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Centralization of DecisionMaking in the Top Management Team

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Title: Centralization of DecisionMaking in the Top Management Team


1
Centralization of Decision-Makingin the Top
Management Team
  • Heitor Almeida
  • New Ideas and Open Issues in Corporate Finance
  • Amsterdam, June 15, 2003

2
Two Notions of Centralization
Top Management Team (CEO)
Division Managers
  • Where in organization should decisions be made
  • Centralization of decisions at a given level of
    the organization - opening up the boxes

3
These are Two Different Questions
  • Examples
  • HP until the 80s decision-making highly
    concentrated in the hands of founders, but
    company was a loose federation of far flung
    divisions each finding its own way to contribute
    to the greater good (Anders, 2003)
  • News Corp.s magic circle (FT May 20, 2003)
    office of the chairman is a group of 5 people
    which meet every Monday to consider every
    acquisition and item of capital expenditure
  • Augustin will talk about 1), I will talk about 2)

4
The Role of Top Managers
  • Focus on decision-making at the top level of the
    organization
  • Why is this an important/relevant question for a
    presentation on centralization?
  • Decision-making power could have been sent down
    the hierarchy
  • Isnt the CEO alone at the top of the hierarchy?

5
Do Top Managers Matter?
  • Question has a long intellectual history in
    management
  • No Lieberson and O'Connor (1972), Hannan and
    Freeman (1977)
  • Yes Weiner and Mahoney (1981), Hambrick and
    Mason (1984), Finkelstein and Hambrick (1996)
  • More recent finance and economics literature
    arguing that managers matter
  • Malmendier and Tate (2001), Bertrand and Schoar
    (2002), Adams et. al (2002)

6
Is the CEO alone at the top?
  • No, or at least not always (Top management team)
  • FH (1996) loosely define TMT as top 3-10
    executives in the organization such as CEO,
    Chairman, President, COO, Senior Vice-President,
    Executive Vice-President, etc.
  • TMT also interacts with the board, and with
    markets (at least when company needs funds)
  • Behavioral theory of senior leadership must
    extend beyond considering executives in isolation
  • Decision-makers are informed, influenced, and
    sometimes constrained by others, both inside and
    outside the organization (FH 1996)

7
A View from the Top
represents an exchange of opinion about decision
TMT
CEO
Other managers
board
markets
proposed decision
final decision
markets opinion carries more weight when company
needs to raise funds - implications for financial
policy
8
A Key Ingredient - Differences of Opinion
  • Justifications for disagreement
  • costly communication
  • differences in ability to process information
  • differences in priors
  • managers are overconfident, or they have vision
  • Disagreement especially likely for types of
    decisions made by TMT
  • weak situation (Mischel, 1977)
  • for many industries in modern economies there is
    uncertainty about logical implications of
    information and actions (Allen, 1993, Radner,
    1997)

9
Disagreement Implies Fallibility
  • When people disagree, some (or all) should be
    wrong, even when they have common goals (no
    agency problem required)
  • ... biases, egos, aptitudes, experiences...greatl
    y affect what happens to companies. This is not
    to say that managers are weak and sinister, only
    that they are human and limited. (FH, 1996)
  • With disagreement, issue is not how to give
    shareholders control, but who should be given
    control (Allen and Gale, 2000)

10
Roadmap for Discussion
  • Simple model of decision-making with disagreement
    based on Sah and Stiglitz (1985, 1986, 1988)
  • Introduce effect of groups and group interaction
  • Applications
  • Interactions within TMT and optimal design and
    distribution of power in the TMT
  • Role of corporate boards in decision-making
  • Potential implications for behavioral corporate
    finance
  • Managers vs. markets implications for financial
    policy
  • Caveats
  • Many more questions than answers
  • I will use management and social psychology ideas
    that are not formally modeled

11
Simple Model Based on Sah and Stiglitz
  • CEO and other top managers face decision of
    whether or not to implement a given project
  • Good projects have NPV of G, bad projects have
    NPV of -B. Fraction ? of projects are good
  • Fallible decision-making
  • CEO judges a good project to be good with
    probability pGCEO lt 1, and he judges a bad
    project to be good with probability pBCEO gt 0
  • Expected output when CEO is deciding alone
  • YCEO ? pGCEO G - (1 - ? ) pBCEO B
  • CEO makes two types of mistakes
  • Type I reject good project
  • Type II accept bad project

12
Introducing a Second Member in the TMT
  • Second member is subject to similar bias as CEO
    (pGM lt 1, pBM gt 0 )
  • Disagreement second manager might have a
    different opinion about the project (even after
    communicating with the CEO)
  • opinions are not perfectly correlated. Assume
    they are uncorrelated
  • SS never modeled communication explicitly. They
    assume managers only observe whether the other
    wants to accept or reject, and do not update
  • How will group decision-making affect the final
    decision?
  • Suppose that both the CEO and the manager have to
    accept the project in order for it to be
    implemented
  • This will lead to the following expected output
  • YTMT ? pGCEO pGM G - (1 - ? ) pBCEO pBM B
  • Group will decrease probability of type II but
    increase probability of type I error

13
Optimal Distribution of Power in the TMT
  • Decentralizing decision-making power pays off
    when
  • CEO is more fallible (low pGCEO, high pBCEO )
  • Manager is less fallible (high pGM, low pBM )
  • Proportion of good projects is low (low ? )
  • Cost of accepting bad projects is high relative
    to benefit of accepting good ones (high B, low G)
  • Notice that when decentralization pays off, it
    does so because of disagreement
  • No benefit when opinions are perfectly correlated
  • It may be important to incorporate opinions of
    both managers in the final decision
  • See Sah (JEP, 1991) for a summary of other
    implications of the Sah and Stiglitzs framework

14
The Role of TMT Heterogeneity
  • Management literature has also argued for need to
    have diverse top management team in some
    circumstances
  • Focus on demographic heterogeneity, i.e.
    dispersion in age, tenure, educational and
    functional background
  • Basic idea
  • Firms in complex and unstable environments
    require more diverse TMT
  • Benefits of broader range of skills, diverse
    interpretations, more debate and questioning,
    i.e. promotion of disagreement
  • In simpler environments heterogeneity may be
    dysfunctional because it promotes conflict and
    hinders communication
  • This idea might already be in the SS model
  • Complex environments might be those where CEO
    is more likely to make mistakes, and where cost
    of type II errors is high
  • But I think they are talking about real exchange
    of information

15
The Role of Group Interaction
  • Decision-making group in Sah and Stiglitz is not
    a truly interacting group
  • Nothing is really exchanged, or at least the
    exchange of information is not modeled
  • TMT heterogeneity idea suggests that group
    members with diverse perspectives can influence
    each other and mitigate all types of individual
    biases
  • In this case a complex environment can simply
    be one where fallibility is more important
  • Large social psychology literature characterizing
    exchange of information in groups, and processes
    by which group members adjust priors following
    group discussion
  • Groupthink (Janis, 1972)
  • Group polarization (Moscovici and Zavalloni, 1969)

16
Groupthink
  • ...dysfunctional mode of group decision-making
    characterized by a relentless striving for
    unanimity, resulting in a reduction in
    independent critical thinking (Forbes and
    Milliken, 1999)
  • Fewer options are considered in the discussion
    preceding a decision because members seek
    concurrence (they dislike disagreement)
  • In the model, manager M says that she always
    agrees with the CEO even when she does not
  • Groupthink reduces benefit of decentralization
    when it is optimal
  • Janis (1972) used this notion to try to
    understand some famous policy fiascoes such as
    invasion of Bay of Pigs by US in 1961 (a perfect
    failure)
  • GT could be important in TMTs, but I am unaware
    of any empirical work exploring that

17
Group Polarization
  • Tendency for group judgment to deviate
    significantly from average of the pre-discussion
    individual judgements, in the direction of higher
    extremity
  • Extremity of a judgment is a measure of its
    deviation from some neutral point in a scale,
    such as not agreeing nor disagreeing with a
    particular statement
  • Evidence that group consensus is more distant
    from the neutral point of the scale than the
    preconsensus mean
  • Individuals seem to change their priors in the
    direction of higher extremity
  • Unlike GT, it is unclear whether this is a bad
    thing
  • Experimental evidence based on laboratory
    experiments with college students in artificial
    contexts - unclear whether this is relevant for
    top executives

18
Economics Literature on Communication and
Exchange of Information
  • In my view, what is missing from the SS model is
    an explicit modeling of communication and
    exchange of information among group members
  • Effectiveness of communication will affect
    optimal structure of decision-making
  • Model could use some of the management and social
    psychology ideas that I presented for motivation
  • Economics literature on communication
  • Radner (1992), Bolton and Dewatripont (1994) -
    not very relevant for problems proposed here (I
    think). More about how to process a given batch
    of information in the fastest and cheapest way,
    than about minimizing costs of decision-making
    errors
  • Krishna and Morgan (2001), Dessein (2002), Harris
    and Raviv (2002) - focus on quality of decision
    and allocation of decision-making authority under
    cheap talk

19
Cheap Talk Models
  • Models based on Crawford and Sobel (1982)
  • Strategic communication of information by an
    expert to a decision-maker
  • Decision-maker makes decision that affects
    utility of both, but the expert has a taste for
    size (empire builder)
  • This agency problem prevents full communication
    and decreases quality of decision
  • Krishna and Morgan (2001) consider multiple
    biased experts
  • Dessein (2002) considers possibility of
    delegating decision to expert (this turns out to
    be always better than communicating information
    to top level decision-maker)
  • Harris and Raviv (2002) consider possibility that
    top level decision-maker also has private
    information

20
Cheap Talk Models and Top Management Teams
  • These papers are more about structure of
    hierarchies, than about distribution of
    decision-making power in a given level of the
    hierarchy
  • Usually agent (division manager) has more
    information (with the exception of Harris and
    Raviv) but is biased towards larger investments
  • In the TMT
  • CEO also has information (perhaps he has the best
    information)
  • If there are agency problems these should be
    similar for all top managers
  • Still, it is possible that managers behave
    strategically when they have biased opinions (if
    they are aware of other peoples biases)
  • i.e, they might exaggerate opinions when they
    interact in a group (group polarization?)

21
The Role of Boards
  • The established view in corporate finance
  • Boards are an economic institution that in
    theory helps to solve the agency problems
    inherent in managing an organization (Hermalin
    and Weisbachs survey, 2002)
  • Problems
  • Weak link between board structure and performance
    (i.e. insiders vs. outsiders, CEO Chairman not
    robustly related to performance)
  • Board composition seems inconsistent with pure
    agency view
  • CEOs make up largest single slice of outside
    directors among the SP500 (20)
  • Very few institutional investors, or other direct
    representatives of SH
  • SH have very little influence over who fills
    board seats

22
What do Boards Really Do?
  • The cynical view - nothing
  • Boards dont matter because they are captured by
    the CEO
  • Boards are just a product of regulation
  • Outside directors are carefully chosen so as to
    be overcommited (thus CEOs)
  • Is there an alternative view?
  • Perhaps boards are an additional tool to help
    the CEOs decision-making - a supra top
    management team (FH, 1996)
  • Example of an active board doing more than just
    monitoring on behalf of SH
  • HPs board after Fiorina took over (Anders, 2003)

23
Ideas From Management Literature (FH, 1996)
  • External and internal roles for board
  • external linking organization to critical
    resources/information that reside in the outside
    environment
  • internal setting strategy and monitoring
    management
  • Limited empirical evidence that boards are
    systematically involved in setting strategy, and
    conditions that make this more/less likely
  • Boards more likely to be advising/evaluating than
    forming strategy
  • Top managers more likely to have influence on
    CEO, and thus literature has focused more on them

24
Interactions Between Monitoring and Advising
  • Key difference between boards and other top
    managers is that boards have (formal) authority
    over CEO and other managers
  • Boards can fire CEO/other top managers
  • Hiring/firing might be the key monitoring role of
    board
  • Interesting effects to model - complementarities
    and trade-offs between monitoring (firing/hiring)
    and advising (direct participation in decision
    making) by the board
  • Such a model might help uncover roles that are
    particular to corporate boards

25
Adams and Ferreira (2003)
  • Key idea information between CEO and board flows
    both ways
  • Board needs information from CEO to perform
    advising role. Advising is a suggestion to accept
    or reject a project (like in SS)
  • But information provided by the CEO also allows
    board to update prior about CEOs ability
  • CEO cares about being fired and thus may not
    provide information if board uses the information
    to update
  • Main result is that board may commit not to
    monitor in order to encourage the CEO to share
    information
  • A theory of friendly boards. In equilibrium
    boards may participate in decision-making but not
    monitor much

26
Some Ideas for Behavioral Corporate Finance
  • Behavioral corporate finance is about the impact
    of managerial biases on firm policies and
    performance (i.e., Malmendier and Tate, 2001)
  • Managerial discretion idea (FH, 1996)
  • ...discretion attenuates the relationship
    between executive characteristics (values,
    experiences and so on) and organizational
    outcomes. Namely, if high discretion exists,
    executive orientations become reflected in
    organizational outcomes if low discretion
    exists, they do not.
  • Discretion is related to
  • Distribution of power in the TMT, and between the
    TMT and the board
  • Environmental factors such as industry and
    financial slack

27
Power Levers Up Overconfidence
  • In the SS model, we can represent an
    overconfident (or more precisely, an optimist)
    CEO as one who holds a stronger belief that the
    project is good
  • Optimist CEO judges a good project to be good
    with probability qG gt pGCEO, and he judges a bad
    project to be good with probability qB gt pBCEO
  • The optimist CEO will clearly overinvest relative
    to the rational CEO (Malmendier and Tate)
  • However, tendency to overinvest will also depend
    on the distribution of power in the TMT
  • Optimist deciding alone invests with probability
    ?qG (1 - ?) qB x
  • Optimist deciding in group invests with prob. ?qG
    pGM (1 - ?)qB pBM lt x

28
Optimal Bias and Centralization
  • It might be optimal to have an optimist CEO
  • Even in basic SS model, rational CEO makes more
    type I errors (rejects good projects more often)
  • Optimality of bias even more likely if we
    introduce motivating effects of optimism
    (vision), as in Rotemberg and Saloner (2000) and
    Van den Steen (2001)
  • If it is optimal to have a visionary CEO it might
    also be optimal to centralize top-level decision
    making (within TMT, and perhaps also weak boards)
  • No dilution of vision with decentralized
    decision-making
  • Example CEO Chairman is required to ensure
    existence of illusion of strong leadership in a
    firm (Finkelstein and DAveni, 1994)

29
Empirical Measures of CEO Power and Discretion
  • It is possible to construct proxies for the
    distribution of power in the TMT, and between TMT
    and boards (Adams et al. 2002, Haleblian and
    Finkelstein, 1993)
  • Formal titles of CEO (President, Chairman, etc.)
  • Founder status
  • TMT executives membership on the board
  • Number of boards where executive is member
  • Compensation ratios in the TMT
  • It is also possible to construct environmental
    measures of managerial discretion based on
    industry (Adams et al, 2002, Hambrick and
    Abrahamson, 1995)
  • These measures can help sharpen tests of
    behavioral hypotheses!

30
Managers and Markets
  • Compared to top managers and boards, outside
    investors are farther away from corporate
    decision-making
  • And boards do not seem to represent their
    interests that much
  • Still, outside investors will have their own
    opinions about optimal actions and consequences
    of actions taken by management
  • Ex HP Compaq merger

31
Disagreement Between Managers and Markets
  • What is the nature of this disagreement?
  • Allen (1993) because many investors are
    computing values, on average mistakes cancel out
    and markets end up more precise than managers
  • Allen and Gale (1999) markets may allow for
    matching between opinions of investors and
    managers
  • Behavioral finance sometimes assumes that markets
    are right and managers are biased (i.e.
    Malmendier and Tate), sometimes that managers are
    right and markets are wrong (i.e. Baker and
    Wurgler)
  • Given possibility of disagreement, question is
    when will outside investors have discretion to
    influence firm policies

32
Disagreement and Financial Policy
  • The most obvious effect
  • Outside investors will have more discretion when
    firms need to raise funds
  • One of the primary purposes of corporate
    financial policies might be to determine the
    extent to which firms (managers) can rely on
    their own perception of the world (Allen, 1993)
  • Theories based on disagreement and discretion
    might help explain some of the main facts of
    corporate finance
  • Firms dislike external finance
  • Financial slack matters for investment and
    financial policies

33
Why not Focus on Cash Policy ?
  • There are already some papers relating
    disagreement and discretion (flexibility) to
    financial policy
  • i.e., Boot and Thakor, 2002
  • Focus is on effects of disagreement and
    flexibility on optimal security design and
    issuance
  • This might be a secondary concern cash (internal
    finance) gives you maximum flexibility. The main
    issue might be how to avoid raising external
    finance
  • A framework to think about optimal cash policies
    Almeida et al, 2003
  • The empirical challenge will be how to
    differentiate such a theory from existing
    arguments
  • Financial constraints, agency

34
Conclusions
  • Behavioral theory of senior leadership should
    incorporate role of other constituencies that
    might have discretion to influence top-level
    decision making
  • Top management teams, boards and markets
  • Questions
  • When do they have discretion?
  • What is the optimal level of discretion?
  • What is their effect on the quality of corporate
    decisions and corporate performance?
  • These research questions might generate insights
    about important unsolved issues in corporate
    finance, such as the role of boards and optimal
    financial policy
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