You are on page 1of 19

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 in
the economic and business life and the related problems that often arise due to such
relationships. It also identifies the role of various corporate governance mechanisms in
mitigating the agency problems. Though no individual corporate governance mechanism
is 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 system
of a country are simultaneously considered.

Keywords: Agency problem, Information Asymmetry, Corporate Governance.


Since its development during the period of industrial revolution, large scale businesses
continue to bring significant changes in financing, ownership and management patterns.
New technologies are continually innovated requiring huge investment in the industrial
unit. To supply this fund, people from different sections of the society are coming up
with their savings. As a result, once a sole proprietorship business is turned into joint
stock type of organization (Khan, Siddiqui and Hossain, 2004). In such a widely-held
corporation, the risk bearing function of ownership and the managerial function of
control are separate functions performed by different parties. These parties often pose
conflicting 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 to
maximize the probability that they will be repaid, which often means the firm
taking 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 the
diversion of resources for their personal benefit, to simply refusing to give up

A previous version of this paper is available at

Pallab Kumar Biswas is a Ph.D. candidate at the University of Western Australia, Perth.

Electronic copy available at:

their jobs in the face of poor performance. Even different shareholders may have
different 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 where
given the decision making discretion, managers could engage in non-value maximizing
behaviour (Habib, 2004). This “agency problem” inherent in the separation of ownership
and control of assets was recognized as far back as in the 18th century by Adam Smith in
his Wealth of Nations1, and studies such as those by Berle and Means (1934)2 and Lorsch
and MacIver (1989) show the extent to which this separation has become manifest in
firms throughout the world. Substantial costs result from such divergence of interests
among different parties. Corporate governance is considered as an effective mechanism
of 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 as
follows. Different agency relationships and related costs are discussed in section two
followed by a discussion of specific nature of agency problem in developing countries in
section three. Following literature, corporate governance have been defined in section
four. Section five discusses the roles of individual governance mechanism in mitigating
agency conflicts. Discussion on the effectiveness of corporate governance mechanisms
has been made in section six. Section seven concludes the paper.

In the eighteenth century, Adam smith (1776) drew attention in the Wealth of Nations to an important
governance issue in his commentary on joint stock companies :
The directors of such companies however being the managers rather of other people’s
money 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; in
the management of the affairs of such a company (vide Jensen and Meckling, 1976).
Their thesis was that the separation of ownership from management had resulted in shareholdings being
unable to exercise any form of effective control over board of directors, who were theoretically appointed
by them to represent their interests.

Electronic copy available at:

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 making
authority to the agent.” Under this agency relationship, both the agents and the principals
are assumed to be motivated solely by self-interest. As a result, when principals delegates
some decision making responsibility to the agents, agents often use this power to promote
their own well-being by choosing such actions which may or may not in the best interests
of principals (Barnea, Haugen and Senbet, 1985; Bromwich, 1992; Chowdhury, 2004). In
agency 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 life
and are an element of the more general problem of contracting between entities in the
economy (Bromwich, 1992). For example, in the context of public corporation, there are
contractual 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 the
latter 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 provide
an ability to improve on the contracts otherwise available; (iv) to allow the advantage of
transaction cost avoidance and (v) to maintain authority relationships including vertical

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 anticipated
and taken into account by principals”.

The problem in the agency relationship occurs as the agent and the principal may be at
variance with each other, and partial nature of agency contract (due to uncertainty and
asymmetric information) can not fully prevent the participants in the agency relationships
from pursuing their self-interests at the expense of other participants. Chowdhury (2004)
identifies several possible reasons for such variance. These include:
§ Perception of risk: The agent is generally assumed to a risk-averter and the
principal to be a risk-seeker or risk-averter;
§ Extent of Involvement with the organization: The agent might have a shorter
duration with the organization than the principal;
§ Limit of earnings: The agent’s earnings are fixed (in the absence of incentive
payments) while the principal is the residual claimant;
§ Management decision making: The principal does not directly take part in the
management decision-making and control (i.e. ownership is separated from
§ Information asymmetry: Information asymmetry occurs when one party (or
economic ‘agents’) has more or better information than the other party. Usually,
the agent has more information about the state of affairs of the company,
including their own performance, than the principal (Marnet, 2008).

Barnea et al. (1985) discuss five broad classes of agency problems in finance: (a) on the
job perquisite consumption; (b) risk incentive; (c) investment incentive; (d) bankruptcy
costs and (e) information asymmetry. These agency problems are found in a joint-stock
type of organization between shareholders and top management, controlling and minority
shareholders, and shareholders and creditors. Often cited sources of conflicts among
these parties include the externalities arising from asymmetries of information,
differences in attitude towards risk and differences in decision-making rights.

In particular, agency problems between shareholders and management generally arise

from a combination of asymmetric information and differences in sensitivity to firm-

specific risk.4 Conflicts of interest between controlling and minority shareholders may
arise as the controlling shareholders, much like controlling managers, can divert part of
the firm’s resources for their own private benefit at the expense of non-controlling
shareholders.5 In both cases (controlling managers as well as controlling shareholders),
non-controlling shareholders suffer because these decisions reduce the cash flow and
ultimately the value of the firm to them. Finally, the problem arises between creditors and
shareholders because creditors don’t participate in the high profit firms beyond the
contractually agreed debt service, but share in losses in case of insolvency. This
asymmetry creates an incentive, once debt has been incurred, for shareholders to prefer
the firm undertake more risky investment projects than creditors would like.

Bromwich (1992) classifies the nature of problems that may arise between the above
mentioned parties into four categories: (a) Moral hazard with hidden action; (b) Moral
hazard with hidden information; (c) Adverse selection and (d) Signaling models. Moral
hazard with hidden action occurs when the agent can determine to a degree the outcome
by his or her actions, and the other party (the principal) can’t directly observe the agent’s
effort, or perfectly infer it from the firm’s information systems. Moral hazard not only
includes acts like fraud and shirking, but also such actions, like risk-reward tradeoffs in
project selection, which are not in the best interests of the principal (Beaver, 1989). A
classic example of moral hazard can be fire insurance, where the insuree may or may not
exhibit sufficient care while storing flammable materials (Kreps, 1990). In case of
adverse selection, the agent knows something relevant to the transaction with hidden
information which the principal does not know. In such case, the principal can not check
whether this private information has been utilized in his or her best interests. Accounting-

Heinrich (2002) uses the term “sensitivity to firm-specific risk” to refer to the process of decision
marker’s ranking of alternative choices that differ in their riskiness. The ranking depends not only on the
decision maker’s preferences (i.e. how the decision maker’s utility varies with the riskiness of his payoff;
these preferences are immutable), but also on how the decision maker’s payoff varies with the riskiness
of the chosen alternative.
For managers, private benefits may include excessive perquisites, such as corporate jets and lavish
headquarter building, or of self-aggrandizing rules without adding value to shareholders, or of delaying
necessary restructuring decisions to avoid unpleasant confrontations with employees, unions, politicians
and the media. For controlling shareholders, such private benefits may take the form of transfer pricing
through which profits can be transferred to other firms in which the controlling shareholder has a large
cash flow stake or of asset sales at bargain prices to firms owned by the controlling shareholders
(Heinrich, 2002).

oriented example of adverse selection is where firms of auditors offer services of
different quality but those employing auditors can not distinguish such quality
differences. To overcome the problem, audit firms may resort to advertising or to market
signaling, where they seek to signal their quality by their actions. Moreover, such a firm
may also seek to make known the formal qualifications of its members if it is generally
believed that such qualifications are correlated with the ability to offer high quality
services (Bromwich, 1992).

The consequences of the agent’s shirking are known agency costs. Agency costs refer to
the decline in the firm’s value due to agent’s behaviour, which are in divergence with the
owners. Jensen and Meckling (1976) argue that realizing the possibility of dysfunctional
activity, the principal will seek to limit divergencies from his or her interests by incurring
different monitoring and bonding costs.6 But even the incurrence of sufficient monitoring
and bonding costs do not necessarily ensure that the agent will maximize the principal’s
utility. Rather, there will be some residual loss arising from the inability to ensure that the
agent acts fully in the principal’s interest, given existing monitoring and bonding devices.

The agency costs in any enterprise depend on the lack of information about the agent’s
activities, and the costs of monitoring and analyzing the management’s performance, the
costs of devising a bonus scheme which rewards the agent maximizing the principal’s
welfare and the costs for determining and enforcing policy rules. They also depend on the
supply of replacement managers.

Monitoring costs are those costs that are incurred in relation to activities like imposing budget and
operating restrictions and constraints on the agent, and linking agent’s compensation with the outcome of
monitoring. Bonding costs, on the other hand, are incurred by the agent (upon approval by the principal)
on activities such as accepting contractual limitations on the agent’s decision making power and agreeing
to have accounts audited by a qualified auditor (Bromwich, 1992).

Expropriation Problem in Developing Countries

In developed countries, much of the debate has focused on the “principal-agent” problem
between shareholders and managers and corporate governance has been seen as a device
to protect the interests of shareholders as other investors are generally protected through
contractual relations with the entity (OECD, 2007). However, in many developing and
transitional economies “pervasive clientelism (“cronyism”) and/or weak judicial systems,
and often poorly defined property rights, tend greatly to weaken effective contract
enforcement. Poor contract enforcement in turn renders the distinction between
“residual” and non-residual claimants of doubtful applicability in practice” (OECD, 2007,
p. 155). In such countries, corporate ownership concentration is a general phenomenon
and corporate ownership dispersion (prevailed in the US and UK) is an exception, not
rule. Moreover, in order to increase the control over an entity beyond direct ownership,
concentration is often reinforced further through mechanisms like pyramidal ownership
structure7, cross-ownership and dual class shares (Berglöf and Pajuste, 2005; OECD,
2007). As a consequence, the key potential conflict in developing economies tend to arise
between controlling shareholders and minority shareholders (domestic as well as foreign)
and other investors. This type of conflict of interest can be termed as the expropriation
problem as the dominant owner-managers often tend to deprive minority shareholders,
and sometimes other investors, of their fair share of income from corporate resources by
channeling those resources to his own account (Berglöf and Pajuste, 2005; OECD, 2007).

A “pyramid” is said to exist when one company (at the top of the pyramid) holds “a dominant equity
share (say 51 per cent, though less may suffice) in and thereby controls one or more other companies (the
second “layer” in the pyramid) each of which may in turn have a dominant equity share in one or more
additional companies (the third layer), and so on” (OECD, 2007, p. 167).

Corporate Governance

Corporate governance has been an integral part of business practices since the creation of
corporate structure and the separation of ownership from management (Dallas and Patel,
2004). Since its inception, different authors have provided different definitions which
often differ significantly in terms of objectives, goals and means and tools to achieve and
realize it. From perception’s point of view, a fairly narrow definition of corporate
governance is provided by Shleifer and Vishny (1997, p. 737), “corporate governance
deals with the ways in which suppliers of finance to corporations assure themselves of
getting a return on their investment.” In this definition, corporate governance is restricted
to the relationship between a company and its shareholders which is the focal point of the
traditional finance paradigm, expressed in ‘agency theory’ (Solomon and Solomon,
2004). A much broader functional definition is provided by the Organisation for
Economic Cooperation and Development (OECD) (2004, p. 11) describing corporate
governance as: “… a set of relationships between a company’s management, its board, its
shareholders and other stakeholders. Corporate governance also provides the structure
through which the objectives of the company are set, and the means of attaining those
objectives and monitoring performance are determined.” This definition recognizes not
only the relationship between company and shareholders but also a wide array of
relationships between company and other stakeholders like employees, customers,
suppliers and bondholders. Such viewpoint is generally expressed in ‘stakeholder theory’
(Solomon and Solomon, 2004). In his definition, Cadbury (2000, p. vi) emphasizes on
corporate governance for the stability and equity of society by saying, “corporate
governance is concerned with holding the balance between economic and social goals
between individuals and communal goals. The governance framework is there to
encourage the efficient use of resource and equally to require accountability for the
stewardship of those resources. The aim is to align as nearly as possible the interests of
individuals, corporations, and society.” Mallin (2007) identifies several key
characteristics of corporate governance: (i) to ensure an adequate and appropriate system
of control within an organization leading to safeguard of assets; (ii) to prevent any single
individual from having too much power and influence; (iii) to establish appropriate

relationship between company’s management, the board of directors, shareholders, and
other stakeholders; (iv) to ensure that the organization is run at the best interests of the
shareholders and other stakeholders and (v) to encourage increased transparency and

Corporate Governance for Agency Problem

Control mechanisms are considered necessary to reduce divergence of agents’ interests

from the principals’ interests. Corporate governance is probably the widest control
mechanism used for efficient utilization of corporate resources. It is a hybrid of internal
and external control mechanisms with a view to achieving efficient utilization of
corporate resources. It is a network among various corporate players such as
shareholders, managers, employees, lenders, government, suppliers, and consumers for
increasing the value of the firm. Corporate governance and monitoring mechanisms are
manifold and generally comprise external control mechanisms as well as internal control
mechanisms. In table 1, attempts have bee made to create a list of corporate governance
mechanism. Some of the important corporate governance mechanism are discussed
briefly in the following sections (for empirical evidence, see Ho, 2005; Biswas and
Bhuiyan, 2008).

Board of Directors and different board committees: The size and composition of the
board of directors act as a corporate governance mechanism. Limiting board size is
believed to improve firm performance because the benefits of larger boards (increased
monitoring) are outweighed by the poorer communication and decision making of larger
groups (Lipton and Lorsch, 1992; Jensen, 1993). The composition of a board is also
important. There are two components that characterize the independence of a board, the
proportion of non-executive directors and the separated (or not) roles of chief executive
officer (CEO) and chairman of the board (COB). Non-executive or outside directors,
through their expertise and independence, can play an important role at firm level through
transferring knowledge as well as at country level through building constituencies for
corporate governance reform (Berglöf and Claessens, 2006). As far as the separation

between the role of CEO and COB is concerned, it generally believed that separated roles
can lead to better board performance and, hence, less agency conflicts (for empirical
evidences, see Rechner and Dalton, 1991; Yermack, 1996; Brown and Caylor, 2004;
Haniffa and Hudaib, 2006). In contrary to this, Finlestein and D′Aveni (1994) find that
board vigilance is positively associated with CEO duality, and association is stronger
when both informal CEO power and firm performance are low.

Table 1: List of corporate governance mechanisms

Internal Mechanisms External Mechanisms
Monitoring Instruments § Market for corporate control (both the hostile
§ Ownership structure (i.e. identities of equity takeover market and the market for partial
holders and their sizes of equity holdings) control through block trading)
§ Institutional shareholding – pension funds § External managerial labour market
and mutual funds § Competition in the product and service
§ Creditor (particularly bank) monitoring8 market
§ Board of directors and different sub- § Arbitration
committees – size and composition § External auditors
§ Corporate bylaws and charters § Regulatory framework of the corporate law
§ Bilateral private enforcement mechanism regime and stock exchange
§ Internal managerial labour market § National legal and judicial systems that
§ Monitoring by employees protect investors’ rights
§ Debt financing (leverage) § Media and social control
§ Dividend payment § Other mechanisms (corporate governance
rating, corporate governance codes etc.)
Incentive Instruments
§ Executive/ Managerial compensation
§ Managerial ownership
Source: Bushman and Smith (2001), Cuervo (2002), Weir, Laing and McKnight (2002), Denis and McConnell (2003),
Gillan, Hartzell and Starks (2003), Correia Da Silva et al.(2004), Bai, Liu, Lu, Song and Zhang (2004), Cremers and
Nair (2005), Goergen, Manjon and Renneboog (2005), Berglöf and Claessens (2006), Smith and Walter (2006), Imam
and Malik (2007), Florackis (2008).

Besides the size and composition of the board of directors, various board committees
representing the internal control system of an organization, particularly the audit
committee and the remuneration committee, also prove to be important control
mechanisms. For example, the audit committee assists the board of directors in
overseeing and ensuring adequate functioning of internal control mechanisms, monitoring
Correia Da Silva et al. (2004) consider creditor monitoring as external governance mechanism. Similarly,
Smith and Walter (2006) report institutional shareholding as external control mechanism. Gillan, Hartzell
and Starks (2003) vies investor/shareholder monitoring as external mechanism.

and focusing on reviewing financial risk and risk management (Bhuiyan, Hossain and
Biswas, 2007). Hence, audit committee helps determine indicators of problems and
address these problems, mitigate possible damage and enhance shareholder value (Haron,
Jantan and Pheng, 2005).

Ownership Concentration: Theoretically, shareholders could take themselves an active

role in monitoring management. However, given that the monitoring benefits for
shareholders are proportionate to their equity stakes, an average shareholder has little or
no incentives to exert monitoring behaviour. In contrast, shareholders with substantial
stakes have more incentives to supervise management and can do so more effectively. As
a result, institutional or large blockholders, find incentives to engage in monitoring
activities through different shareholder activisms like voting at the Annual General
Meeting on issues like membership of the board of directors, remuneration policy,
engagement of the external auditor, budget and operating restrictions, shareholder
resolutions, incentive schemes and contracts like share ownership and stock options,
threat of dismissal in case of low income, sale of shares etc. (Bromwich, 1992; Shleifer
and Vishny, 1997; Patel, Balic and Bwakira, 2002; Bushman and Smith, 2003; Correia
Da Silva et al., 2004; Solomon and Solomon, 2004; Goergen et al., 2005).

Monitoring by Banks: It is widely believed that debt servicing obligations help to reduce
agency problems relating to free cash flow and information asymmetry particularly in
case of privately held debt (e.g. bank debt) (Florackis, 2008). As lenders, banks requires
such firm behaviour that ensures timely payment of their loans. Moreover, as Berglöf and
Claessens (2006, p. 142) argue, “banks can compensate for some weaknesses in the
general enforcement environment, as they have repeated dealings, have a reputation to
maintain in lending, and can economize on monitoring and enforcement technology.” As
a result, bank debt incorporates significant signaling characteristics that can mitigate
informational asymmetry conflicts between managers and outside investors. For example,
the announcement of a bank credit agreement conveys positive news to the stock market
about the company’s credit worthiness (Florackis, 2008).

Managerial Ownership: Jensen and Meckling (1976) suggest that managerial ownership
can align the interest between the two divergent groups of claimants and, therefore,
reduce the agency costs within the firm. According to their model, the relationship
between managerial ownership and agency costs is linear. Subsequent studies, however,
mostly report non-monotonic relationship between managerial ownership and agency
costs (for example, Morck, Shleifer and Vishny, 1988; McConnell and Servaes, 1990;
Short and Keasey, 1999).

Managerial Compensation: Periodic performance reviews and incentive compensation in

the form of accounting-based bonuses, stock option grants, stock appreciation rights, or
restricted stock can reduce a variety of agency problems (Habib, 2004). This is because,
satisfied managers will be less likely to expropriate organizational resources for self-
benefit. Empirically, Hall and Liebman (1998) and Main, Bruce and Buck (1996) find
that when stock options are included, a stronger pay-performance link can be identified.
Aggarwal and Samwick (1999) report that executive’s pay-performance sensitivity for
executives at firms with the least volatile stock prices is greater than that at firms with
most volatile stock prices. Examining the relation of managerial rewards and penalties to
firm performance in Japan, the US and Germany, Kaplan (1994a, 1994b) reports that
poor stock performance and inability to generate positive income increases the likelihood
of top management turnover in these countries. In another study, using time series data
from the UK and Germany, Conyon and Schwalbac (2000) report a significant positive
association between cash pay and company performance in both countries.

Dividend Payment: Dividend policy, another important corporate governance mechanism,

often serves as substitute and/or mechanism to other corporate governance insturments
(Correia Da Silva et al., 2004). Substitute’ in the sense that a high dividend payout
policy often directs manages to generate sufficient amount of cash flows and thereby,
enable them to distribute to the shareholders. On the other hand, ‘complementary’ in the
sense that presence of large shareholders or a strong board of directors can impose such a
high dividend payout policy and such a dividend policy is often used as a defence against
hostile takeover (Correia Da Silva et al., 2004).

Market for corporate control: Market for corporate control is an important external
corporate governance mechanism. The role of this mechanism may be direct or indirect
(Correia Da Silva et al., 2004). For example, the role is direct in case of hostile takeover.
However, whether poorly performing firms are more likely to be the target of hostile
takeover is not overwhelmingly supported in the literature. As indirect role, a mere threat
of a takeover may increase the efficiency of management ex ante, or setting-up of anti-
takeover devices may coincide with reduction in share price (Correia Da Silva et al.,

A market for partial control generally operates irrespective of the effectiveness of hostile
takeover. Unsatisfied shareholders’ decision to sell shares in a non-performing company
allows other shareholders with monitoring abilities to increase their stake in the
organization in order to reinforce their position as (majority) shareholders. As a result,
such block trading allowing the purchaser to achieve substantial control often triggers
more favourable market reaction than those transactions which do not confer control to
the purchaser (Correia Da Silva et al., 2004).

Managerial Labour Market: Career opportunities and potential for higher compensation
provides incentive for effective managers, as opposed to ineffective mangers, to increase
stockholder value and limit self-serving behaviour (Habib, 2004).

Effectiveness of Corporate Governance as a Control Mechanism

Although corporate governance mechanisms or instruments are designed to alleviate

agency problem within an organization, none of them are perfect due to several reasons.
Monitoring and supervision is a costly business. As discussed earlier, an average
shareholder has little or no incentives to exert monitoring managerial behaviour but to
free ride (Berglöf and Claessens, 2006). These individual shareholders mainly rely on
‘exit’ rather than ‘voice’. If they are not happy with company performance, they are free
to sell their shares and thus get rid of the problems (Chowdhury, 2004). Even institutional

shareholders may not intervene because the existence of active secondary markets and the
difficulties of intervention normally provide them with less costly option of simply
exiting (selling their shares). Similarly, independence of non-executive directors is a
difficult task to achieve. Forbers and Watson (1993) argue that corporate debt providers
intervene only when the security of their investment is seriously at risk. Besides, poor
enforcement of property rights in a country often results in incomplete monitoring
mechanisms (Berglöf and Claessens, 2006). On the other hand, the effectiveness of
incentive mechanisms is not without limitation. Walsh and Seward (1990) identify three
shortcomings of pay-for-performance plans as an incentive mechanism: (i) managers can
manipulate accounting rates of return through adopting favourable accounting policies
and thus, ensuring their interests being served when their bonus plans are linked to the
accounting rates of return; (ii) the motivational potential of rewards, irrespective of its
size, is likely to diminish whenever compensation is linked to such strict market
measures that are subject to many factors beyond a manger’s control; and (iii) incentive
plans often focus only on desired outcomes without paying any attention to the means of
achieving those. As a result, managers often get reluctant to achieve those goals.
Moreover, it may be more beneficial for managers to maintain and increase firm size
without any price impact in the market or to favour large shareholders than to go for the
incentive contracts offered to them (Stulz, 1999).

Heinrich (2002) argues that governance mechanisms have benefits in terms of reducing
agency costs as well as opportunity costs in terms of aggravating agency problems. He
identifies two sources of opportunity costs in this respect. Firstly, governance
mechanisms which reduce information asymmetries may simultaneously reduce
differences in risk sensitivity and thereby destroy possible gains from insurance.
Secondly, any governance mechanism which mitigates one agency problem (say between
shareholders and managers) may simultaneously aggravates other agency problems
(between controlling shareholders and minority shareholders or between shareholders an
creditors). Both types of opportunity costs give rise to complementarity and substitution
relationships between various governance mechanisms. Complementary relationship
occurs when one mechanism reduces the opportunity costs (or raise the benefits) of the

other at the margin and substitute relationship is said to exist when one governance
mechanism raises the opportunity costs (or reduce the benefits) of the other. As a result,
organizations generally choose specific combinations of internal and external governance
mechanisms which reinforce each other in minimizing the agency costs.

Empirical results regarding the interaction between internal and external mechanisms
have been mixed. Studies like Hadlock and Lumer (1997), Mikkelson and Partch (1997),
Cremers and Nair (2005) suggest that there exists complementary relationship between
internal and external control mechanisms. In contrary to these results, Huson, Parrino and
Starks (2001) find that effectiveness of internal monitoring is not dependent on external
monitoring. Weir et al.(2002), however, report that market for corporate control is an
effective external control mechanism and can be used as the substitute for other control

The prevailed system of governance in any particular country affects the effectiveness of
internal and external governance mechanisms. Broadly speaking, two distinct governance
systems can be identified: one is the Anglo-American ‘market-based’ system and the
Japanese and the other one is the German ‘relationship-based’ system. Table 2 presents a
comparative overview of different corporate governance mechanisms used under these
two systems. Table 2 suggests that the effectiveness of corporate governance mechanisms
varies. The enforcement environment in a country has a large role to play in this respect.
For example, countries where court systems function properly, large shareholder
monitoring as well as formal protection of minority shareholders can be ensured through
private litigation. However, in a weaker enforcement environment, promoting private
mechanisms and empowering shareholders through information dissemination can serve
a better role (Berglöf and Claessens, 2006).

Table 2: Governance Mechanisms in Alternative Systems
Corporate Governance “Anglo-Saxon”/ “market- “Japanese-German”/ “bank-
Mechanism based”/ “transaction-based”/ centered”/ “relationship-based”/
“arm’s length”/ “outsider” “control-oriented”/ “insider”
system system
Firm-level Mechanisms
Stock Ownership Dispersed stock ownership, Concentrated stock ownership or
mostly by households and proxy control by banks.
institutional investors.
Cross-Shareholdings Little cross-shareholdings Substantial cross-ownership
between firms and little bank between firms, substantial direct as
ownership for firms. well as indirect bank ownership.
Market for corporate Existence of active market for Virtually non-existence of active
control corporate control. market for corporate control.
Involvement of bank Minimal bank involvement in Direct and substantial bank
firms’ operations and control involvement in firms’ operations
activities. and control activities.
Policy-level Mechanisms
Disclosure and Far-reaching disclosure and Limited disclosure and accounting
accounting requirements rigorous accounting requirements.
requirements in stock market.
Shareholders activities Existence of multiple barriers Existence of few barriers to large
to large shareholder activity. shareholder activity.
Source: Adapted from Heinrich (2002)


Agency problem is a natural outcome of joint stock type of organization. Monitoring,

bonding and residual loss are the costs incurred due to the existence of agency problem.
Nature of agency problem found in developed countries is different from that found in the
developing nations. Different corporate governance mechanisms have been suggested in
the literature and implemented by different organizations to solve such problem.
However, it is not always possible to completely get rid of such problem as corporate
governance mechanisms are not effective to the same extent and most often dependent on
the existing legal system in a country. As a result, blind adoption of corporate governance
instruments following other countries without considering the differences in legal
systems may not result in desired outcome. Corporate governance is more likely to be
effective in countries where different mechanisms are chosen considering factors like

level of development of the capital market and effectiveness of legal system in protecting
investors’ interests.


Aggarwal, R. K., and Samwick, A. A. (1999). The Other Side of the Trade-off: The Impact of
Risk on Executive Compensation. Journal of Political Economy, 107(1), 65-105.
Bai, C.-E., Liu, Q., Lu, J., Song, F. M., and Zhang, J. (2004). Corporate governance and market
valuation in China. Journal of Comparative Economics, 32(4), 599-616.
Barnea, A., Haugen, R. A., and Senbet, L. W. (1985). Agency Problems and Financial
Contracting. New Jersey: Prentice Hall, Inc.
Beaver, W. H. (1989). Financial Reporting: An Accounting Revolution (2nd ed.). New Jersey:
Prentice Hall.
Berglöf, E., and Claessens, S. (2006). Enforcement and Good Corporate Governance in
Developing Countries and Transition Economies. World Bank Research Observer, 21(1),
Berglöf, E., and Pajuste, A. (2005). What do Firms Disclose and Why? Enforcing Corporate
Governance and Transparency in Central and Eastern Europe. Oxford Review of Economic
Policy, 21(2), 178-197.
Berle, A. A., and Means, G. C. (1934). The Modern Corporation and Private Property. New
York: The Macmillan Company.
Bhuiyan, M. H. U., Hossain, D. M., and Biswas, P. K. (2007). Audit Committee in Banks:
Current Regulatory Framework and Disclosure Practices in Bangladesh. The Cost and
Management, 35(2), 5-18.
Biswas, P. K., and Bhuiyan, M. H. U. (2008). Corporate Governance and Firm Performance:
Theory and Evidence from Literature. Working Paper
Bromwich, M. (1992). Financial Reporting, Information and Capital Markets. London: Pitman.
Brown, L. D., and Caylor, M. L. (2004). Corporate Governance and Firm Performance.
Working Paper (
Bushman, R. M., and Smith, A. J. (2001). Financial accounting information and corporate
governance. Journal of Accounting and Economics, 32(1-3), 237-333.
Bushman, R. M., and Smith, A. J. (2003). Transparency, Financial Accounting Information, and
Corporate Governance. Federal Reserve Bank of New York Economic Policy Review, 9(1),
Cadbury, A. (2000). Foreword. In M. R. Iskander & N. Chamlou (Eds.), Corporate Governance:
A Framework for Implementation Washington, D.C.: World Bank.
Chowdhury, D. (2004). Incentives, Control and Development: Governance in Private and Public
Sector with Special Reference to Bangladesh. Dhaka: Viswavidyalay Prakashana Samstha.
Conyon, M. J., and Schwalbach, J. (2000). Executive Compensation: Evidence from the UK and
Germany. Long Range Planning, 33(4), 504-526.
Correia Da Silva, L., Goergen, M., and Renneboog, L. (2004). Dividend Policy and Corporate
Governance. Oxford: Oxford University Press.
Cremers, K. J. M., and Nair, V. B. (2005). Governance Mechanisms and Equity Prices. The
Journal of Finance, 60(6), 2859-2894.
Cuervo, A. (2002). Corporate Governance Mechanisms: a plea for less code of good governance
and more market control. Corporate Governance: An International Review, 10(2), 84 - 93.

Dallas, G., and Patel, S. A. (2004). Corporate Governance as a Risk Factor. In G. Dallas (Ed.),
Governance and Risk: An Analytical Handbook for Investors, Managers, Directors &
Stakeholders (pp. 2-19). New York: McGraw-Hill.
Denis, D. K., and McConnell, J. J. (2003). International Corporate Governance. ECGI - Finance
Working Paper No. 05/2003 (
Finkelstein, S., and D'Aveni, R. A. (1994). CEO Duality As A Double-Edged Sword: How
Boards Of Directors Balance Entrenchment Avoidance And Unity Of Command. Academy
of Management Journal, 37(5), 1079-1108.
Florackis, C. (2008). Agency Costs and Corporate Governance Mechanisms: Evidence for UK
Firms. International Journal of Managerial Finance, 4(1), 37-59.
Forbes, W., and Watson, R. (1993). Managerial Remuneration and Corporate Governance: A
Review of the Issues, Evidence and Cadbury Committee Proposals. Accounting & Business
Research, 23(91A), 331-338.
Gillan, S. L., Hartzell, J. C., and Starks, L. T. (2003). Explaining Corporate Governance: Boards,
Bylaws, and Charter Provisions. Weinberg Center for Corporate Governance Working
Paper No. 2003-03 (
Goergen, M., Manjon, M. C., and Renneboog, L. (2005). Corporate Governance in Germany. In
K. Keasey, S. Thompson & M. Wright (Eds.), Corporate Governance: Accountability,
Enterprise and International Comparisons. West Sussex: John Wiley & Sons, Ltd.
Habib, A. (2004). Governance through ownership, A synthesis of research on causes and
consequences of corporate ownership structure and some evidences from Bangladesh.
Dhaka University Journal of Business Studies, XXV(1), 107-129.
Hadlock, C. J., and Lumer, G. B. (1997). Compensation, Turnover, and Top Management
Incentives: Historical Evidence. The Journal of Business, 70(2), 153-187.
Hall, B. J., and Liebman, J. B. (1998). Are CEOS Really Paid Like Bureaucrats? Quarterly
Journal of Economics, 113(3), 653-691.
Haniffa, R., and Hudaib, M. (2006). Corporate Governance Structure and Performance of
Malaysian Listed Companies. Journal of Business Finance & Accounting, 33(7-8), 1034-
Haron, H., Jantan, M., and Pheng, E. G. (2005). Audit Committee Compliance with Kuala
Lumpur Stock Exchange Listing Requirements. International Journal of Auditing, 9(3),
Heinrich, R. P. (2002). Complementarities in Corporate Governance. Berlin: Springer.
Ho, C.-K. (2005). Corporate Governance and Corporate Competitiveness: An International
Analysis. Corporate Governance: An International Review, 13(2), 211-253.
Huson, M. R., Parrino, R., and Starks, L. T. (2001). Internal Monitoring Mechanisms and CEO
Turnover: A Long-Term Perspective. The Journal of Finance, 56(6), 2265-2297.
Imam, M. O., and Malik, M. (2007). Firm Performance and Corporate Governance Through
Ownership Structure. International Review of Business Research Papers, 3(4), 88-110.
Jensen, M. C. (1993). The Modern Industrial Revolution, Exit, and the Failure of Internal Control
Systems. Journal of Finance, 48(3), 831-880.
Jensen, M. C., and Meckling, W. H. (1976). Theory of The Firm: Managerial Behavior, Agency
Costs and Ownership Structure. Journal of Financial Economics, 3(4), 305-360.
Kaplan, S. N. (1994a). Top Executives Rewards and Firm Performance: A Comparison of Japan
and the United States. The Journal of Political Economy, 102(3), 510-546.
Kaplan, S. N. (1994b). Top Executives, Turnover, and Firm Performance in Germany. The
Journal of Law, Economics, & Organization, 10(1), 142-159.
Khan, A. R., Siddiqui, J., and Hossain, D. M. (2004). Reporting on Corporate Governance as a
Voluntary Disclosure: A Study on the Annual Reports of BEXIMCO Group. Dhaka
University Journal of Business Studies, XXV(1), 131-145.
Kreps, D. M. (1990). A Course in Microeconomic Theory. New York: Harvester Wheatsheaf.

Lipton, M., and Lorsch, J. W. (1992). A Modest Proposal for Improved Corporate Governance.
The Business Lawyer, 48(1), 59-78.
Lorsch, J. W., and MacIver, E. (1989). Pawns or Potentates: The Reality of America's Corporate
Boards. Boston: Harvard Business School Press.
Main, B. G. M., Bruce, A., and Buck, T. (1996). Total Board Remuneration and Company
Performance. Economic Journal, 106(439), 1627-1644.
Mallin, C. A. (2007). Corporate Governance (Second ed.). Oxford: Oxford University Press.
Marnet, O. (2008). Behaviour and Rationality in Corporate Governance. Oxon: Routledge.
McConnell, J. J., and Servaes, H. (1990). Additional Evidence on Equity Ownership and
Corporate Value. Journal of Financial Economics, 27(2), 595-612.
Mikkelson, W. H., and Partch, M. M. (1997). The decline of takeovers and disciplinary
managerial turnover. Journal of Financial Economics, 44(2), 205-228.
Morck, R., Shleifer, A., and Vishny, R. W. (1988). Management ownership and market
valuation: An empirical analysis. Journal of Financial Economics, 20, 293-315.
OECD. (2004). Principles of Corporate Governance. Paris: OECD.
OECD. (2007). Corporate Governance for Economic Development. In Business for Development:
Fostering the Private Sector: OECD.
Patel, S. A., Balic, A., and Bwakira, L. (2002). Measuring transparency and disclosure at firm-
level in emerging markets. Emerging Markets Review, 3(4), 325-337.
Prowse, S. D. (1999). Corporate Governance in East Asia: a framework for analysis [Electronic
Version] from
Rechner, P. L., and Dalton, D. R. (1991). CEO Duality and Organizational Performance: A
Longitudinal Analysis. Strategic Management Journal, 12(2), 155-160.
Shleifer, A., and Vishny, R. W. (1997). A Survey of Corporate Governance. The Journal of
Finance, 52(2), 737-783.
Short, H., and Keasey, K. (1999). Managerial Ownership and The Performance of Firms:
Evidence from The UK. Journal of Corporate Finance, 5(1), 79-101.
Smith, R. C., and Walter, I. (2006). Governing the Modern Corporation: Capital Markets,
Corporate Control, and Economic Performance. New York: Oxford University Press.
Solomon, J., and Solomon, A. (2004). Corporate Governance and Accountability. West Sussex:
John Wiley & Sons Ltd.
Stulz, R. M. (1999). Globalization of Equity Markets and the Cost of Capital. Dice Center
Working Paper no. 99-1 (
Walsh, J. P., and Seward, J. K. (1990). On the Efficiency of Internal and External Corporate
Control Mechanisms. The Academy of Management Review, 15(3), 421-458.
Weir, C., Laing, D., and McKnight, P. J. (2002). Internal and External Governance Mechanisms:
Their Impact on the Performance of Large UK Public Companies. Journal of Business
Finance & Accounting, 29(5&6), 579-611.
Yermack, D. (1996). Higher Market Valuation of Companies with a Small Board of Directors.
Journal of Financial Economics, 40(2), 185-211.