The Theory of Agency and Moral Hazard

Corporate governance is an important component of the current business

environment since it influences organisational behaviour and decision-making. It relates to a
collection of procedures and policies that guarantee the management is effectively under
control and accountable to shareholders and other stakeholders. However, the problem of
moral hazard, which can have negative effects for all parties involved, is an ongoing issues in
corporate governance. In this discussion, a theory relating to the moral hazard problem in
corporate governance will be examined, along with its causes, effects, and possible solutions.

The moral hazard problem in corporate governance can be clarified using the concept
of agency. This theory holds that shareholders (the principals) provide managers (the agents)
decision-making power and control over firm resources so they may act in their best interests
(Valentine, 2009). However, this delegation establishes a principal-agent relationship, which
raises the risk of moral hazard.

When agents have a motivation to act in a way that serves their own interests over
those of the principals, this is known as moral hazard. Moral hazard can take many different
forms in the context of corporate governance, including excessive risk-taking,
misappropriation of company's assets, and manipulating financial information (Arcot &
Bruno, 2011). These behaviours may result in monetary losses, damage to reputation, and a
decrease in the organization's long-term value.

The occurrence of moral hazard in corporate governance is caused by a number of

factors. One important factor is the separation of ownership and control, which occurs when
shareholders, who are the actual owners of the business, lack direct authority over managerial
decisions (Achim & Borlea, 2013). Due to managers' better comprehension of the day-to-day
operations and financial performance of the company, this separation results in an
information asymmetry. Managers might take advantage of opportunities for their own
benefit while hiding risks or unfavourable outcomes from shareholders due to this
information asymmetry.

The imbalance of incentives between shareholders and managers is another factor

(Achim & Borlea, 2013). Stock options, bonuses, and other performance-based remuneration
are frequently given to managers as part of their compensation packages. Although these
incentives are intended to bring managers' interests and shareholders' interests together, they
may unintentionally provide perverse incentives. For instance, managers could be encouraged
to prioritise short-term gains above any other consideration or take excessive risks in order to
maximise their own remuneration, even if performing so is harmful for the company's
sustainability in the long run.

Moral hazard has wide-ranging effects on corporate governance that might have
negative effects on all stakeholders. From a financial standpoint, moral hazard can result in
resource misallocation, ineffective investment decisions, and in severe circumstances, even
bankruptcy. The majority of these effects are encountered by shareholders in the form of
decreases in stock prices and lower investment value.

Moral hazard is also damaging businesses' reputations by eroding the public's trust in
companies (Achim & Borlea, 2013). Relationships with clients, suppliers, and other
important stakeholders may suffer as a result of this lack of trust. Additionally, it can result in
more stringent regulatory oversight, legal proceedings, and possible penalties. If moral hazard
is not controlled, the overall effectiveness and stability of the financial system may be
affected.

Several tactics and procedures can be used to reduce the moral hazard problem in
corporate governance. First and foremost, improved transparency and disclosure practices are
critical. Managers may be held responsible for their actions by providing shareholders
accurate and timely information, which lowers the possibility of moral hazard. It may be
possible to better align managers' interests with those of shareholders by disclosing executive
salaries, conflicts of interest, and risk management procedures.

The creation of an effective board of directors is yet another tactic. To ensure that
decisions are taken in the best interests of the firm and its stakeholders, independent directors
with the necessary knowledge and experience can serve as a check on managerial activities.
Strong board oversight, which includes regular monitoring and evaluation of managerial
performance, can aid in identifying and avoiding moral hazard situations.

Additionally, incentive programmes should be properly planned to integrate

managers' objectives with the creation of long-term value for shareholders. Key financial and
non-financial measures that represent the sustainability and overall condition of the
organisation should be linked to performance-based rewards. This strategy dissuades
managers from taking excessive risks in looking for quick incentives and motivates them to
operate in the long-term interests of the business.
 Regulatory organisations are also very important for controlling moral hazard. Moral
hazard may be avoided by strengthening corporate governance laws, monitoring compliance,
and enforcing penalties for wrongdoing. A culture of ethics and integrity should be promoted
within organisations by regulators using standards and best practices.
 REFERENCES

Abdullah H., & Valentine N. (2009). Fundamental and Ethics Theories of Corporate
Governance, EuroJournals Publishing, Inc. 2009.

Achim, M. V.; & Borlea, N. S. (2013). Corporate governance and business performances.
Modern approaches in the new economy. Germany: Lap Lambert Academic
Publishing.

Arcot, Sridhar & Bruno, Valentina. (2009). Silence is Not Golden: Corporate Governance
Standards, Transparency and Performance. SSRN Electronic Journal.
10.2139/ssrn.1343446.