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Agency Problem and the Role of Corporate Governance

Agency Problem and the Role of Corporate Governance

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Published by Ian Try Putranto

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Published by: Ian Try Putranto on Jul 07, 2010
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12/07/2013

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Electronic copy available at: http://ssrn.com/abstract=1287185
Electronic copy available at: http://ssrn.com/abstract=1287185
1
Agency Problem and the Role of Corporate Governance Revisited
 
Pallab Kumar Biswas
 
 Abstract:
This paper is an attempt to identify various agency relationships that exist inthe economic and business life and the related problems that often arise due to suchrelationships. It also identifies the role of various corporate governance mechanisms inmitigating the agency problems. Though no individual corporate governance mechanismis a perfect one, a careful selection of individual and/or combination of these is likely to serve a better purpose when factors like level of capital market development, legal systemof a country are simultaneously considered.
  Keywords:
 Agency problem, Information Asymmetry, Corporate Governance.
 
Introduction
Since its development during the period of industrial revolution, large scale businessescontinue to bring significant changes in financing, ownership and management patterns. New technologies are continually innovated requiring huge investment in the industrialunit. To supply this fund, people from different sections of the society are coming upwith their savings. As a result, once a sole proprietorship business is turned into jointstock type of organization (Khan, Siddiqui and Hossain, 2004). In such a widely-heldcorporation, the risk bearing function of ownership and the managerial function of control are separate functions performed by different parties. These parties often poseconflicting nature of interests. For example, as Prowse (1999, pp. 115-116) argues,
…shareholders’ preferences are to maximize the value of the firm’s equity,without regard for the value of its debt. Creditors, on the other hand, prefer tomaximize the probability that they will be repaid, which often means the firmtaking on less risky projects than the shareholders would prefer to have.Managers prefer to engage in activities that maximize their own return rather than that of outside financiers: this can vary from policies that justify paying them a higher salary (for example, by increasing the size of the firm), to thediversion of resources for their personal benefit, to simply refusing to give up
A previous version of this paper is available at http://papers.ssrn.com/abstract=1250842.
Pallab Kumar Biswas is a Ph.D. candidate at the University of Western Australia, Perth.
 
Electronic copy available at: http://ssrn.com/abstract=1287185
Electronic copy available at: http://ssrn.com/abstract=1287185
2
their jobs in the face of poor performance. Even different shareholders may havedifferent objectives. In particular, large shareholders that have a controlling interest in the firm (“insiders”) would prefer, if they could, to increase their returns at the expense of smaller, minority shareholders (“outsiders”).
This causes the classic principal-agent problem between owners and managers wheregiven the decision making discretion, managers could engage in non-value maximizing behaviour (Habib, 2004). This “agency problem” inherent in the separation of ownershipand control of assets was recognized as far back as in the 18th century by Adam Smith inhis
Wealth of Nations
1
, and studies such as those by Berle and Means (1934)
2
and Lorschand MacIver (1989) show the extent to which this separation has become manifest infirms throughout the world.
 
Substantial costs result from such divergence of interestsamong different parties. Corporate governance is considered as an effective mechanismof reducing these costs. In this article, attempts have been made to find the role of corporate governance mechanisms in mitigating agency problems. It is organized asfollows. Different agency relationships and related costs are discussed in section twofollowed by a discussion of specific nature of agency problem in developing countries insection three. Following literature, corporate governance have been defined in sectionfour. Section five discusses the roles of individual governance mechanism in mitigatingagency conflicts. Discussion on the effectiveness of corporate governance mechanismshas been made in section six. Section seven concludes the paper.
1
 
In the eighteenth century, Adam smith (1776) drew attention in
the Wealth of Nations
to an importantgovernance issue in his commentary on joint stock companies :
The directors of such companies however being the managers rather of other people’smoney than of their own, it cannot well expected that they should watch over it with the same anxious vigilance which the partners in private copartnery frequently watch over their own … Negligence and profusion, therefore, must always prevail, more or less; inthe management of the affairs of such a company (vide Jensen and Meckling, 1976).
2
Their thesis was that the separation of ownership from management had resulted in shareholdings beingunable to exercise any form of effective control over board of directors, who were theoretically appointed by them to represent their interests.
 
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Agency Relationship and Agency Costs
Agency theory is concerned with contractual relationship between two or more persons.Jensen and Meckling (1976, p. 308) define agency relationship as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision makingauthority to the agent.” Under this agency relationship, both the agents and the principalsare assumed to be motivated solely by self-interest. As a result, when principals delegatessome decision making responsibility to the agents, agents often use this power to promotetheir own well-being by choosing such actions which may or may not in the best interestsof principals (Barnea, Haugen and Senbet, 1985; Bromwich, 1992; Chowdhury, 2004). Inagency relationship, the principals and agents are also assumed to be rational economic persons who are capable of forming unbiased expectations regarding the impact of agency problems together with the associated future value of their wealth (Barnea et al.,1985).
3
Such agency relationships are common everywhere in economic and business lifeand are an element of the more general problem of contracting between entities in theeconomy (Bromwich, 1992). For example, in the context of public corporation, there arecontractual relationships between the shareholders and the board of directors, between the board of directors and the executives, and between the executives and their subordinates.In the above mentioned relationships, the former can be called the principal(s) and thelatter can be called the agent(s). The main reasons behind the relationship, as prior literature suggests and Bromwich (1992) identifies, include: (i) to take advantage of economies of scale and scope; (ii) to exploit any asset specific advantage; (iii) to providean ability to improve on the contracts otherwise available; (iv) to allow the advantage of transaction cost avoidance and (v) to maintain authority relationships including verticalintegration.
3
In the words of Barnea et al. (1985, p. 26), “rationality implies that every individual recognizes the self-interest motivations of all others so that future decisions by agents based on their interests are anticipatedand taken into account by principals”.

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