Theories of Corporate Governance

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.

Purpose of agency theory

The purpose of agency theory is to highlight areas where corporate interest groups are in conflict. Banks want to reduce risk, whereas shareholders want to make the most money possible. The ability of managers to turn profits and then impress the board is what makes them even riskier when it comes to maximising profits. There are costs involved with each group trying to control the others because modern corporations are established on these relationships.

Agency problems/conflicts

Agency theory is used to understand the interactions of agents and principals. The agent represents the principal in a particular business transaction and is required to act in the principal’s best interests, regardless of personal financial benefit. Conflicting interests of principals and agents may arise because some agents may not always act in the best interests of the principal. Miscommunication and disagreement can lead to a variety of issues within businesses. Each stakeholder may become divided due to incompatible desires, which can lead to inefficiencies and financial losses. It brings up the principal-agent issue. The principal-agent problem occurs when a principal’s and an agent’s interests conflict. When owners’ and managers’ interests diverge, agency conflicts take place. They appear in various forms. They arise in several ways.

Moral hazard

The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. A manager has an interest in receiving benefits from his or her position as a manager. These include all the benefits that come from status, such as a company car, a private chauffeur etc.

Risk aversion

The company for which executive directors and senior managers work typically provides the majority of their income. As a result, they are concerned about the company’s stability because it will protect their job and future earnings. This suggests that management might be risk-averse and reluctant to fund more risky projects. Shareholders, on the other hand, may want a company to take bigger risks if the expected returns are sufficiently high. It matters less to shareholders if one company takes risks because they frequently invest in a portfolio of various businesses.

Time horizon

Shareholders are concerned about their company’s long-term financial prospects because the value of their shares is based on long-term expectations. On the other hand, managers might only have short-term concerns. This is because they might only expect to work for the company for a short period of time and because they might receive annual bonuses based on short-term performance. Managers may thus be motivated to increase the accounting return on capital employed (or return on investment), whereas shareholders are more concerned with long-term value as measured by net present value.

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.

In American politics, an example of the stewardship theory is where a president practices a governing style based on belief; they have the duty to do whatever is necessary in national interest, unless prohibited by the Constitution. The Stewardship approach is often associated with Theodore Roosevelt, who viewed the Presidency as a “Bully pulpit” of moral and political leadership.

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.

Additionally, governments and local communities are considered as a legal or rule responsibility.  Specifically, these stakeholders have the following characteristics in the theory.

Shareholder: According to the act and the constitution of corporations, shareholders could exercise a serious of power such as voting and transfer ownership. When shareholders received better dividends from a company, they will buy more shares and help the company maintain stability through their rights. In general, shareholders only passively react company’s operation rather than actively participate in corporate governance.

Employees: Company gives employees more attention such as good training and generous welfare, they will work more effectively to bring better profit to the company. Moreover, employees could own a part of the shares in the company. As long as the company’s stock price rises, employees can benefit from it.

Government: The government collects a large amount of fiscal revenue through tax collection, while at the same time providing a convenient trading environment for enterprises. Even the government will give allowance to support company improvement.

Bank and financial institution: When a company provided a confident financial report with them, these financial institutions will not recall funds and would lend the company more money in the future. In addition, the company is able to borrow funds at a low rate.

Community: Local residents will provide the company with a large number of labor resources, and the company can rely on them for efficient production. Local residences will also prefer to purchase the company’s products or services when the company supports community building through charity activities such as help the community develops local traditional culture.

Environment: A number of environmental lobby groups considered as one part of the stakeholders and these lobby groups requested all companies to meet environmental standards during production. If the company is outstanding in the field of environmental protection, the environmental protection organization actually has a propaganda role for the company. These stakeholders can affect the company in many ways and become a significant role in corporate governance. Companies have the responsibility to treat these stakeholders equally and consider their interests. Because these companies need stakeholders to support their operations so that profit from it. Thus, stakeholder theory is significant in the practical application of corporate governance.

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

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