Theories of Corporate Governance: Agency Theory, Stewardship Theory,

Resource Dependency Theory, Stakeholder Theory, Transaction Cost Theory,

and Political Theory.
There are many theories of corporate governance which addressed the challenges of
governance of firms and companies from time to time. The Corporate Governance is the
process of decision making and the process by which decisions are implemented in large
businesses is known as Corporate Governance. There are various theories which describe the
relationship between various stakeholders of the business while carrying out the activity of
the business.

Theories of Corporate Governance:

We will discuss the following theories of corporate governance:

 Agency Theory
 Stewardship Theory
 Resource Dependency Theory
 Stakeholder Theory
 Transaction Cost Theory
 Political Theory

Agency Theory:

Agency theory defines the relationship between the principals (such as shareholders of
company) and agents (such as directors of company). According to this theory, the principals
of the company hire the agents to perform work. The principals delegate the work of running
the business to the directors or managers, who are agents of shareholders. The shareholders
expect the agents to act and make decisions in the best interest of principal. On the contrary,
it is not necessary that agent make decisions in the best interests of the principals. The agent
may be succumbed to self-interest, opportunistic behavior and fall short of expectations of
the principal. The key feature of agency theory is separation of ownership and control. The
theory prescribes that people or employees are held accountable in their tasks and
responsibilities. Rewards and Punishments can be used to correct the priorities of agents.

Agency Problem and Corporate Governance:

In simple terms, Governance means “the process of decision-making and the process by
which decisions are implemented”. Thus governance related to large businesses is called
Corporate Governance. Firms are social entities and have certain social obligations. A firm
needs coordination between many groups of people known as stakeholders. The stakeholders
are the owners, the managers, the workers, the suppliers, the creditors, the customers, the
competitors, the government, and even the society at large. The stakes of various
stakeholders are:
 Owners get a share of the profits
 Managers get salaries.
 Workers get wages
 Suppliers get paid for their inputs to the firm
 Customers want to get good quality products at reasonable prices
 Creditors wants their loans to be repaid in time
 Competitors want fair competition in the market place.
 Government wants the firm to declare its true earnings and pay appropriate taxes
Good Corporate Governance requires that the firm:
 Pursue its goal efficiently
 At the same time take into account the harm that it is causing to some stakeholders
and try to ensure that those losers are adequately compensated.
The corporate form of business raises large capital from public; therefore there are millions
of shareholders contributing small capital. Since contribution of shareholder is small, it is not
practically possible for shareholders to run the day-to-day management of business. Thus in
between owners and business, a corporate form of business introduced a new entity called
Management. This management consists of professional managers who manages the
company and take the important decisions.
Corporate Governance and Agency Problem:
We have seen that in corporate form of business, there is separation of ownership and
business. This creates a unique type of problem known as Agency Problem. The problem of
Principal-Agent is universal. Agents (Managers) are expected to work for the benefit of
principal (owners) and take decisions that are beneficial for the principal. However often
agents take decisions that are beneficial for themselves. When ownership and business is
separated, the managers are expected to act for the benefits of the owners. However, there
is chance that managers may pursue certain alternative objectives that are beneficial to
themselves rather than owners. The conflict is called Agency Problem.
Mitigating Agency Problem:
One solution to mitigate the agency problem is to appoint the honest and ethical managers.
But question is how to determine whether a manager is honest/ethical or not. Thus there is
need to do something beyond appointment of managers.
 Traditionally auditing was instituted to resolve the agency conflict. Auditors are
expected to work on behalf of owners and examine the conduct of business run by
managers and submit the report to owners. However the auditing is restricted to
financial auditing which can unearth the financial frauds. But it cannot question the
managerial efficiency.
 In addition to auditing, the corporate governance is used to resolve the agency
conflict. Under the corporate governance, the emphasis is on the board including the
appointment of directors for the board, who are expected to be independent and
expert in their fields. In addition, the board forms sub-committees to have more close
interaction with management.
Stewardship Theory

The steward theory states that a steward protects and maximises shareholders wealth
through firm Performance. Stewards are company executives and managers working for the
shareholders, protects and make profits for the shareholders. The stewards are satisfied and
motivated when organizational success is attained. It stresses on the position of employees
or executives to act more autonomously so that the shareholders’ returns are maximized. The
employees take ownership of their jobs and work at them diligently.

Stakeholder Theory

Stakeholder theory incorporated the accountability of management to a broad range of

stakeholders. It states that managers in organizations have a network of relationships to serve
– this includes the suppliers, employees and business partners. The theory focuses on
managerial decision making and interests of all stakeholders have intrinsic value, and no sets
of interests is assumed to dominate the others

Resource Dependency Theory

The Resource Dependency Theory focuses on the role of board directors in providing access
to resources needed by the firm. It states that directors play an important role in providing or
securing essential resources to an organization through their linkages to the external
environment. The provision of resources enhances organizational functioning, firm’s
performance and its survival. The directors bring resources to the firm, such as information,
skills, access to key constituents such as suppliers, buyers, public policy makers, social groups
as well as legitimacy. Directors can be classified into four categories of insiders, business
experts, support specialists and community influentials.
Transaction Cost Theory

Transaction cost theory states that a company has number of contracts within the company
itself or with market through which it creates value for the company. There is cost associated
with each contract with external party; such cost is called transaction cost. If transaction cost
of using the market is higher, the company would undertake that transaction itself.

Political Theory

Political theory brings the approach of developing voting support from shareholders, rather
by purchasing voting power. It highlights the allocation of corporate power, profits and
privileges are determined via the governments’ favor.