problem and its relevance in the financial system
Choon Yin (2003)
Interestingly, more people are investing their
money in publicly owned corporations. They are willing to place their money in the hands of professional managers to run the
companies on their behalf. In return, investors obtain income in the form of dividends, which are to be determined by the
board of directors (whom the shareholders appoint). Usually, the dominant strategy in share investment is to buy-and-hold
the shares. In this case, the time line for cash flows resembles that of a perpetuity. In reality, many sell their shares
somewhere along the time line. In the process, they reap capita gains or incur capital losses.
is it that more people are investing in shares? Robert Monks, in his latest book, provides six reasons (Monks, 2001, pp. 65-66).
The reasons given are as follows.
1. Corporations can be organized by anyone
for any purpose anywhere with virtually no minimum requirements. This makes the corporate form available to all who seek the
opportunity to convert their genius, energy and good fortune into marketable wealth.
2. A corporation with publicly traded stock
permits an optimal division of specialties. Those capable of providing ideas, energy and management can be rewarded alongside
those whose contribution is limited to money.
3. Investors are safe in limiting the extent
of their liability to the amount that they invest in the corporate enterprise.
4. Once money is invested as part of the equity
of a corporation, management can employ that money however it wishes to achieve its objectives without fear that the money
will be removed.
5. The investor in a publicly traded stock has
the ability to dispose of his holding at will. Thus long-term capital for the enterprise is a short-term commitment for the
6. Corporations are creatures of the state
and are, therefore, in theory, subject ultimately to the state; determination of limits on its operations, as dictated by
the public interest.
Although investing in publicly owned corporation
has become more dominant, investors are generally becoming more passive over the years. They are less interested to monitor
how their funds are used and allocated by the professional managers. This is unlike the past. During the middle-age period
for instance investors were active to see that corporations were socially responsible. This has since changed. Why is this
so? There could be several reasons. Investors find that they are able to dispose off their shares easily in the stock exchange.
Brokers can be easily engaged to dispose off the shares if investors are unhappy with the invested corporations. More choices,
both domestically and abroad, are available thus limiting their loyalty to invested companies. Some were not interested to
monitor the companies they had invested because they wanted to free ride. Knowing that governments, via their regulatory agencies,
and institutional investors are doing the monitoring job, they want to enjoy whatever benefits derived from the monitoring
activities without contributing to their creations. Some are not able to monitor the managers’ performance perhaps due
to their inability to decipher information that is given to them. Accounting records can be too technical. Also, some may
not know their rights as shareholders (or minority shareholders). These are essentially the kind of people that need protection
from higher standards of corporate governance.
Unfortunately, lack of monitoring of companies’
performance can be detrimental to shareholders and the society. Professional managers engaged to run the firms may do things
that are not in tandem with the notion of profit maximization. It is possible that poorly managed firms end up losing money
and bankrupted leading to loss of savings to shareholders and jobs to workers. In important organizations like banks and other
financial institutions, their failures can trickle down to other sectors of the country’s economy. Economic and financial
crises can be resulted in the process. This was the case in the Asian crisis. Weak
corporate governance standards see majority shareholders effectively stealing from minority shareholders, and managers stealing
The need to monitor managers’ performance
is created because of the separation between ownership and control. In a firm in which the owner is the employee himself,
ownership and control essentially lies on the same person. In this case, there are effectively lesser problems concerning
the issue on separation between ownership and control. But this is not the case in publicly owned corporations. In these organizations,
shareholders are the rightful owners. But they do not run their corporations. They engage professional managers to do the
job for them. The Chief-Executive Officer and Chairman of the board head the management team.
are signed with the managers in listed companies to specify their responsibilities and duties to care for the shareholders.
Unfortunately, the contracts are often incomplete. It is technically infeasible to specify exactly how the managers are to
allocate their time. It is also not possible to specify in the contracts how the profits are to be used; retained or distributed
to the shareholders. Under-controlling the managers is unhealthy. However, some forms of autonomy must be given to the managers
to carry out their jobs more effectively. Over-control is thus unhealthy to the organization as well. The challenge and difficulty
is to strike the right balance.
see that the managers properly run the organizations in accordance to their contracts, the board of directors are usually
elected. In the ideal case, the board should consist a majority of independent individuals who have no direct interest with
the business, which could hinder their independent judgment. They are other ways to align the interests of managers with those
of the shareholders. They will be discussed later.
It is perhaps timely at this juncture to bring
in the important concept of principal-agent problem. The owners of the firms are known as principals. The managers
are the agents employed to run businesses on behalf of the principals. Principal-agent problem refers to the problem
where the agents make decisions that are not in tandem with the overall goals of the organization. As agents of the organizations,
it is their duty to maximize the organization’s profits. This is what the principals want in general. Unfortunately,
the agents may make decisions that are beneficial to them and not the principals. Some examples are illustrated clearly in
Mansfield et al (2002). They are:
1. Minimizing effort
much additional effort a manager is willing to put in to make an extra dollar for the owner? Given two choices; one involving
less effort than the other, it is likely that the manager would choose the former rather than the latter which yields higher
profits. Without any contingent compensation to the manager, the perception he holds is that the ‘owner reaps the profits;
not the manager’.
2. Maximizing job security
believe that bad results are more likely to gain notice than good results. Given a choice to make investment decisions; one
with a large probability of high returns but high risk and one with smaller probability of high returns but less risk, it
is likely that the manager would go for the second choice. The manager is less willing to opt for the riskier option for fear
of losing his or her job. Perhaps a more serious agency problem is the unwillingness of managers to leave their posts even
when if they are no longer competent to run the company. This is one of the ways in which the managers can expropriate the
shareholders (Shleifer and Vishny, 1996)
3. Enhancing reputation
A manager may
do things meant to promote him rather than maximizing profits for shareholders. Mansfield et al (2002) use the example of
a CEO with the ambition to hold public office to show himself as a ‘good citizen’ by lowering prices of goods
sold below profit-maximizing level. This is done at the expense of shareholders whom he is accountable for. It is also possible
for the manager to spend lavishly using company’s resources like spending on luxury travel, furnishing the offices with
first-class art works or investing in pet projects. The expenditures are made using the shareholders’ funds rather than
distributing the excess cash flows to shareholders in the form of dividends.
Clearly, the above examples illustrate the possibility
where interests of principals and agents can be on different sides of the fence. We will see later how the agents’ interests
can be aligned with those of the principals. At this moment, it is important to recognize that decisions made in an organization
can be attributed solely to managers’ discretion. Problems are created when the managers do not make decisions based
on strong economic and ethical principles, which are desirable to principals.
some organizations, the CEOs have substantial power to dictate how they are to be compensated. They have the control of the
board. High pay can be awarded to CEOs because of their connections with board members, and not due to improved corporate
performance. How does this affect the shareholders? Clearly such actions are detrimental to the society in general and the
shareholders in particular. Companies may end up passing on the ‘higher cost’ to consumers in the form of higher
prices possibly leading to lower market share and profits to the organizations. Shareholders are getting lesser than what
they should be getting in the form of dividends. CEOs setting their own pay represent a form of corruption in the corporate
problem is perhaps more common among family-owned businesses where the CEOs often have significant power to dictate how the
firms are to be run. The CEOs are often founders of the firms. While they are likely to be the major shareholders, that should
not give them the right to dictate how they are rewarded. The interests of other shareholders must be taken into consideration.
Independence of decisions made must prevail. The problem is worsened if the same person holds the CEO and Chairman of the
How is the
problem applicable to the financial system?
We know that in the financial system, funds are
transferred from lenders to borrowers either directly or indirectly (through financial institutions). The relevant institutions
make borrowings and lending decisions. Potential borrowers have to assess the financial viability of their investments. Careful
thoughts must be given to see that the interests of shareholders are taken care off. The same applies to lenders. Banks for
examples have to see that the financial risks of lending to potential borrowers are accounted for. The credit risk of potential
borrowers must be carefully taken into consideration. The purpose is to determine the financial viability of lending funds
to the borrowers. To make the decisions effectively, the board members of financial institutions must work closely with their
Unfortunately, the actual scene is not as simple
as what I have described. Conflicts of interests may prevail. Excessive and borrowings may be resulted. In financial institutions,
lack of attention may be placed to monitor the loans awarded to borrowers. Credit
risks of potential borrowers may not be properly assessed. This could be because the borrowers are related to some political
figures. The financial institutions may lend to such persons because they perceive that some persons elsewhere will help the
borrowers to repay their loans should they default. This is an example of the moral hazard problem. This problem is not restricted
to local incorporated financial institutions. Foreign financial institutions too may be willing to lend to persons they believe
are ‘protected’. They believe that some ‘individuals’
(or even the governments and international institutions like the International Monetary Fund) will provide aids to the borrowers
should the latter defaulted in their loans. As Nobel Prize Winner Joseph Stiglitz wrote, ‘….repeatedly, the IMF
programs provide funds for governments to bail out western creditors. The creditors, anticipating an IMF bailout, have weakened
incentives to ensure that the borrowers will be able to repay. This is the infamous moral hazard problem well known in the
insurance industry and, now, in economics’ (Stiglitz, 2002, p. 201).
course, the perception formed may end-up to be untrue. The loans may not be re-paid at all both by the initial borrowers and
their supposedly ‘protectors’. Overtime, failures to repay the loans will be reflected in the financial institutions
accounts. This can be seen from growths in non-performing loans. But whether shareholders and board members are aware of the
problem is another matter. Nowadays, information can be hidden from the principals and other relevant parties through creative
accounting devices. Liabilities can be hidden from the balance sheet while profits can be inflated.
a recent book, Susan Squires, Cynthia Smith, Lorna McDougall and William Yeack detailed the failure of Arthur Andersen, an
auditing and consulting firm. The book discusses how Andersen had misled the public with its auditing works involving companies
like Baptist Foundation of Arizona, Sunbeam Corporation, Waste Management Inc and Enron. It is particular interesting to read
about Enron’s attempt to cook its financial statement by manipulating its financial relationships with partner companies
using Special-Purpose Entities (SPEs). On March 2002, Andersen faced a felony charge for obstructing federal investigation
on Enron. David Duncan, the lead Andersen auditor on the Enron account, confessed to have ordered the shredding of Enron files.
Andersen’s reputation was lost. The company lost many of its audit clients. On 31 August 2002, Andersen ceased to be
an auditing firm for publicly traded companies (Squires et al, 2003).
is possible thus for managers in financial institutions to make more risks than what is desirable by the institutions’
shareholders. There’re exists the principal-agent problem. Generally, when a bad loan is created, both lenders and borrowers
are at fault. It was resulted from a bad judgment and inadequate standards of corporate governance in participating individuals
in financial institutions have a fiduciary duty to see that the shareholders’ interests are protected. They also have
the duty to ensure that funds deposited in their institutions are well protected. Depositors place their hard-earned money
with them. Depositors would not be happy with the financial institutions if the latter do not take sufficient care to see
that they can liquidify their deposit accounts. The social costs of any banks’ failures are high. The stakeholder approach
in management is highly relevant in this case to financial institutions. Not only that managers and the their board members
need to care for shareholders’ interest, the interests of depositors and society have to be taken into consideration
as well. Different parties therefore monitor financial institutions to see that they are properly run. Financial regulatory agencies, consumer interest groups, shareholders and the general public are some these
is clearly a need to raise the standards of corporate governance in both lending and borrowing institutions. How this is to
be done, both within and without the institutions, is dealt with in the next section.
Tackling the principal-agent
The principal-agent problem is a result of incomplete
contract signed with the agents. As such, agents can make decisions that are not in tandem with that of the principals. They
can get away with them because of asymmetric information. The agents have additional knowledge and actions that are unknown
to the principals. They are phenomenon commonly known as adverse selection and moral hazard respectively. How can the principal-agent
problem be minimized? Another way of putting this is, what are the different approaches available to align the interests of
the agents with that of the principals? The following paragraphs provide the answers.
Perhaps the most fundamental of all is the appointment
of an independent board of directors in the organization to oversee the managers’ decisions and activities. In the ideal
situation, the board of directors should consist a majority of independent members who are able to make independent judgment.
They should play the important role of monitoring the executive directors, decide how they are to be remunerated and audit
the accounts prepared. The independent directors should carry out these duties effectively. Of course, they should not forget
their usual role of setting corporate objectives and strategies. They must see that the executive directors implement the
plans in the most effective and efficient manner.
theory, the shareholders are responsible in appointing the board members. In reality, this is often not the way. The Chairman
of the board usually initiates the appointments. It is unlikely that his/her recommendations are rejected (Cadbury, 2002).
It is important then to make sure that the same person does not hold the positions of CEO and Chairman of the board. This
is to prevent concentration of too much power on one person. Having two separate persons to take-up the two positions allows
second or external views to be heard. This is particularly useful in the case where the founders have aged and perhaps not
much in touch with recent developments relevant to their businesses as much as what they ought to be. It is generally healthy
to have separate persons acting as CEO and Chairman of the board. Their duties differ. The Chairman thinks in a larger context
and formulate corporate strategies while the CEO implements them. The latter is more concerned with day-to-day operations
what extent the board helps in aligning the principals and agents’ interests really depends on the nature of the business
and personalities of the people involved. In family-owned businesses, the board may be less effective if the founders and
their family members are very powerful. In this case, the board members are merely ceremonial figures. The family in-charged
is still making all the decisions with minimal constructive inputs coming from the rest of the members. This is done perhaps
unintentionally. But the problem is that the family position is so dominant that it creates a sense of fear among the rests
to voice out their concerns or provide any alternative views that may go directly against the controlling voters regardless
of how good the alternative views are. Such a development is unhealthy to the organization.
It is possible for the family to resist interference from others. It will take the second and third generation Asian business
leaders to alter the present corporate governance system and change the way their organizations are currently managed. Some
family members may form the perception that they, being the core family members and owners of the firm, should have the ultimate
power in deciding the direction for the firm to take. Inputs from others are simply unwelcome. Even if they are someone who
dares to provide alternative voices, their inputs can be easily outvoted during meetings by the majority shareholders.
As I have suggested elsewhere, firms should take the initiative to allow their employees to voice out their concerns (Sam,
2003a). Employees generally want their firms to do well. They feel proud working for successful organizations. Make their
demands and unhappiness known. It is better to let them sound their unhappiness internally rather than blowing the whistle
and letting the general public knows about the problem. The employees should be given the opportunities to make suggestions
in improving how things are currently working. Establishing the staff suggestion scheme (with anonymity allowed) represents
a right initial approach moving towards this direction. It is important for the senior management to ensure that the anonymity
other approach aimed to eradicate the principal-agent problem is through the issuance of stock options plan to agents. The
options plan provides the holders the right but not the obligation to buy the company’s share at some stated price (known
as the exercise price). The plan aims to align the interests of agents with that of the principals. It hopes to encourage
the agents to work harder for the company and raise the company’s share price. The agents themselves would gain in the
process for they can then exercise their right to buy the share at a lower price and selling them at a higher price in the
There are several problems with the approach. First, the incentive to work harder may be missing especially among lower positioned
workers. They may have the perception that influencing the share price is beyond their control. Why would they want to work
harder if it requires a collective effort to push up the company’s share price? Free ridership problem may prevail.
Share prices are also influenced by external forces like economic growth which cannot be controlled by any one individual
or the corporation for that matter. To those who have the ability to influence financial statements, stock options plan gives
them the unnecessary incentives to inflate profits and hide liabilities from balance sheets. This is to allow options holders
to put more money into their pockets when they exercise their call options. Companies like Enron, WorldCom and Global Crossings
which did this had landed themselves in trouble.
the options holders are allowed to exercise their options only after holding the options for a certain period of time. They
are usually not allowed to exercise the options in the short term. The incentives to work harder would thus be missing if
the employees were short sighted, and job-hopping was common. Third, the rewards associated with the stock options are in
the form of capital gains, not dividends. The shorter-term reward thus is not forthcoming.
that the principal-agent problem exists because persons who own the companies do not actual control the use of companies’
resources. The professional managers (agents) do. So, why are the agents non-profit maximizers? Why do agents behave in a
manner that is in conflict with the principals? The rationality concept provides an answer. In may view, a person is said
to be rationale if he/she, after accounting for all alternatives that he/she has in making a decision, chooses the option
that yields the highest net benefit. In theory, a rational person must have all the relevant information therefore allowing
him/her to make the rational choice. In practice, it is not realistic to assume that all information is available to a person.
Some information may simply be non-available (for instance, information that is confidential) or that the information is too
costly to obtain. Cognitive limitations to decipher the information may force the person to make less than optimal choices,
a kind of behaviour known as satisficing. Does this mean that the rational behaviour cannot be attained? Absolutely not. A
person can still be considered rational if, in his mind, he/she has done all that he/she can to obtain the information, and
has considered the cost implications of acquiring the information. Upon doing so, he/she then assess all the options and chooses
the one that gives him/her the highest net benefit. Rationality, to me, is a concept that explains the thinking process of
individuals, rather than a tool to predict the eventual choice or option undertaken. It is not possible in reality to predict
choices made by individuals simply because their actions are hidden and personal. A person may choose differently even if
everything else is controlled. The actual decision made depends on the person’s personality. He/she can be utilitarian,
egoistic or altruistic.
Given that individuals are rational, the agents would choose to shirk in their jobs (instead of the option ‘not shirking’)
if the choice provides higher net benefits to them. Generally, the agents would not attempt to maximize the firm’s net
worth if the alternative provides higher yields to them. There is an implication to this. To align the interests of agents
with those of the principals, the principals need to raise the benefits of non-shirking and the costs of shirking. Being rational,
the agents will factor in these benefits and costs into their decisions, thus leading to more desirable choices made at least
from the principals’ point of view. Generally, this is essentially what agents should do to minimize the principal-agent
problem. To gain a better understanding of human behaviour and then initiate ways to raise their productivity levels.
Culture matters. Different culture responds differently to the initiatives. Workers in the west like in the US for example
are very much interested in doing things their own way rather than listening and following every instruction given by their
superiors. They want to take responsibility. They want to have the freedom or autonomy to make decisions and accept responsibilities
(both good and bad) for their actions. Giving the workers more freedom thus raises their satisfaction in working for the organization.
Will this work in Asian countries? May be not. Asian workers are generally more obedient. They respect their superiors. Following
the superiors’ instructions is more acceptable in the Asian context as compared to the west. In the Asian context, clarity
in instructions and developing closer manager-employee relationship are perhaps more appropriate strategies to undertake.
One way perhaps to align the managers’ interests with that of the principals is to shame the former in the event where
‘offences’ towards the shareholders are committed. In the Asian society, there is a strong fear of losing face.
Asians are generally afraid of being shamed in public. As such, raising the probability that public shaming will be resulted
for any offences committed can increase the cost of choosing the ‘wrong’ option.
Essentially, there should be some checks on acts of corruption in private corporations. Corruption in private corporations
can include acts like paying themselves higher salaries, using shareholders funds to maximize their own interests (like spending
lavishly on business travels and furnishing their offices unnecessarily), offering job opportunities to friends and relatives
without going through the proper screening process and others. Board members should see that proper checks are installed to
minimize corruption. Raise the probability of being caught, increase the penalty costs, shaming the offenders in public and
encourage staff to inform board members when they spot managers acting corruptly, are some methods in which the board can
introduce. In some countries like Singapore, the anti-corruption agency encourages staff to whistle blow. Staffs are encouraged
to inform the agencies directly in the event that corruption acts are committed within the private corporations. See Sam (2003b).
The above discussion focuses mainly on internal efforts aimed to raise standards of corporate governance. Efforts can also
come from outside the private corporations. Many countries around the world have developed their respective codes of corporate
governance. The objective is to provide a set of guidelines for private corporations to follow. Ultimately, the corporations
will gain. Investors are becoming more responsive to corporate governance standards in determining which companies to invest
their funds in. Financial institutions are also looking at lenders’ corporate governance standards as a measure of financial
risk. To encourage private corporations to follow the guidelines, some institutions like the Securities Investors Association
of Singapore (SIAS) in Singapore reward corporations based on their standards of corporate governance. Companies are also
gauged on how well they have followed the codes stipulated by the regulatory agency, the MAS. In 2003, Singapore Telecommunications
(SingTel) won the top prize followed by Keppel Corporation and OCBC Bank holding second and third positions (The Straits Times,
29 September 2003).
The speed of establishing codes of corporate governance increases with the outbreak of the Asian crisis. Most of the codes
were based on the best practices in UK (from codes established in the Cadbury Report, Hampel Report and others) and the OECD.
Cadbury, Adrian (2002) Corporate Governance and Chairmanship: A Personal View. Oxford
University Press (Great Britain).
Mansfield, Edwin; Allen, Bruce; Doherty, Neil; and Weigelt, Keith (2002) Managerial
Economics: Theory, Applications, and Cases. Fifth edition. W.W. Norton (United States).
Monks, Robert (2001) The New Global Investors: How Shareholders
can Unlock Sustainable Prosperity Worldwide. Capstone Publishing Limited (Great Britain).
4. Sam, Choon Yin (2003a) Principal-Agent Problem in Family-Owned Businesses (unpublished manuscript).
5. Sam, Choon Yin (2003b) Whistleblowing and Corruption (unpublished manuscript).
6. Shleifer, Andrei and Robert .W. Vishny (1996), ‘A Survey of Corporate Governance’. NBER Working
Paper 5554. Also published as ‘A Survey of Corporate Governance’, Journal
of Finance, 52, pp. 737-783, 1997.
7. Squires, Susan; Smith, Cynthia; McDougall, Lorna and Yeack, William (2003) Inside Arthur Andersen: Shirting
Values, Unexpected Consequences. Prentice Hall/Financial Times (United States).
8. Stiglitz, Joseph (2002) Globalisation and its Discontent. Allen
Lane/ The Penguin Press (Great Britain).