Why can’t CEOs foresee a crisis?∗

This paper explains why CEOs are unable to curtail risky investments before a crisis. CEOs rely on the advice of their employees to understand the riskiness of their investments. When employees observe noisy signals, they may be reluctant to disclose their information for the fear of getting fired. So, the CEO needs to offer contracts which provide incentive to disclose their information. The paper shows that in presence of moral hazard with respect to effort, it may not be possible to offer contracts which also incentivizes disclosure. Even when CEOs are able to offer such contracts, there will be a coordination problem in disclosure of information. These frictions are accentuated when the prior beliefs about an investment strategy being good is high. If the task of disclosing signals is separated and assigned to a risk manager who receives signals of same quality, it can result in more efficient outcomes.