PRINCIPAL-AGENT PROBLEM AND REGULATORY FRAMEWORKS Name: Course: Professor: Institution: City and State: Date: Contents Contents 2 1.0 Introduction 3 2. 0 The principal-agency theory 3 3.0 Corporate governance 5 3.1 The role of the board of directors 5 3.1.1 Size: 6 3.1.2 Expertise 7 3.1.3 Independence 8 3.2 Commitment of the board members 9 3.3 Incentive schemes 10 3.4 Information asymmetry 11 4…
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In this article, Ribstein (2002) argues that since principals do not directly participate in the daily decision-making process, they lose the ability to influence the practice on how decisions are made. Likewise, once the voters delegate their duties to the politicians, the politicians could opt to follow their interests rather than those of the agents. In addition, in such a relationship, the voters become the hostage of the politicians. The principal-agency problem can further be extrapolated to the health sector, where the health providers can act as imperfect agents of patients by prescribing unnecessary drugs. This paper assesses the principal-agency problems in explaining failures of corporate governance. The paper further examines how the recent regulatory framework has been used to mitigate the principal- agent problem. 2. 0 The principal-agency theory In the article, Theory of the firm: managerial behavior, agency costs and ownership structure, Jensen and Meckling, suggest managers as being the agents of the shareholders (Huber, 2002). The principal model guides agency relationships where the shareholders, otherwise known as the principals, delegates duties to the agents to act on their behalf. The model is defined by a number of features, which are defined in the following section. Firstly, as suggested by Bodie, Alex and Alan, agents undertake actions, which determine the payoff to the principal (2002). In other words, the effort of the agent determines the profits realized by the principal. Secondly, within a principal-agent relationship, the concept of information symmetry arises. In this regard, the principals can be able to observe the outcomes of agents’ actions but monitoring the agents’ actions is almost impossible. In instances where an imperfect contract exists, the agents could be encouraged to act to carry out actions that benefit their interests, and the possibility of a moral hazard happening becomes even more real if there is a large information asymmetry. To address the problem of information asymmetry, the principals could put in place monitoring mechanisms and initiate incentive contracts. The board of directors remains one of the common used weapons, in reduction of information symmetry by monitoring and ratifying the most important decisions carried out by the management. Beside acting on the behalf of the shareholders, the board of directors is also supposed to control resource allocation and accompanying risks. Thirdly, the agent-principal relationships assume that agent’s preferences differ from the principals. When the agents and the principals have differing risk preferences a conflict of interest occurs. Just to illustrate further, the shareholders may be risk-averse while the management is risk-neutral, which means the management is incentivized to make risky decisions against the will of their principals. If such a situation happens, the board of directors is mandated to ensure the interest of the management, and the shareholders are aligned. To deal with the challenges that are associated with the principal-agent relationships, the principals may result to outcome-based incentives. This
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