AGENCY THEORY

Aakanksha Vats (061)

Hriniya Bose (107)
Balaji.S (148)
What is Agency theory?
Agency theory (financial theory) is concerned with resolving
problems that can exist in agency relationships; that is,
between principals (such as shareholders) and agents of the
principals (for example, company executives).

The theory attempts to deal with two specific problems:

How to align the goals of the principal so that they are not in
conflict (agency problem), and

that the principal and agent reconcile different tolerances for risk.


Origins Of agency Theory:
During the 1960s & 1970s , economists explored risk sharing among
individuals or groups. The literature described the risk sharing
problem as one that arises when co-operating parties have different
attitudes toward risks.

Agency Theory broadened this risk sharing literature to include the
agency problem that occurs when co-operating parties have different
goals and division of labor.

Specifically, this theory is directed at the ubiquitous agency
relationship ,in which one party delegates work to another agent who
performs that work.
Agency Theory attempts to describe this relation using the metaphor
of a contract. Agency Theory suggests that the firm can be viewed as
a nexus of contracts (loosely defined) between resource holders.

CONFLICTS BETWEEN MANAGERS & SHAREHOLDERS


The agency theory, considering the potential conflicts of interest
between shareholders and management may arise as a result of
several factors:

Reward to management
Risk attitudes of management and shareholders
Takeover decisions by management
Time horizon of management
SELF-INTERESTED BEHAVIOR

Agency theory suggests that, in imperfect labour and capital
markets, managers will seek to maximize their own utility at the
expense of corporate shareholders.

The interest of shareholders may include:

Increasing earning per share (EPS), and current share prices
Increasing investor ratios such as dividend per share (DPS), dividend cover, dividend yield,
price-earning (P/E) ratio
Others may include the company improving its corporate and social responsibilities

Management interest may include:

Managing the firm to achieve its objectives
Increasing the wealth and size of the company, by expanding the companys activities, the
bigger the size of the company they manage the better they are perceived to be.
Increasing their personal wealth by paying themselves high remunerations and other benefits




COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT

Agency costs are defined as those costs borne by shareholders to encourage
managers to maximize shareholder wealth rather than behave in their own self-
interests.

There are three major types of agency costs:

(1) expenditures to monitor managerial activities, such as audit costs;

(2) expenditures to structure the organization in a way that will limit undesirable
managerial behaviour, such as appointing outside members to the board of directors or
restructuring the company's business units and management hierarchy; and

(3) opportunity costs which are incurred when shareholder-imposed restrictions, such
as requirements for shareholder votes on specific issues, limit the ability of managers
to take actions that advance shareholder wealth.
MECHANISMS FOR DEALING WITH SHAREHOLDER-MANAGER
CONFLICTS

There are two polar positions for dealing with shareholder-manager agency conflicts.

At one extreme, the firm's managers are compensated entirely on the basis of stock price changes.
In this case, agency costs will be low because managers have great incentives to maximize
shareholder wealth. It would be extremely difficult, however, to hire talented managers under these
contractual terms because the firm's earnings would be affected by economic events that are not
under managerial control.

At the other extreme, stockholders could monitor every managerial action, but this would be
extremely costly and inefficient.

The optimal solution lies between the extremes, where executive compensation is tied to
performance, but some monitoring is also undertaken. In addition to monitoring, the following
mechanisms encourage managers to act in shareholders' interests:

(1) performance-based incentive plans,
(2) direct intervention by shareholders,
(3) the threat of firing, and
(4) the threat of takeover.
Agency theory & Management Compensation
Agency theory states that by linking managers compensation
to firm performance and owners ROI, managers will be less
likely to engage in a behavior that is in conflict with
stakeholders interests.
It assigns executive compensation a disciplinary role in the
relationship between top managers and stockholders by
adding strategic component to the motivational role of
executive compensation.
Executive compensation in the form of fixed salary promotes
managerial opportunism, whereas equity ownership promotes
managers compliance with stockholders interests.
Empirical evidence on the effect of compensation on
managers behavior and firms performance is inconclusive.

Executive Compensation
Principal mechanism in alleviating the agency problem between the
managers and stockholders.

Market based compensation schemes (ie, plans that tie
executives income to market value of the firm) are more effective in
aligning managers behavior with stockholders interests than fixed
salaries or accounting based bonus plans.[Fama & Jensen, 1983; Lambert &
Larcker,1985]

Executives with fixed salaries lack incentive to promote in firms
performance because they do not share in the resulting gains in firm
value.
Leads them to behave in opportunistically and inefficiently through risk
aversion and short term orientation in investments.
Decline in firm performance would not affect the fixed income of executives

Executive Compensation
In contrast, where in addition to salary executives are
provided with equity, stock options, promote managers
identification with stockholders interests.
Through equity ownership, executives share both the
gains and the risks of the organizations performance with
the shareholders.
Here management has a direct interest in making
decisions which promote firms value and protect
stockholders rights.
Executives who receive large portion of their
compensation in equity are less likely to engage in
opportunistic behavior than those who dont. [Source: Kosnik-
Agency theory and the motivational effect of management compensation]

Critique of the theory
Donaldson (1990) criticized the agency theory dominance
in terms of methodology individualism, narrow-defined
motivation model, regressive simplification, disregarding
other research, ideological framework, organizational
economics and corporate governance's defensiveness.
Focus of agency theory's studies is individual consistent
with rational, economic model of human behavior
Agency theory's predictive strength lies in description of
the situations where parties act rationally, focusing on
their personal interest, with risk aversion or unbiased
towards risk.


Critique of the theory
Analysing phenomena only within agency theory framework
may result in:
1) disregarding of principal's obligation towards agent;
2) ignoring distrust development and disrespect of agents;
3) neglecting ethical aspects and
4) overlooking of prospective solutions consistent with ethical norms.

From corporate governance perspective, successful resolution
of agency problem significantly reduces potential and validity of
agency theory in analysis of governing relations, leaving
opportunity for application of stewardship theory and other
organizational theories.



Industry Insights
Goldman Sachs
Principal Paulson & Co, IKB
Agent Goldman Sachs

In 2006 they entered into a deal.
IKB suffered losses of $150 million
SEC alleged that Goldman made materially misleading
statements and omissions.
In 2010 Goldman was fined $550 million

Analysis according to Agency Theory
1. Conflicts of Interest
Serving two clients on the opposite sides of the same
deal
Serving two clients and the institution itself in the same
deal

2. Truth Telling and Transparency
CITI Group
Principal Shareholders
Agent CITI group management

In 2012 55% of shareholders voted against CITI CEO
Vikram Pandits new compensation plan as part of SECs
say-on pay rule.
Analysis according to Agency Theory
According to Agency Theory, managers will always work
according to their own self interest.

CITI shares had underperformed the previous year.
Thank You