The “Agency Problem” in Business Management is ill-conceived

Managers, as agents of shareholders, are often alleged to pursue their own interest rather than the stockholders’ (Smith, 1976); a practice in business management, most often, referred to as the “Agency Problem”.

The agency problem has been quoted and cited copiously in publications and, as such, energised, and an entrenched concept in business governance.

The agency problem, in the above context, is ill-conceived because corporate governance intense proscriptions make it less likely to occur and, more especially, corporate risks management in business governance is recent a phenomenon and, therefore, not a corporate behavioural practice.

Corporate governance practice until the 1980s was dominated by few executives, who held modest stocks in enterprises and got rewarded through the performance-based system – that is, sales or earnings on growth.

During this time, the board of directors’ oversight responsibility on managers was weak and shareholders generally passive. Consequently, chief executive officers (CEOs) took things for granted and shareholders suffered from such blatant managers’ negligence.

The inherent deficiencies resulted in numerous takeovers that taught managers a bitter lesson and made them treat capital, more especially equity capital, an expensive asset to an organisation.

Even, business’s inability to generate enough returns is considered a default and pushes managers to work hard for increased returns leading to high institutional investors getting on board.

The application of governance principles and the quest for engaging qualified managers taking up management positions have helped to increase profits for investors.

Again, the adherence to an enhanced governance structure in an organisation has increased trust for CEOs in decision-making on stock market capitalisation, access to finance, revenue and good returns to the business.

Without sacrificing prudent decision-making for mistakes, enterprises insure their directors in case managerial decision fails to accomplish expected objectives.

Insurance for management enables better corporate performance for enhanced growth and profit maximisation, high returns to capital and outputs, and engenders corporate stability and certainty.

Indeed, directors who demonstrate moral ingenuity and make risky but efficient decisions are indemnified since courts protect them should these decisions fail to deliver intended goals.

Also, the recruitment of auditors external to the organisation for financial audits at all levels reduces financial irregularities in corporate management.

I am not, by this, however, suggesting that gatekeepers – including auditors, rating agencies, securities market regulators and independent directors cannot be dubious and dishonest in their duties.

An in-depth understanding of risks is incomplete without situating it in the context of financial theories including rational wealth maximisation, risk/return tradeoff, and no-arbitrage rule. Also, the existing literature identifies shareholder value maximisation and managerial risks aversion in risk management discussion.

The shareholder value maximisation posits that the enterprise pursues risk management policies so long as it improves the share values for shareholders.

The value addition, therefore, leads to costs reduction in finance and other investment assets. The “Agency Theory”, out of which managerial risk aversion is derived, is used to explain the phenomenon of this type of risk.

Thus, the managerial risks aversion postulates that chief executive officers (CEOs) or managers pursue their narrow interests through formulating risks management strategies that insulate them yet disadvantage the shareholder.

Although the enterprise conception is preceded by uncertainties that constitute risks, issues regarding risks are decisively not addressed in an organisation’s decision-making process (Tucker, 2005).

Again, discourse on risks during organisational decision-making does not position the concept of risks as a managerial behaviour (Hershey & Schoemaker, 1980).

The practical reality is that, in the day-to-day management of an enterprise, managers are faced with risks emanating from the decisions they make and, as such, the assumption that chief executive officers or managers pursue their narrow interests at the enterprise expense (cost), in part, through formulating risks management strategies to insulate themselves is frivolous, preposterous, unfounded, and, therefore, ill-conceived.

The early treatment of risks portrays claims that individual human decision-makers are risks averse, in that when faced with an alternative having a given positive outcome and another option with uncertainty but has the same expected value as the former, an individual will choose the positive outcome rather than the uncertain one (Pratt, Raiffa, et al. 1964; Arrow, 1965; Ross, 1981).

It follows, therefore, that decision-makers should normally be rewarded for variation in possible outcomes; for the greater the returns on investment the greater should be the variance involved.

The conventional Decision Theory emphasises choice and reinforces a possible trade-off between risks and expected returns. Risk-averse decision-makers allow for low risks and sacrifice some expected returns to reduce the variation in possible outcomes.

Risks seeking decision-makers take high risks and sacrifice some expected profits to increase the variation. The theory assumes that decision-makers deal with risks by first calculating and choosing among alternative risk-return combinations that are available.

Corporate risk management is, therefore, pursued especially when managers realise that their human capital and wealth are poorly diversified.

The writer is Director, Monitoring and Evaluation

Ministry of Tourism, Arts and Culture

By DR. ALPHONSE KUMAZA