Agency Theory in Corporate Governance

Written by walter johnson
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Agency theory relative to corporate governance assumes a two-tier form of firm control: managers and owners. Agency theory holds that there will be some friction and mistrust between these two groups. The basic structure of the corporation, therefore, is the web of contractual relations among different interest groups with a stake in the company.

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Features

In general, there are three sets of interest groups within the firm. Managers, stockholders and creditors (such as banks). Stockholders often have conflicts with both banks and managers, since their general priorities are different. Managers seek quick profits that increase their own wealth, power and reputation, while shareholders are more interested in slow and steady growth over time.

Function

The purpose of agency theory is to identify points of conflict among corporate interest groups. Banks want to reduce risk while shareholders want to reasonably maximise profits. Managers are even more risky with profit maximisation, since their own careers are based on the ability to turn profits to then show the board. The fact that modern corporations are based on these relations creates costs in that each group is trying to control the others.

Costs

One of the major insights of agency theory is the concept of costs of maintaining the division of labour among credit holders, shareholders and managers. Managers have the advantage of information, since they know the firm close up. They can use this to enhance their own reputations at the expense of shareholders. Limiting the control of managers itself contains costs (such as reduced profits), while profit seeking in risky ventures might alienate banks and other financial institutions. Monitoring and limiting managers itself contains sometimes substantial costs to the firm.

Significance

The agency model of corporate governance holds that firms are basically units of conflict rather than unitary, profit-seeking machines. This conflict is not aberrant but built directly into the structure of modern corporations.

Effects

It is possible, if one accepts the premises of agency theory, that corporations are actually groups of connected fiefs. Each fief has its own specific interest and culture and views the purpose of the firm differently. In analysing the function of a corporation, one can assume that managers will behave in a way to maximise their own profit and reputation, even at the expense of shareholders. One might even understand the manager's role as one of institutionalised deceit, where the asymmetry of knowledge permits managers to operate with almost total independence.

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