CEO overconfidence: The moderating role of inside debt

This paper investigates the interplay between chief executive officer (CEO) overconfidence, a prominent behavioral bias, and the governance role of inside debt. We argue that the well-documented effects of CEO overconfidence on corporate risk-taking and firm value are moderated by the structure of CEO compensation, specifically deviations from a firm-specific optimal level of inside debt, which is a structure of deferred and/or pensions meant to align CEOs with the risk facing traditional debtholders. Using a large panel of the United States (U.S.) firms, we find that overconfident CEOs are associated with larger negative deviations from optimal inside debt levels. Our results show that positive deviations from optimal inside debt mitigate the risk-taking behavior of overconfident CEOs, particularly in research and development (R&D) investment. Conversely, negative deviations amplify their risk-taking tendencies. Furthermore, we find that the positive effect of overconfidence on firm value is significantly stronger when constrained by above-optimal inside debt. These findings contribute to the behavioral corporate finance literature by highlighting the importance of tailoring executive compensation to the psychological traits of managers.