainty.
consumer choice theory, as choices are inseparable from risk, (Fischhoff, Watson, & Hope, 1990). When speaking about risk in the field of consumer behavior, most often it refers to ‘perceived risk’, i.e. risk which individuals assess in a certain context, (Haddock, 1993). This means risk is also about the individuals perception of uncertainty and outcomes (Dowling & Staelin, 1994). Moutinho (2000) states, risk (in the context of tourist behavior) includes the following: uncertainty inherent in the product, uncertainty in place and mode of purchase, degree of financial and psychosocial consequences and the subjective uncertainty experienced by the tourist. It is composed of factors, which are internal and will affect the decision maker like the degree of consequences and how risk is assessed as well as external factors, which creates uncertainty.
Towards a Model of Risk Taking Behavior
propensity, defined as an individual’s trait of “willingness to take risk” (MacCrimmon &Wehrung, 1990) is argued to affect risk perception, while risk perception on its turn is influenced by previous decisions made and their outcomes, the so called outcome history (March & Shapira, 1987; Osborn & Jackson, 1988; Thaler and Johnson, 1990). The variables outcome history, problem framing, risk perception and propensity show that risk-taking behavior is not solely due to the nature and/or traits of an individual. Several studies identified different circumstances, which might influence the degree of risk taking.
intensifies the effect of new losses. In terms of risk taking its means that people with recent gains will act more risky while recent loss results into more risk averse decisions. Linville and Fisher (1991), further examined the “house money effect” concluding that people are more affected by losses following losses, but gradually recover from the risk averse state over time. In a recent study, Seo, Goldfarb & Barrett (2010) examined the effects of emotion on the risk attitude changing effects of recent gains and losses. They discovered that affective states of individuals mediated the house money effect. Experiencing pleasant feelings with recent gains reduced the risk averseness while both pleasant and unpleasant feelings reduced the risk seeking effect of recent losses as affective states changes subjective utilities of each outcome. Delgado-Garcia, Fuente-Sabate & Quevedo-Puente (2010) investigated the effect of bank CEO’s emotional traits on risk taking. Albeit not in the context of recent gains or losses, they also observed that emotion do play a role in the level of risk taking. Specifically, positive affective traits did not influence risk attitude while negative affective traits correlates to more risk averseness.
By combining prospect theory, behavioral theory and theories of social cognition a modified model of Sitkin & Pablo (1992), where the mediating role of risk propensity and risk perception are posited, is proposed:
--- Insert Figure 1 about here ---
behavior proves to have more powerful explanatory value than examining the antecedent variables individually. However, Sitkin & Weingart (1995) results shows that risk propensity’s effect on behavior actually was mediated by risk perception (predicted by the original reconceptualization, arrow ‘a’ in figure 1) but have no significant direct effect on the risk behavior. Furthermore, problem framing was found to not only have an indirect effect on the risk taking behavior but a direct one (arrow ‘b’, figure 1) as well. This is in line with an extensive amount of literature about the interaction effect of problem framing. The general idea is that decision makers are more sensitive/ responsive to information cues after a failure (Bateman, 1986; Bateman & Zeithalm, 1989; Staw & Ross, 1978) or are more affected by negative signals (Beach and Strom, 1990; Fiske, 1980; Lewicka, 1997; Peeters & Czapinski, 1990; Wong and Weiner, 1981). Therefore, the manner of how problems are presented or perceived (mediating effect of risk perception) is affecting the actual decision. In line with prospect theory decision makers opt to exhibit risk-averse preferences when a selection need to be made among positively framed prospects, while risk-seeking behavior is exhibited when identical situations are framed negatively (Kahneman & Tversky, 1979; McCue, 2000; Wiseman and Gomez-Mejia, 1998).
This will lead to the first four propositions (relating to arrow a, b, and c):
Proposition 1: The higher the level of risk propensity the riskier the individual’s decision will be.
Proposition 3: Risky decisions are negatively associated with the individuals perceived level of risk.
Proposition 4: Positively framed outcomes led to the making of risk- averse decisions, whereas negatively framed outcome lead to risk seeking.
The other antecedents, which are argued to influence behavior through risk perception, are the following (arrow e, figure 1):
Homogeneity of top management: The compositions of top management teams are
argued to limit the risk perception of individual decision makers. The roots of this notion find it base in theories concerning group decisions, where it is argued that group dynamics affects decision quality. For example (Janis, 1972), argues dysfunctional individual decision-making when groups are too homogenous or when norms foster groupthink. In the same paper Janis (1972) hypothesize homogenous groups’ tendency to perceive judgments, which are consensual, as correct. Sitkin & Pablo (1992) further argues that (Stoner, 1968) ‘risky or cautious shift’ groups implies that individual members of a more homogenous team will perceive risk as more extreme. Lastly as suggested by Hambrick and Mason (1984) team heterogeneity will be positively associated with profitability in turbulent, discontinuous or risky environments. Therefore, team composition is argued to affect risk through risk perception:
Social influence: Organizations are argued to dominate other influences of individual
perceptions and behaviors (Davis-Blake & Pfeffer, 1989; Snyder & Ickes, 1985) by channeling individual attention and activity. Individuals are socialized into the organizations culture, viewing the world from their organizations lens. More importantly the cultural risk values will be seen as a guideline when confronting uncertainty (Douglas & Wildavsky, 1982; Hofstede, 1980; Louis, 1980). Also role models are seen as a guideline of what is expected, what is acceptable or what will be rewarded (Gaertner, 1988; Grey & Gordon, 1978; Schein, 1985; Wildavsky, 1988). Leading to the following proposition:
Proposition 6: Organizations cultural risk values are in line with individuals risk perception
Problem domain familiarity: Cumulative experience from past decisions regardless of
Proposition 7: Low and high problem domain familiarity creates a less accurate perception of risk than moderate level of problem domain familiarity.
Organizational Control Systems: This is how the organizational system rewards
behavior. For example Ouichi (1977) identifies two types of control systems. Process oriented in which the individual follow organizational guidelines and get rewarded independently of the outcome. The individual might bear no risk while the organization will be responsible. On the other hand, outcome oriented systems focus on the actual result, rewarding individuals bearing greater risk, and therefore potentially receiving bigger rewards or punishment. Perception of risk will then be different for individuals in different control systems. Sanders & Hambrick (2007) examined the effect of CEO stock options on risk behavior. The empirical results show that CEO stock options bring about corporate performance, which are more extreme (bigger gains and bigger losses). Where bigger losses are more common. Albeit their data did not give insight in this deterioration of performance they argued for a shift in the CEO’s risk perception, with option-loaded CEOs being more focused on prospective gains, neglecting early signs of failure. These may suggest the following propositions:
Proposition 8a: Individuals within outcome-oriented organizations will perceive higher level of risk.
For Risk Propensity, the general tendency of the decision maker to take risk, the antecedents suggested by past researches are the following (arrow d, figure 1):
employed professionally and those in non-professional occupations (Grey & Gordon, 1978; Haliassos & Bertaut, 1995) where the notion is that professionally employed possess more risk tolerance. This is perhaps related to prior literature about one’s formal education and risk taking. The general consensus for this relationship is a positive one, increased formal education also increase a person’s risk tolerance (Grable & Lytton, 1998; Shaw, 1996). Therefore the general risk orientation of an individual is positively related to the tendency of taking risk:
Proposition 9: Risk preference is positively associated with risk propensity.
Inertia: Overtime individuals develop a stable pattern of risk handling (Baron, Leider
& Stack, 2008; Kogan & Wallach, 1964; Rowe, 1977; Slovic, 1972). Risk averseness will therefore lead to more risk averseness while risk seekers continues to be risk seeking in their next decisions. Therefore the following proposition is suggested:
Proposition 10: Overtime inertia is exhibited in an individual’s risk propensity.
Outcome history: New decisions involving risk are influenced by the outcome of
previously made decisions. Decisions, which resulted in a positive outcome, would make similar decision more likely to be made in the future. (March & Shapira, 1987; Osborn & Jackson, 1988; Thaler and Johnson, 1990).
The modified model here also propose a less stable concept of risk propensity. Where Sitkin & Pablo (1992) and Sitkin & Weingart (1995), already propose risk propensity as an emergent property of the decision maker, which can change over time, and less as a stable attribute as argued by (Fischhoff, Lichtenstein, Slovic, Derby, & Keeney, 1981; Rowe, 1977). Risk propensity therefore can change due to for example recent gains/losses (arrow f, figure 1). Keeping in line with the framing effect under prospect theory (Kuhberger, 1995), individuals will tend to avoid risk in the domain of gains (above their reference point), while seeking risk under loss (below point of reference).
Proposition 12: Recent gains decrease risk propensity while recent losses increase risk propensity.
Seo et al. (2010), identifies affective state as moderating this effect of recent gains / losses (arrow g, figure 1). This is in line with existing research identifying human affect as an important individual-level factor. Experiencing pleasant feelings with recent gains reduced the risk averseness while both pleasant and unpleasant feelings reduced the risk seeking effect of recent losses. This research suggest the proposition:
Proposition 13: Affective state diminishes the framing effect.
events or outcomes (Johnson & Tversky, 1983). Moreover the mood congruence effect argues for more individual awareness of the negative / positive implications of the decision. Meaning that affective state influence risk perception through problem framing. (arrow h, figure 1).
Proposition 14: Affective state affects problem framing.
MANAGERIAL DISCRETION & RISK TAKING
While the model proposed above explains how the process of behavior concerning risk comes into place, within organizations the actual relationship between an individual’s role and an outcome is also influenced by other factors. As Hambrick and Finckelstein (1987) already explain, top executives can only influence their companies in proportion to the amount of discretion (manager’s latitude of action) they possess. The empirical evidence further shows the importance of discretion to actual outcomes (Crossland & Hambrick, 2007; Crossland & Hambrick, 2011; Finkelstein & Boyd, 1988; Finkelstein & Hambrick, 1990; Li & Tang, 2010). These prior research shows that the scope of managerial discretion is determined by individual as well as environmental, organizational and national factors. Broadly, these different level factors relate to different types of constrains which limits the executive’s discretion.
Finckelstein, 1987; Tushman & Romanelli, 1985). Even though the willingness to undertake a certain action exists within the executives, organizational factors might limit their power to shape the organization accordingly. For example larger organizations are more likely to have established routines (Nelson & Winter, 1982) or difficulties in implanting large changes (Aldrich, 1979). Other organizational factors relates to the degree of power the executives have in relation to their principals or key stakeholders. For example factors which can increase ‘information asymmetry’, a well-known concept in agency theory (Eisenhardt, 1989; Bebchuck & Fried, 2003), or factors decreasing board vigilance like chair-CEO duality (Crossland & Hambrick, 2007) will surely increase managerial discretion. The role of the board is therefore of great influence in risk taking within organizations as they can limit managerial discretion. This will be discussed in a later section.
Concerning national factors, normative constraints and institutions are the key elements. Hambrick and Finkelstein (1987), argues that executives have discretion as long the action falls within the ‘zone of acceptance’ of stakeholders with power. Managerial discretion will then diminish according to degree to which the action is seen as objectionable and the relative power of those who perceive it as objectionable. At national level, formal and informal institutions affect these two factors (Crossland & Hambrick, 2007; Crossland & Hambrick, 2011). Traditions, customs and social norms constrain behavior to provide structure to interactions (Colson, 1974), and because of the guidelines institutions provide, constrains are also created (Nelson & Nelson, 2002). Informal institutions, defined by (Helmke & Levitsky, 2006: 5) as “socially shared rules,
actions (Crossland & Hambrick, 2011). Whether societies will perceive certain actions as objectionable will therefore be dependent on norms and conventions within that society.
On the other hand, formal institutions, defined as “rules and procedures that are
created, communicated, and enforced through channels widely accepted as official”
(Helmke and Levitsky, 2004: 727), relates to the power of key stakeholders. Executives will adhere to these formal rules to avoid state-controlled sanctions. Across varying national systems, managerial discretion will then differ due to the different legal rights and responsibilities of executives relative to the company’s stakeholders (Crossland & Hambrick, 2011). The two factors, perceived objectionability and power of stakeholders shows the importance of corporate governance and the role of the board as they can be seen as controllers of decisions, the one who ratifies and control the actions of top management (Fama & Jensen, 1983).
Managerial Discretion - Organizational Level
Existing theory points out different roles of the board. Probably the most well known role and the most relevant for risk management is the monitoring function of the board, which has its theoretical underpinning in agency theory. The board serves as a control instrument for its shareholders (Fema & Jensen; Williamson, 1996), monitoring the management, controlling decisions, and replacing inefficient executives (Barnhart, Marr, & Rosenstein, 1994; Raheja, 2005). With respect to the shareholders, the board is believed to be the first line of defense against below-par performing management (Weisbach, 1988) and or the second best remedy (Weisbach & Hermalin, 2003).
Besides the monitoring role the board also has a strategic function to fulfill. Where the board actively participates in decision making and decision evaluation. Judge and Zeithaml (1992) emphasize the discretion managers and boards have to adapt their organization to the environment. Indicating that board members are also players in the strategic decision process. This strategic role of the board is also posited by Goodstein, Gautam and Booker (1994) elaborating that taking decisions which helps the company adapt to its environment as the strategic function of both the management and the board.
controlling each other activities, coordination increases, which is a solution to the problem of interdependence and uncertainty. This is in line with Huse (1994), which states that trust and interdependence are central elements of relational contracting.
Clearly these functions of the boards affect risk taking in firms by two ways. Firstly as discussed in the previous section, one of the factors relating to managerial discretion is the power of the stakeholders relative to the management. If board members represent shareholders then the ownership structure of the firm will be a relevant factor to consider as shareholders often have the power to appoint the director. Diversified owners are believed to opt for more risk taking than managers (Demsetz & Lehn, 1985; Esty, 1998; Galai & Masulis, 1976; Jensen & Meckling, 1976), as they do not have a large personal stake in the firm. Where diversified owners are more powerful than non-shareholding managers, even though there will be less managerial discretion, there might be a tendency for greater risk taking. This means that lower managerial discretion do not only relates to less risk taking but can actually promotes it. Besides the diversification of owners, the ownership concentration also affects the power balance. Executives can exercise greater discretion when there is a dispersion of owners (Crossland & Hambrick, 2007), while concentrated ownership provides incentives and means for the shareholders to impose decisions and constrain managerial actions (Demsetz & Lehn, 1985; Shen & Cho, 2005).
goals but do have to take into account the interests of different stakeholders (constrain is at the level of means) (Shen & Cho, 2005). Coherently due to the multiple interests of different shareholders, which all have to be balanced, managers are more limited from taking radical actions in civil law countries (Crossland & Hambrick, 2011).
mentioned above clearly influence all major players with respect to their perceptions of actions, which fall in the zone of acceptance (Hambrick and Finkelstein, 1987).
Concerning perception of the shareholders the board with their monitoring and strategic function plays a major role as long as they can fulfill these duties efficiently. However, several researches points out that managers can exercise considerable power which can affect the board and its functioning. For example Baliga & Moyer (1996) discovered that management is able to influence board composition and control information flows therefore increasing managerial discretion. CEO-duality as another example is also found to increase managerial discretion, as board vigilance will be weaker. (Hayward & Hambrick, 1997; Li & Tang, 2010; Mizruchi, 1983). With respect to this power play between managers and board members certain board characteristics and or compositions are found to have a positive effect on the functioning of the board. The following section will discuss these board characteristics.
THE BOARD & RISK TAKING Independence
to the power of managers in appointing who sits on the boards, the interest of outside directors will be more likely aligned with the managers (Mace, 1986; Jensen, 1993) or managers might even succeed in reserving positions for incompetent outside directors (John & Senbet, 1998). These two differing views concerning independent directors only affirm the monitoring function of the board. When an efficient board is in place (for this case having competent outside directors), managerial discretion will be less. For example badly performing managers are more likely removed by outside-dominant boards (Weisbach, 1988). Hermalin and Weisbach (1988) discovered that more independent directors are appointed after a period of poor stock performance, indicating that the presence of outside directors also serves as a positive signal to the outside world, more specifically to the firm’s investors. This is further confirmed by the studies of Byrd and Hickman (1992), who found that independent directors have a neutralizing effect on the negative reactions of the market to the announcement of a take-over. While Brickely, Coles and Terry (1994) discovered that independent directors also neutralize the negative effect of the adaptation of anti-takeover measures by the management. Furthermore outside directors are associated with better oversight of the financial processes within the firm (Klein, 2002), indicating more reliable financial reports (Anderson, Mansi & Reeb, 2004), and less chance on financial statement fraud (Uzun, Szewczyk & Varma, 2004). The papers of Block (1999), Cotter, Shivdasani and Zenner (1997), and Hermalin and Weisbach (2003) further argue that independent directors, when correctly functioning, will promote the interests of the shareholders.
taking will be dependent on the risk decision-making behavior of the executives in relation to the stakeholders the outside directors are representing. That of course would be the ideal situation, implying that the outside directors’ risk preference and risk perception (see figure 1, appendix), are the same as the stakeholders they are representing. Pathan (2009), for example argues that on average firms with independent boards would have less risk taking as independent directors are also more independent from shareholders (who wants more risk taking) and are therefore more sensitive to regulatory compliance (to avoid lawsuits).
Furthermore the risk behavior of the outside directors needs to be different than that from the executives. Coherently this will be the case when comparing the individual elements in figure 1.
Firstly, by examining risk propensity, difference between the outside directors and executives can be found. As risk preference is different for each individual it is unlikely to be the same for both directors and executives. When this general risk orientation turns out to be similar, it is still unlikely that both inertia and outcome history are similar as well. Outside directors from different firms, having encountered different outcomes in their own business would have faced a different path than the firm they are monitoring. Furthermore as outside directors have no business or personal relation with the firm, previous results (whether gain/loss, positive/negative) would be interpreted differently than the executives leading to different outcome history.
less informational asymmetry as the outside directors (Huang, 2006). Therefore outside directors with different information as the executives would have a different risk perception i.e. different estimation of how risky a situation is in terms of probabilities of the situational uncertainty, the controllability of the uncertainty and the confidence in those estimates (Baird & Thomas, 1985; Bettman, 1973).
Expertise
hedging found the practice to be corresponding with firms whose board members hold degrees surpassing the bachelor level (Smith and Stulz, 1985).
Board Tenure
Concerning how board tenure is related to risk taking, prior literature is split in two contrasting streams. Firstly like the effects of intra-firm experience, multiple years of directorship in the same board is reasoned to be associated with greater experience, commitment and competence (Buchanan, 1974; Vafeas, 2003; Vance, 1983). Looking back at the study of Sirmon et al (2008), longer board tenure in the same firm means a better understanding of that specific industry and will therefore result in recognizing or preferring certain (familiar) strategies while being critical of other. Opposing these ‘greater expertise theories’ is the ‘management friendly’ board theories. According to Vance (2003), the longer the board tenure the more likely directors befriend management leading to less monitoring. This is further argued to be more often the case in firms controlled by powerful CEOs (involved in the nomination process, significant voting power, extended tenure in the CEO position). The outsider director becomes more similar to insider director when this happen. Lipton and Lorsch (1992) further supports this statement by advocating term limits for directors, as they recognize that in time directors might even attempt to usurp some of the CEO’s function. Canavan, Jones, & Potter (2004) reason that while longer board tenure has benefits, many of these also have a flip side. Besides personal ties that directors develops (affecting their independence), seasoned directors are more prone to defend policies and decisions they supported in the past, fail to keep up with the changing business environment, lack fresh ideas and critical thinking new directors can bring to the board.
in firms with more powerful CEOs. This might possibly be explained by relationships, which have been developed. The finding from Core, Holthausen and Larcker (1999), that directors who are appointed in the current CEO’s tenure are more generous with respect to the compensation partially supports this statement. CEO’s tenure is one of the most cited indicators of CEO power within the firm. As outside directors are not involved with the day to day business of the company one can argue that the longer the CEO’s tenure the more information asymmetry with the board can exist. Relating to Core et al (1999) seasoned CEO’s may also gain more influence in board member selection (Westphal & Zajac, 1995). Furthermore, overtime the board might trust the CEO implicitly (Shen, 2003), weakening their monitoring. Some prior literature suggests that longer tenure means the CEO is conforming to the shareholders interests (Brickley, Coles, Jarrell 1997; Shwenk, 1993), and requires less monitoring. While other researches conclude that in the case of a ‘fresh’ board, CEO tenure is negatively associated with risk taking (Pathan, 2009; Walters, Kroll, & Wright 2007) while a more tenured board would advocate for greater risk taking.
Board size
less risk taking activities which confirms that larger boards are related to less alignment with the interest of shareholders. However other researchers such as Singh and Harianto (1989) argue that larger boards might actually reduce CEO domination. This reasoning is in alignment with the findings that firms with strong insider control have a smaller board generally (Bagha & Black, 1996; Gertner & Kaplan, 1997) or those firms, which still have the founder as CEO, also have smaller boards (Agrawal & Knoeber, 1999). With respect to board efficiency Klein (2002), argue in favor of larger boards with the reason that the committees in larger boards would be more effective as there will be more directors to spread around.
CEO Duality
entrenchment. However, the findings of Finkelstein & D’Avine (1994), shows that boards are more concerned with unity of command than CEO entrenchment, contradicting agency theory. Furthermore in the same research it is elaborated that the informal power of the CEO and also positive firm performance, is of great influence in the tendency for CEO entrenchment (which is in favor of agency) theory.
This is an indication that CEO duality on its own will not always lead to greater risk taking or weaker board vigilance. It stresses out that psychological and situational factors are as equally important (Wasserman, 2006). Finally, Shen (2003) suggest that boards should focus on leadership development of fresh CEOs and enhance monitoring as the CEO becomes more tenured, as it takes time to build authority and trust from other directors needed to pursue one’s own interests.
DISCUSSION
factors at organizational and even national level (Crossland & Hambrick, 2011). In turn outcomes and individual factors such as affective state play a role in future decisions.
Risk taking in firms has been shown to be a function of individual factors such as risk preference and organizational level factors such as award systems and team composition. Moreover, the board of directors plays a large role in monitoring and directing executive behavior. While these all take place in a certain environment, which is dependent on certain characteristics within a country. Therefore future research should try to take most, if not all, of these factors into account.
Consequently difficulties will be encountered in disentangling intercorrelations and in attributing cause and effect. Other methodological concerns are the changing composition of management or board while there is a lag in outcomes of decisions. Also researchers need to be careful in their choice of measure for risk or other variables as the context can be of great importance. For example Sirmon et al. (2008) points out, that directors prior board experience have an effect on their preferred strategy. A measure of risk not capturing this preference might bring false result. The current position of the firm is regarding prospect theory also a factor to consider. Managers of firms with above target level will then behave differently than in below target level firms.
By examining all of the factors considered in this paper as a whole, an improvement in predictive models can be accomplished. Predictions about corporate risk taking will be more accurate which is beneficial to shareholders, directors and top management and ultimately to society.
provide the firm with strategic directions, lower level employees are still the one who has to carry the day-to-day activities. How risk taking is converted top-down in an organization have not been covered albeit this also deserves attention. For example, examining leaders personal characteristics and traits, that helps foster a culture of risk taking or risk avoidance will surely be of relevance and will further improve predictions about risk taking in firms.
Implications for Practice
This study has several implications for top management, directors and owners of an organization. When searching for a right top management or director candidate, experience is often highly valued. This research shows that decision makers should be aware that higher experience should not always been given priority. Where lack of experience can lead to incorrect assumptions about risk, abundant experience might result into overconfidence. Coherently the type of experience brings different risk preferences to the board. Experience accumulated from the same industry or company will bring specific market knowledge, preferring investment strategies to aggressive market strategies (Sirmon et al, 2008). This can bring about incorrect results for scholars using investment or certain strategies as a measure for risk taking. Lastly when headhunting for top-level executives special attention needs to be given to how this would affect the team homogeneity. For that the candidates’ prior experience, surface-level attributes and deeper-level factors should be examined.
to one’s own risk preference. As Pathan (2009) argues independent boards might be independent from the management but perhaps too independent from the shareholders as well. Risk taking in a firm is the result of interplay between the managers, supervisors and shareholders as well as environmental and national factors. Shareholders should aim for an efficiently functioning supervisory board but should not neglect to provide sufficient managerial discretion to managers.
Implications for Research
in literature, I also want to direct attention to exploring the link between psychological attributes and problem framing. This is particularly important as problem framing is considered to be closely related to risk taking. Furthermore the interplay between psychological attributes and ‘social influence’ as well as ‘organizational control systems’ seems to be promising. ‘Social influence’ or how organizations affect one’s behavior and perception is surely different for different psychological attributes. Likewise one’s behavior with respect to the way organizations rewards certain behavior deserves more attention.
Prospect theory (Kahneman & Tversky, 1979), which suggest that in the area of gains decision makers tend to be more risk averse, is thought to be influenced by a person’s affective state (Seo et al. 2010) either reducing or enhancing the effect. In the proposed model this is depicted as the feedback loop from the outcome of a decision to risk propensity. However one can argue that emotions experienced by an outcome is related to one’s psychological profile. Where somatic theories argues that emotions are simply the feelings of certain bodily changes as a result of perception of some fact (Ellsworth, 1994), cognitive theories (Mindler, 1984; Solomon, 1993) discuss that; judgments, thoughts, and evaluations are necessary for an affective state to establish. Further studies between the interplay of emotions, and psychological factors are necessary considering this under investigated area. Affect research combined with models of risk taking can produce new insights.
affect the person’s managerial discretion when evaluated by stakeholder. Coherently psychological traits and characteristics might further change an individual’s perception of his discretion and therefore affects outcome.
Conclusions
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