Are local CEOs less myopic than non-local CEOs?

An attachment to where we come from affects business decisions

This article is republished with permission from China Business Knowledge, the knowledge platform of Chinese University of Hong Kong (CUHK) Business School. You may access the original article here.

Chief executive officers are often hailed as superheroes for businesses. Most companies are willing to provide highly competitive packages to attract top CEO talent in the belief that the talents and personal values of individual CEOs can either make or break a company.

Although salary packages vary for different CEOs, the majority of their compensation is based on company performance. In other words, the more profits the company makes under a CEO's leadership, the higher the salary the CEO receives.

This performance-driven compensation seems to be a rational arrangement for CEOs. After all, they are hired to lead the companies into profit-making paths.

But some CEOs may be good at making short-term profits while others are keen to develop long-term plans balancing business interests and community needs.

A research study by George Yang, an associate professor in the school of accountancy at Chinese University of Hong Kong (CUHK) Business School, sheds light on how CEOs prove their abilities by making different business decisions.

His working paper, East, West, Home's Best: Are Local CEOs Less Myopic?, aims to find out whether CEOs working near their birthplaces are likely to be more long-term oriented in terms of business development than non-local CEOs.

The study was carried out in collaboration with Lai Shufang Lai, a professor  at Southern University of Science and Technology, and Li Zengquan, a professor  at Shanghai University of Finance and Economics.

"While monetary incentives play an important role in curbing short-term decisions, social and cultural factors could also be leveraged to reinforce this effect by imposing less financial burden on firms," says Yang.

We found that the non-local CEOs in our study were 16.9% more likely to cut R&D funding than the local CEOs near retirement

George Yang

Cutting spending

We all have attachments to certain places in our lives. It may be our birthplace or cities we have lived in. How does this place attachment influence business decisions, in particular among CEOs?

The researchers looked at S&P 1500 firms in the US from the period of 1992 to 2012 and observed more than 2000 unique CEOs.

Managerial myopia was measured by the likelihood of cutting the research and development expenditure to avoid a potential earnings decrease from the previous year. The team also calculated the likelihood of cutting R&D spending to avoid potentially failing to meet analysts' consensus forecasts, as a supplement measure.

The empirical results showed the local CEOs in the study were less likely to do either. According to the study, the chances of local CEOs cutting R&D spending were 14.6% lower than the non-local CEOs in general circumstances.

However, in situations such as firms experiencing small decreases in earnings that could be salvaged by cutting R&D spending, the odds of the local CEOs cutting R&D were 25.5% lower than for the non-local CEOs.

This effect was stronger when the CEOs were approaching their retirements. It echoes the findings from previous studies stating that CEOs often behave myopically and tend to spend less on R&D in their last years of office.

"We found that the non-local CEOs in our study were 16.9% more likely to cut R&D funding than the local CEOs near retirement," Yang says.

In addition, the researchers also looked at firms that experienced at least one change in CEOs during the sample period. The results showed that a firm which replaced a non-local CEO with a local CEO had lowered the tendency to cut R&D to avoid earnings decrease.

Reputational concern

To more fully understand how locality of CEOs affects their business decisions, the researchers studied whether local and non-local CEOs differed in terms of their decisions in firms' tax payments and corporate social responsibility measures.

This is because paying more state taxes could contribute to the local infrastructure while corporate social responsibility initiatives could benefit the environment and local communities.

The results showed firms paid 7.3% higher taxes to their home states under the leadership of local CEOs than non-local CEOs; in other words, the local CEOs were more willing to be socially responsible in improving the environment, community and employment.

Apart from locality, could there be other reasons for this difference in making myopic business decisions? Some may wonder if local CEOs are just better at their jobs than non-local CEOs so they don't need to cut spending to improve earnings.

But after examining the educational backgrounds and professional certifications, the researchers could not find any substantial skill differences between the two groups of CEOs.

"So it all boils down to two fundamental factors: insufficient concern for long-term reputation as well as information asymmetry between the CEO and stakeholders regarding the CEO's professional capability," says Yang.

"For instance, low concern for reputation would lead a CEO to narrowly focus on near-term payoffs, which in turn would incentivise the CEO to manipulate earnings and succumb to pressure from myopic investors," Yang explains.

"On the other hand, high information asymmetry between the board of directors and the CEO about the CEO's skills would lead the board to shorten evaluation periods to avoid potentially excessive damages that could be imposed by an incompetent CEO. The CEO, in turn, would be preoccupied with proving himself by delivering superior short-term profits."

Social bonds

The researchers also discovered that local CEOs are less myopic when the company's business involves more local interests – for example, the firm's operation is mainly concentrated in its home state or the local residents are likely to invest in the firm.

In addition, they found that local CEOs do not tend to develop myopia when the state has a low population mobility and high social capital – when the connections among local residents are enhanced by its religious organisations, civic and social associations, political organisations, and so on.

"Because local CEOs run businesses in their home areas, their opportunistic behaviours [would be] likely to impair the interests of those with whom they are closely bound. Their reputation and trustworthiness [would] then be tarnished, which [would] further affect their social status in their social networks," Yang says.

"As local places feature more close-knit social bonds and hence more social capital, local CEOs' long-term reputation concerns will be greater and they are less likely to be myopic," he adds.

According to Yang, hiring a local CEO can reduce the information asymmetry for the board of directors regarding his or her character and skills.

Coming from the local community, the directors are likely to have more access to the information about the CEO from their local social networks. The board and the CEO will have a better mutual understanding so that the CEO will have less pressure to prove his or her ability by making myopic decisions.

"Hiring a local CEO gives an advantage to a firm by elevating the CEO's long-running concern for her reputation," Yang says. "This finding should be of interest to investors, practitioners, boards of directors, and market regulators."