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Principal-agent problem and its relevance in the financial system

Principal-agent problem and its relevance in the financial system

Sam Choon Yin (2003)

 

Principal-agent problem

            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.

Why 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 capital provider.

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 from shareholders.

            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.

Contracts 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.

To 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

How 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

Managers often 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.

In 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 system.

The 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 Board positions.

 

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 managers.

            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).

Of 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.

In 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).

It 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 and institutions.

Managers 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 interested parties.

There 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 problem

            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.

In 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 and decisions.

To 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 is protected.

The 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 secondary market.

            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.

            Second, 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.

Recall 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.

 

References

1.               Cadbury, Adrian (2002) Corporate Governance and Chairmanship: A Personal View. Oxford University Press (Great Britain).

2.               Mansfield, Edwin; Allen, Bruce; Doherty, Neil; and Weigelt, Keith (2002) Managerial Economics: Theory, Applications, and Cases. Fifth edition. W.W. Norton (United States).

3.               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).