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. However, 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 Prof. George Yang, Associate Professor of School of Accountancy at The Chinese University of Hong Kong (CUHK) Business School sheds some light on how CEOs prove their abilities by making different business decisions.
His working paper entitled "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 the nonlocal CEOs. The study was carried out in collaboration with Prof. Shufang Lai at Southern University of Science and Technology; and Prof. Zengquan Li at Shanghai University of Finance and Economics' School of Accountancy.
"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 Prof. Yang.
Place Attachment and Business Decisions
We all have attachments to certain places in our lives. It might be our birthplaces or cities that 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 United States from the period of 1992 to 2012 and observed over 2,000 unique CEOs.
Managerial myopia is 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.
Local versus Nonlocal CEOs
The empirical results showed that the local CEOs in the study were less likely to cut R&D expenditure to avoid earnings decreases or meet analyst consensus forecasts.
According to the study, the chances of local CEOs cutting R&D spending were 14.6 percent lower than the nonlocal 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 that would actually cut R&D were 25.5 percent lower than the nonlocal 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 nonlocal CEOs in our study were 16.9 percent more likely to cut R&D funding than the local CEOs near retirement," Prof. 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 nonlocal CEO with a local CEO had lowered the tendency to cut R&D to avoid earnings decrease.
Locality and Social Responsibility
To fully understand how locality of CEOs affect their business decisions, the researchers also studied whether local and nonlocal CEOs differed in terms of their decisions in firms' tax payments and corporate social responsibility (CSR) measures. It is because paying more state taxes could contribute to the local infrastructure while CSR initiatives could benefit the environment and local communities.
And the result showed that the firms paid 7.3 percent higher taxes to their home states under the leadership of the local CEOs than the nonlocal 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 in this difference between nonlocal and local CEOs in making myopic business decisions? Some might wonder perhaps local CEOs are just better at their jobs than nonlocal CEOs so that they don't need to cut spending to improve earnings.
However, 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 Prof. Yang.
"For instance, low concern for reputation would lead a CEO to narrowly focus on near-term payoffs, which in turn would incentivize the CEO to manipulate earnings and succumb to pressure from myopic investors," Prof. 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."
In addition, the researchers also discovered that local CEOs are less myopic especially 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 organizations, civic and social associations, political organizations, etc.
"Because local CEOs run businesses in their home areas, their opportunistic behaviours are likely to impair the interests of those with whom they are closely bound. Their reputation and trustworthiness will then be tarnished, which will further affect their social status in their social networks," he 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.
Advantage of Hiring Local CEOs
According to Prof. 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 for the information about the CEO's 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," Prof. Yang comments. "This finding should be of interest to investors, practitioners, boards of directors, and market regulators."