The emphasis on the contribution of local knowledge to economic growth is a key tenet of classical economic theory. The Hayekian worldview, for example, sees the dispersion of local pockets of knowledge across the economy as the primary reason why centralized planning fails to produce optimal results. In the realm of corporate finance, these considerations emphasize the importance of firms’ reliance on local CEOs with access to social networks where information flows in a subtle and nuanced way that highly depends on specific individuals rather than formal institutions. Focusing on the local, however, comes at a cost, as a rich set of empirical studies show that it brings its own biases to the table. For instance, local managers may jeopardize the financial resilience of their firms by making suboptimal decisions such as favoring local (and expensive) labor (Yonker 2017a) and prioritizing the value-destroying acquisitions of local targets (Jiang, Qian, and Yonker 2019).
Whether the benefits of a local focus still exceed its costs in the highly developed and integrated U.S. market, and at a time when information costs are at a record low, remains an empirical question. As the formal assessment of a firm’s debt rating by reputable credit rating agencies (CRAs) is recognized as a fundamental determinant of financing costs, a significant positive influence of local CEOs on the firms’ credit ratings would suggest that tacit-local knowledge remains an integral contributor to the firms’ financial performance. In contrast, evidence indicating that the impact of local CEOs on a firm’s credit rating is negative or insignificant would suggest that the emphasis on the relative gains from local geographic knowledge relative to its biases are overrated in the age of digital information, low search costs, and highly transferable skills. Prior literature has paid much attention to the effects of CEO characteristics, but so far only scant studies have attempted to explore the role of CEO attributes for firms’ credit rating (Bonsall, Holzman, and Miller 2017; Cornaggia, Krishnan, and Wang 2017; Ma et al. 2021).
In a new paper, we draw a hopeful picture about the role of local CEOs in enhancing a firm’s creditworthiness. The most challenging part of our empirical analysis was to separate the local CEOs from non-local ones. To address this challenge, we manually collected information on where CEOs were born or grew up from sources like The Complete Marquis Who’s Who Biographies, Wikipedia, NNDB, and Google. Despite the widely documented biases that come with a local focus, our results point that its benefits, on average, exceed its costs, even in the highly developed and fully integrated U.S. market.
We find that firms with local CEOs are awarded higher credit ratings by CRAs than comparable firms with non-local CEOs. We also show that such higher ratings are backed by a clear and quantifiable economic rationale emphasizing the effectiveness of local CEOs in enhancing a firm’s performance and efficiently exploiting a carefully built social capital to navigate adverse uncertainty shocks. This is consistent with the argument that social capital, associated with institutional initiatives and targeting a firm’s secondary stakeholders or society at large, can enhance the long-term sustainability of those CEOs’ firms and provide firms with insurance-like protection and hedging effects. Such attributes can effectively preserve financial performance in times of external negative shocks (Bae, Choi, and Lim 2019; Godfrey 2005; Godfrey, Merrill, and Hansen 2009; Lins, Servaes, and Tamayo 2017, among many others).
Indeed, the CEO’s local affiliations seem to enhance the firm’s creditworthiness when it is needed the most; that is, when the firm is small, financially constrained, and operating in a highly competitive environment. In a dynamic setting, our results suggest that the firms that replace local CEOs with non-local ones experience periods of reduced creditworthiness and poor business performance.
Our results emphasizing the positive contribution of local CEOs to credit ratings, their ability to neutralize uncertainty shocks, and their effective exploitation of social capital have wider implications on the market for managerial talent. Specifically, our findings provide a clear rationale behind the robust evidence suggesting a strong geographic segmentation in the U.S. market for CEOs, as firms are almost five times more likely to hire local CEOs compared with the benchmark where geographic considerations are irrelevant (Yonker 2017b).
To conclude, CRAs seem to make an evidence-based decision by awarding firms led by local CEOs higher debt ratings than firms led by non-local CEOs. Indeed, the CEO’s local affiliations seem to enhance the firm’s creditworthiness when it is needed the most; that is, when the firm is small, financially constrained, and operating in a highly competitive environment. The main takeaway from our paper is that, when it comes to preserving creditworthiness, improving financial performance, navigating uncertain business conditions, and efficiently using social capital, local geographic knowledge is here to stay.
REFERENCES
Bae, John, Wonik Choi, and Jongha Lim. 2019. “Corporate Social Responsibility: An Umbrella or a Puddle on a Rainy Day? Evidence Surrounding Corporate Financial Misconduct.” European Financial Management, August, eufm.12235.
Bonsall, Samuel B., Eric R. Holzman, and Brian P. Miller. 2017. “Managerial Ability and Credit Risk Assessment.” Management Science 63 (5): 1425–49. https://doi.org/10.1287/mnsc.2015.2403.
Cornaggia, Kimberly J., Gopal V. Krishnan, and Changjiang Wang. 2017. “Managerial Ability and Credit Ratings.” Contemporary Accounting Research 34 (4): 2094–2122. https://doi.org/10.1111/1911-3846.12334.
Godfrey, Paul C., Craig B. Merrill, and Jared M. Hansen. 2009. “The Relationship between Corporate Social Responsibility and Shareholder Value: An Empirical Test of the Risk Management Hypothesis.” Strategic Management Journal 30 (4): 425–45.
Godfrey, Paul C. 2005. “The Relationship between Corporate Philanthropy and Shareholder Wealth: A Risk Management Perspective.” Academy of Management Review 30 (4): 777–98.
Jiang, Feng, Yiming Qian, and Scott E. Yonker. 2019. “Hometown Biased Acquisitions.” Journal of Financial and Quantitative Analysis 54 (5): 2017–51.
Lins, Karl V., Henri Servaes, and Ane Tamayo. 2017. “Social Capital, Trust, and Firm Performance: The Value of Corporate Social Responsibility during the Financial Crisis.” Journal of Finance 72 (4): 1785–1824.
Ma, Zhiming, Lufei Ruan, Danye Wang, and Haiyan Zhang. 2021. “Generalist CEOs and Credit Ratings.” Contemporary Accounting Research. https://doi.org/10.1111/1911-3846.12662.
Yonker, Scott E. 2017a. “Do Managers Give Hometown Labor an Edge?” Review of Financial Studies 30 (10): 3581–3604.
Yonker, Scott E. 2017b. “Geography and the Market for CEOs.” Management Science 63 (3): 609–30.
This post comes to us from Professor Samer Adra at the Sheffield University Management School, University of Sheffield, and from Yang Gao, a PhD candidate, and Jing-Ming Kuo, a professor, at the Birmingham Business School, University of Birmingham. It is based on their recent working paper, “The Triumph of Locality in Troubled Times: Local CEOs, Social Capital, and Credit Ratings under Uncertainty,” available here.