AGENCY THEORY

AGENCY - a business or organization established to provide a particular service, typically one that
involves organizing transactions between two other parties.

Why is agency important?

In today's organizations, agency can stand out as a cornerstone for driving innovation, decision-
making, and problem-solving. Agency, is like when team members are empowered to make decisions
and take action that results in positive outcomes

What is the agency theory

Agency theory is defined as the relationships between principals, such as shareholders, and agents, such
as corporate executives and managers. The shareholders, who represent the owners or principals of the
business, are said to employ the agents to carry out tasks. Directors or managers, are the shareholders’
agents and are given authority by principals to manage the company. According to the agency theory,
shareholders expect agents to act and make decisions in the best interests of the principal. On the
contrary, the agent may not always act in the best interests of the principals. In the 18th century, Adam
Smith identified such a problem, and Jensen and Meckling presented the first detailed description of
agency theory in 1976.

Features of agency theory

Agency theory is a popular theoretical framework in corporate governance. Its popularity stems from
two features.

 Firstly, it is straightforward because it divides large corporations into managers and

There are generally three sets of interest groups within the company: directors, shareholders, and
creditors (such as banks). Since banks and managers have different overall priorities, stockholders
frequently disagree with both of them. Shareholders are more interested in slow and steady growth
over time, whereas managers look for quick profits that increase their own wealth, power, and
reputation.

Purpose of agency theory

The purpose of agency theory is to highlight areas where corporate interest groups are in conflict. Banks
want to reduce risk, whereas shareholders want to make the most money possible. The ability of
managers to turn profits and then impress the board is what makes them even riskier when it comes to
maximising profits. There are costs involved with each group trying to control the others because
modern corporations are established on these relationships.

Agency Theory

Agency theory is a branch of economic theory that examines the relationship between principals (such
as shareholders) and agents (such as managers) in organizations. The theory seeks to explain how these
two groups can align their interests and work towards a common goal, despite the fact that they may
have different objectives and face different risks.

Agency theory examines the relationship between the agents and principals in the business. In an
agency relationship, two parties exist – the agent and principal, whereby the former acts and takes
decisions on behalf of the latter.

The theory revolves around the relationship between the two and the issues that may surface due to
different risk perspectives and business goals. In finance, the most talked-about agency relationship
exists between shareholders and executives of a corporation where the top brass is elected to act in the
interest of the company’s true owners.

Agency Theory in Corporate Governance

Agency theory in corporate governance relates to a specific type of agency relationship that exists
between the shareholders and directors/management of a company.

The shareholders, true owners of the corporation, as principals, elect the executives to act and take
decisions on their behalf. The aim is to represent the views of the owners and conduct operations in
their interest. Despite this clear rationale for electing the board of directors, there are a lot of instances
when complicated issues come up and the executives, knowingly or unknowingly, take decisions that do
not reflect shareholders’ best interest.

In the dynamic business environment, the agency theory of corporate governance has garnered much
attention and is seen and evaluated from different points of view.

Importance of Agency Theory

Agency theory remains a valuable tool for understanding the complex relationships between
shareholders and managers, and how these relationships can impact organizational performance, but it
should be complemented with other theories or frameworks to overcome its limitations.

 Different Risk Appetite

One of the major reasons for such strife is the levels of risk appetite each is willing to undertake.
Shareholders are mostly not involved in the day-to-day working of the company and hence are not fully
equipped to understand the rationale behind critical business decisions. On the contrary, managers are
more far-sighted and have a far greater risk appetite due to their close access to the relevant
information. They believe in the going concern concept of accounting, and most of their decisions are
taken keeping the long-term view of the company in mind. While the shareholders are keen to increase
the current and future value of their holdings, the executives are more interested in the company’s long-
term growth. Thus, the differences in their approach create a feeling of distrust and disharmony.

 Super Self Centered Executives

The situation could be exactly the opposite also when the managers have an interest in showing short-
term performance to the owners to get their pay hikes. This is a more prevalent and more dangerous
situation.

Agency problems/conflicts

 Moral hazard

The prospect that a party insulated from risk may behave differently from the way it would behave if it
were fully exposed to the risk. A manager has an interest in receiving benefits from his or her position as
a manager. These include all the benefits that come from status, such as a company car, a private
chauffeur etc.

 Risk aversion

The company for which executive directors and senior managers work typically provides the majority of
their income. As a result, they are concerned about the company’s stability because it will protect their
job and future earnings. This suggests that management might be risk-averse and reluctant to fund
more risky projects. Shareholders, on the other hand, may want a company to take bigger risks if the
expected returns are sufficiently high. It matters less to shareholders if one company takes risks because
they frequently invest in a portfolio of various businesses.

 Time horizon

Shareholders are concerned about their company’s long-term financial prospects because the value of
their shares is based on long-term expectations. On the other hand, managers might only have short-
term concerns. This is because they might only expect to work for the company for a short period of
time and because they might receive annual bonuses based on short-term performance. Managers may
thus be motivated to increase the accounting return on capital employed (or return on investment),
whereas shareholders are more concerned with long-term value as measured by net present value.

 Effort level

It’s possible that managers put in less effort than they would if they were the company’s owners. This
“lack of effort” could lead to lower earnings and a lower stock price. Both the middle and upper levels of
management in a large corporation will be affected by the issue. Managers’ interests and senior
managers’ interests may diverge, particularly if senior managers receive pay incentives to boost profits
while managers do not.

 Earnings retention
The size of the company, not its profits, is frequently a determining factor in how much directors and
senior managers are paid. Instead of increasing shareholder returns, this gives managers an incentive to
expand the business by raising sales and assets. Instead of paying out dividends, management is more
inclined to want to reinvest earnings in the business to expand it. When this happens, businesses might
make investments in capital projects with low expected profitability and a negative net present value.

Reducing the agency problem

Certain measures and principles can be followed by both the principal and the agent to reduce the
likelihood of conflict. They are mentioned below.

 Full transparency

When there is limited knowledge between the agent and the principal, agency problems are most
frequent. The agent has far too much opportunity and too much temptation to use the knowledge gap
for their own gain. When agent-principal relationships arise in business, full transparency can aid in
closing the knowledge gap and preventing the agency problem from arising.

 Restrictions on the agent’s capabilities

Giving the agent excessive authority to act on your behalf invites future issues and could influence the
financial advisor to make poor decisions. Most successful governments use checks and balances because
it limits the power of any single individual or entity, reducing corruption. Imposing restrictions is an
effective method of limiting the agent’s power.

 Commission and bonus structures

Relationship conflicts are less likely when incentives and bonuses are introduced and removed. Bonuses
are a great way to encourage an agent and enable them to act in the principal’s best interests in order to
achieve the desired incentive. Contrarily, bonuses may drive an agent to act solely in the interest of their
own financial gain, disregarding the principal’s best interests in the process. Since every principal-agent
relationship is different, it’s essential to choose the right strategies for every circumstance in order to
maintain a decent, healthy relationship.

Criticisms of agency theory

Various authors have criticised agency theory. Numerous authors, in particular, have criticised the
assumptions underlying the standard agency model as too restrictive, that is, not generalizable to the
vast majority of humans but rather specific to a subset of individuals.

1. This theory is one-sided, emphasising economic factors while ignoring (among other things)
political factors, internal government problems, and the roles of other stakeholders.

2. Numerous legal concerns are raised by some authors when presenting shareholder-manager
relationships based on agency theory. For instance, not only shareholders are subject to risk.
 Other parties involved in value creation contribute resources that are essential to the company
and take on the risk associated with its operations.

3. By assuming that people behave opportunistically, some authors contend that agency theory
paints an extremely negative picture of human nature.

4. Several academics are skeptical of the concerns about ownership of a firm. From a legal
standpoint, shareholders own only the shares of a company, and thus they should not be
considered the sole residual claimants.

5. The exclusive rights of shareholders modify the risk taken by various stakeholders, because
managers controlled by shareholders will choose strategies that result in relatively safe financial
returns, even at the expense of a lack of innovative development or ignoring other important
goals for the firm.

From a legal standpoint of shareholders and from the exclusive rights of shareholders.

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Agency Theory

 Focused on the agency relationship, in which one party (the principal) delegates work to another
(the agent), who performs this work.
 Attempts to describe this relationship using the metaphor of a contract.

Concerned with two basic problems:

Agency Problem which arises when:

• The desires or goals of the principal and agent conflict and

• It is difficult or expensive for the principal to verify what the agent is actually doing

The problem here is that the principal cannot verify that the agent has behaved appropriately.

Used to understand relationships whereby a principal (e.g. shareholders) employs the services of an
agent (e.g. executive directors) to perform some activity on their behalf and delegates the decision-
making authority to the agent.

• If the interests of the agent and principal are not aligned, moral hazard can result e.g. managers can
misspend shareholders' funds on areas without maximising shareholders' interest.