Corporate Governance

- Agency Theory-

Beyza Oba
Spring 2004
 Corporate governance; an old problem a
new solution
“the owner of a business, when contemplating any change, is led by his own interest to weigh the
whole gain ..against the whole lost. But the privete interest of the salaried manager, or offical,
often draws him in another direction: the path of least resistance, of greater comfort and least risk
to himself, is generally that of not striving very energetically for improvement; and of finding
plausible excuses for not trying an improvement suggested by others, until its success is
established beyond question” (Alfred Marshall, 1920)

Seperation of ownership and control in joint-stock company (Berle and Means 1932)
allows the firm’s behaviour to diverge from the profit maximizing, cost minimizing
ideal
The principal problem rests in the abuse of power by corporate elites; status quo leaves
excess power in the hands of senior management, some of whom abuse this in the
service of their own interest (Hutton, 1995), the result is damaging for shareholders

Corporate governance includes “the structures, process, cultures and systems that
engender the successfull operation of organisations ” (Keasey and Wright 1993) and
mechanisms to cope with these elements

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 Agency Theory

Assumptions:
 Bounded rationality
 Opportunism
 Information asymmetry

AT focuses on the relationship and goal incongruance between

managers and stockholders

Agency relationships occur when one partner in a transaction (the

principal) delegates authority to another (the agent) and the
welfare of the principal is affected by the choices of the agent

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 Agency Theory

The delegation of decision-making authority from principal

to agent is problematic in that;
1. The interests of principal and agent will diverge
2. The principal cannot perfectly and costlessly monitor
the actions of the agent
3. The principal cannot perfectly and costlessly monitor
and acquire the information available to or possesed
by the agent

These constitute the agency problem - the possibility of

opportunistic behaviour on the part of the agent that
works against the welfare of the principal

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 Agency costs
Agency costs; incur to protect principal’s interests and to reduce the possibility
that agents will misbehave
 Monitoring expenditures by principals
 Bonding expenditures by agents
 Residual loss of the principal

Essential sources of agency problems:

Moral hazard; more of the agent’s actions are hidden from the principal or are
costly to observe

Adverse selection; the agent posseses information that is, for the principal
unobservable or costly to obtain

Risk aversion; as organisations grow managers become risk averse

(they would like to protect their position, managers would like to
max. chance of success by projects that have already brought success,
managers build structures to increase their chances of control)

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 Resolving agency problems

Principals and agents resolve agency problems through;

 Monitoring; observing the behaviour and performance
of agents

 Bonding; arrangements that penalise agents for acting

in ways that violate the interests of principals or reward
them for achieving principal’s goals

Contracts between agents and principals specify the

monitoring and bonding arrangements

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 Why do principals delegate authority to
agents?
 Size

 Simplicity of business operations (conceiving

opportunity, funding, making and implementing
decisions)

 Decision making situation can overhelm the cognitive

capacity of a single individual, decison quality can be
impreoved by assigning different parts of the decion to
different individuals

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 What monitoring mechanisms can
principals put to minimize agency costs?
Owners seek maximum effort from employees at minimal cost while employees seek to
minimise effort and maximise remuneration (i.e. pay and benefits)

Monitoring mechanisms;
A) Contracts

 Principals can monitor agents by collecting information about their behaviour

(decisions and actions)
behavioural contracts; specify the activities workers should engage in
e.g. institutional investors monitor the decisions of of senior managers, board of directors
monitor top management...

 Principals can monitor consequences of (only partially obseved) agent behaviour

outcome based contracts; compensation, rewards, piece rate production,
commissions..

When tasks are not highly programmable monitoring performance (output) is more
efficient
Performance monitoring is problematic in relation to teams, free rider problems

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 What monitoring mechanisms can
principals put to minimize agency costs?
B) Board of directors
board is charged with fiduciary responsibility (i.e. legal trustee) of
safeguarding the stockholder’s investment
Inside and outside board members

The outside board membersprovide objectivity as the board ratifies and

monitors the decisions of managers

responsibilities of the board of directors;

 establish policies and objectives for the firm
 elect, monitor, evaluate and compensate top managers
 monitor, approve the financial condition of the firm
 ensure that regulations are enforced

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 What specific bonding mechanisms can
agents use to reassure principals?
Principals have an incentive to monitor agents
Agents also have an incentive to assure principals that they are behaving
in ways consistent with the principal’s interests

Bonding mechanisms take the form of incentives that agents create for
themselves
Incentive mechanisms should address “participation” and “incentive
compatibility”, i.e. agents must be induced both to engage in the contract
and once engaged to invest effort in those areas which benefit the
principal
Incentive bondings
1. Compensation package of agents; profit related bonuses, executive
share option..
2. Promotions or other forms of recognition which may enhance their
reputations and probability of increased future income

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 The role of market discipline
 Managerial labour market views the previous associations of managers
with success and failure as information about their talents
Managers of failing firms may not see a reduction in wages , but will be
disciplines as the managerial labour market attaches less value to their
services
Managers in more sucessful markets may not receive any immediate gain in
wages but the success of their firm may increase their value in
managerial labour market
 Capital market and corporate control
If managers (agents) of a firm take actions that are viewed by the market as
adversly affecting the value of the firm’s assets, then the price of the
assets (i.e. stock price) will likely to drop. Managers in other firms,
beleiving that they can profitably manage the assets of the failing firm,
may be engaged in a takeover battle. The managers of the troubled firm
will loose control of their firm and old high agency cost managers will be
replaced by low (?) agency cost managers

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