CEO Overconfidence and the Cost of Private Debt: Evidences from Bank Loan Contracting

This paper studies whether banks charge higher or lower interest rates on loans to firms with overconfident CEOs. It establishes a theoretical model to show the relationship between the loan rate and overconfidence of the borrowing firm’s CEO. It also conducts empirical analyses to test the predictions of the model. As predicted in the model, firms with overconfident CEOs enjoy lower loan rates if banks are hedged against the downside risk of the loan payments, or if these firms have more growth opportunities. In addition, overconfident firms bring more future business opportunities to banks, and there is evidence suggesting that banks may lower lending standards on overconfident firms if the banks have downside protection in the loan contracts or if the firms have more growth opportunities. This paper implies that banks may prefer high-risk borrowers if the future benefits from doing businesses with these borrowers are sufficiently high. JEL: G21, G32, G33, G34