The Role of Agency Theory as a Contributory Factor to the Crisis - Literature review Example

Agency Theory Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Lecture Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date 1.0 Introduction In 2007, the lives of people all over the world were affected by the global economic crisis. Millions of individuals lost their life savings and mortgages as years of unethical practices in the US financial sector finally caught up with the perpetrators. In this paper I argue that the management crisis precipitating the near global collapse of financial system referred to as the Global financial crisis was as a consequence of propagation of faulty management theory. Among these management theories that is at the center of this crisis include Agency theory. According to Ghoshal (2005), the central assumption of Agency theory that an organization exists to maximize shareholder value remains intact although the agency has been called into question by other dominant managerial ideologies. Ghoshal (2005) analyzes agency theory and links it to the Global financial crisis accusing its dominance in management education and practice as the root cause of the Global financial crisis. This paper seeks to analyze the role of agency theory as a contributory factor to the crisis. The paper starts by an analysis of the agency theory and its underlying assumption. Secondly, it critically analyzes agency theory by using literature that has reviewed and assessed the agency theory, noting various gaps in the theory as a dominant management thought. Thirdly, the paper presents organizational theory and stewardship theory as alternative theories that can help organizations overcome the shortcomings of the agency theory. Further, the paper gives the possible implication of the literature reviewed in the study and practice of management in the future. Unlike, Ghoshal (2005) who advocates for a radical change of the management curricula, the paper concludes that Agency theory should be integrated with other theories of management to purge the theory to practice gaps noted in the theory. 2.0 Literature Review 2.1 Defining Agency theory According to Eisenhardt (1989), an agency relationship will occur where an agent is depended on by another party to act on their behalf. Agency theory has been much attached to corporate governance where there is emphasis of managers being charged with the responsibility of controlling businesses with the aim of maximizing the value of shareholders (Jensen and Meckling, 1976). It has been theorized that employees and their employers have competing interests when it comes to running companies. According to Kim, K. I., Park, H. J., & Suzuki, N. (1990) employees would rather spend their time doing leisurely activities or Shirking instead of working. In order for employers to maximize the performance of the employee’s agency theory employs two approaches the behavior/time based and outcome/incentive based approach. The incentive based approach to employee motivation is at the epicenter of the Global financial crisis. According to Eisenhardt (1989) company’s trying to motivate their employees offered various incentive schemes to their top management. One of the most popular incentives was a share option where managers were allocated shares in the company as rewards for good performance (Ghoshal 2005). Another reward scheme involves the offering of bonuses to financial managers, especially those involved in the sale of loan products. 2.2 Critical Views of Agency Theory As stated by Mintzberg and Gosling, (2002), the argument for agency theory is weak as it is not supported by comprehensive research on its effects on firm management. Its acceptance in business schools where it is taught as the dominant management theory brings into question the type of managers produced by present day management institutions. Pfeffer and Fong, (2002) support the fact that due to inadequacy in research conducted, agency theory has brought about negative influences on management practices where through the adoption of certain theories in management, there have been specified ideas and information that takes control of any management research that is to be conducted. This directs us to several questions of if only specific theories are set to govern any research, does that mean any other theory to be formulated will not be effective? Further, how many research methods have been conducted to prove that only the set ideas and information provided in the research conducted have proved to be sufficient for management practices? These two questions indicate that there is much pretense in the knowledge presented to students and the business world in the agency theory explanation (Mitroff 2004). The agency theory ignores the behavior that managers should have hence demands less integrity on the morals and attitudes of top managers. A question that can be asked at this point is: Does the manager operate on his or her own? Does he not have any other people who he has to partner with in order to bring up a successful team that will indicate positive managerial practices? Using the social theory, Pfeffer (1993) affirms that all management theories should be rooted to discipline and it is through that, that negative managerial behavior will be eliminated. By upholding the social theory and agency theory, any research that is to be conducted will be trusted as the assumptions and analysis will have been legitimized (Donaldson 1990). This is because a theory that is based on assumptions and largely incorporate opportunistic behavior in description of managers is more likely to be trusted than in theories that only incorporate trust as the basis of evaluating managerial effectiveness. Management theories –agency theory being part of them have a correlation in social sciences as mentioned by Lan and Heracleous (2010), who claim that management is an art that needs to be practiced as it is always faced with dynamic situations. The only difference that comes in while practicing is the method that is to be used in the practice. Having given different modes of practice, managers have the flexibility to choose which is appropriate in the organization. With the three modes given: intentional, functional and casual, Piderit (2000) concentrates on intentional mode where any action is predetermined by certain intentions and functions that guide a specific act. Taking an example of the capital markets, there is the demand for the economy and that of a company. A manager has to adopt both social and agency theories to come up with the right choices. This is because he has been assigned the responsibility of making decisions that will be comfortable with the stakeholders and shareholders (Pfeffer, 1993). By only using shareholder value as the aim makes an agency theory a limitation and to some extent it has become self-centered as managers to carry out the demands of the principals which in this case are the shareholders. With this in mind, managers who uphold social ethics strike a balance in the contribution brought in by the shareholders through financial capital and the contribution brought in by stakeholders which is human capital (Jensen and Meckling, 1976). The agency theory as stated by (Jensen and Meckling, 1976) does not give solid evidence of any prediction by all the authors but is entirely based on assumptions on how to increase the shareholder value. It can thus be argued out that this theory is one sided and largely supports investors leaving behind those who are the backbone of ensuring that the set targets have been achieved. Martnov (2009), supports this argument, calling into question the legitimacy of the theory as only some parties are considered while others are disregarded. 2.3 Alternative theories to Agency Theory Organizational theory has been suggested as an alternative perspective of management to rival the profit maximization objective of the agency theory. Unlike the agency theory, the organizational theory view organizations from a social perspective where the human subjects are important part of organizational management (Hosmer 1995). Organizational theory tries to determine the way organizations behave under certain conditions. In organizational theory rational view of the organization where an organization is a mechanism that behaves in a prescribed ways is abandoned (Hosmer 1995). According to Hosmer (1995), organizations must factor in risk factors brought about by the fact that organizations are run by people who are not perfect. In contrast rational view of the organizations including agency theory largely ignores the human factor instead it contends that data and facts are more important in understanding how organizations work. One of the organizational theories that is closely associated with agency theory is scientific management as propagated by F.W Taylor (Tranfield and Starkey 1998). In scientific management emphasis is placed on the enhancing procedures in the organization through scientific means. Like the Agency theory, scientific management tries to enhance performance by providing scientific solutions to organizational problems. However, unlike Agency theory, scientific management focuses on the individual work process, starting at the employee level. In contrast, to agency theory, scientific management is a bottom-up approach while Agency theory applies scientific solutions to top management only. Like Agency theory, scientific management had the effect of enhancing the shareholder value while ignoring the human factors in the organization. Application of scientific management in practice just like agency theory became widespread and led to a period of accelerated growth in industrial production (Ofori-Dankwa and Julian 2005). Although, it has been largely abandoned, Agency theory draws heavily from it as they both aim at maximizing shareholder value albeit in different ways. Stewardship theory is one of the managerial theories that has been suggested as a possible alternative theory for management practice. Stewardship theory has a more positive view of managers in contrast to Agency theory, as they are viewed as sharing the same objective as top shareholders of the organization (Davis, Schoorman and Donaldson 1997). Another important contrast of the two theories is the discipline they are based in; while Stewardship theory draws from sociology and psychology literature, the Agency is informed by economic literature. Davis, Schoorman and Donaldson (1997), maintain that managers are stewards of the organization, and they will disregard their personal motivations and incentives in the interests of the organization's shareholders. In contrast to Agency theory that perceives motivation to be rationally possible under two approaches the behavior/time based and outcome/incentive based approach, Stewardship theory views motivation as more varied and complex (Davis, Schoorman and Donaldson 1997). Stewardship theory recognizes that managers have their own self-incentive and an intrinsic motivation to achieve excellent results. According to Davis, Schoorman and Donaldson (1997), the challenge of completing challenging tasks and excising power is appealing for organizational stewards as it impresses their peers and satisfies them they have gotten the job done. According to Davis, Shoorman and Donaldson (1997), Stewards recognize the trust given to them by the shareholder in running the company. In contrast to the agency relationship, shareholders need not control manager, as the mindset of management they are an embodiment of the shareholders. The recognition of trust accorded by the shareholders to the Stewards is where the ideas of Agency theory and stakeholder theory show the greatest gap. 2.4 How the practices of agency theory contributed to the GFC According to Ghoshal (2005), the three main reasons that led to the Global financial crisis are the taking of excessive risks, poor corporate governance and greedy management. These reasons show how the practice of agency theory is directly linked to the crisis. According to Albrecht, Albrecht and Albrecht (2004), the first practice factor that led to the GFC was the concealing of years of unethical behavior and business problems. In the 1990s and 2000s Companies were able to sweep imprudent investment behavior as they remained profitable. The economy was booming and CEO’s were able to satisfy the performance expectations of their stakeholders without seeking to know the success of their company. Agency theory helps the managers rationalize the masking of potential problems as the firm is performing well (Albrecht, Albrecht and Albrecht 2004). Another problem with agency theory is its short term perspective as it is satisfied with achievement of short term objectives. Secondly, the practice of offering performance incentives under the agency theory was very widespread in many organizations (Watson 2006). In most company the better the company performed the more the top executives were paid. In most cases, the extra bonuses were offered as stock options and companies also offered corporate loans to executives to purchase company shares (Ungston and Steers 1984). As a consequence, the managers were now more concerned with the stock performance of the company rather than the company’s business performance. Thirdly, managers had to put the performance expectations of their company’s in-line with the expectations of Wall Street analyst. Company boards expected their companies' stocks on Wall Street to perform similarly to firms in the same industry (Sims and Brinkmann, 2003). As agency theory asks managers to strive to satisfy the expectations of the Shareholder in their own interests maintaining higher stock performance became a matter of life and death for them. In one case a company inflated its operating income by $500 million to stay in line with the Wall Street focus of its earnings per share (Albrecht, Albrecht and Albrecht 2004). A fourth factor that is closely related to the global financial crisis is the presence of greed among CEO, investors and financial institutions. Before the crisis transactions were highly lucrative and companies were benefiting from high profits made by partner firms (Sims and Brinkmann, 2003). In the case of the Enron greedy firm who were transacting business with the firm failed to alert individual investors of the impending collapse of the company as they continued to benefit from its investment products (Albrecht, Albrecht and Albrecht 2004). In this situation the greedy companies could not disclose Enron troubles as it would mean they are not benefiting anymore. This action is informed by the fact that Agency theory rationalizes this action as it is a move to maximize stakeholder’s value. 3.0 Implications of the Literature From the review of literature it has been found that the practice of Agency theory has led to organization of low moral integrity. The development of agency theory can be traced to other organizational theories like scientific management that ignore human factors in perceiving how organizations should be run. It has been shown that the main failure of Agency theory is its misplacement of incentives and it short-termed view of a business performance. Misplaced incentives meant that CEO’s motivated by their own greedy interests were ready to cook up positive performance results in order to access various pay based bonuses. The weakness of Agency theory both as a theory and its failings to account for human behavior are the main reasons why it contributed to the global financial crisis. The gaps in agency theory mean the theory needs to be enhanced by other competing views of the organization. Although most of the alternative theories are limited in terms of providing strategic advantage to organizations the gaping holes in agency theory cannot be ignored anymore. More focus on human factors in organizational management need to be included while coming up with new theories to run organizations (Walsh, Weber and Margolis 2003). The immoral conduct of executives could have been avoided if they had based their decisions on a different school of management thought. If for example organizational theory was the dominant thought informing decisions to award incentives, then the incentives would have been different. Since organizational theory factors in human behavior it would be aware that stock-based options as incentives would increase the greed of top executives. Alternatively, a stewardship based reward structure would unethical conduct by executives as it removes their motivation to commit fraud. Stewardship theory allows managers to take into account the long-term success of the firm and therefore reduces the inclination to commit fraud. Therefore, academics in the field of management should come up with ways to integrate Agency theory with theories like organizational theory and stewardship to come up with managerial theories that will prevent future ethical problems in management. The literature also implies that the current education in management schools is ineffective in promoting ethical behavior in management professionals. According to Mitroff (2004) educations should be aimed at cultivating desired behavior among those being educated. Therefore educators must start teaching students about the drawbacks and gaps in the theories applied in current management. If management education continues ignoring alternative views of management social advancements of self-interest in decision making will continue (Daily, Dalton and Cannella 2003). Management thought must recognize the presence of multiple actors in corporate governance other than those of just the Principal-Agent as proposed by the Agency theory. Consequently, more research on the application of management theory in organization needs to be undertaken to guide future management practice. Management education should also increasingly focus on cultivating ethical values in their management graduates (Pfeffer and Fong 2002). In the present business environment executives must put into consideration the interest of all stakeholders in their business. By teaching ethics management school encourage values that see the interests of customers as stakeholders taken care of. 4.0 Practice Relevance This paper has several implications for management practice in the future. By using highly relevant articles to management practice, the paper is able to come up with theoretical recommendations which will greatly enhance future management practice. Through a critical review of the highly authoritative academic article this paper is able to plug the theory to practice gap that is inherent in agency theory. The paper supports the view of prolific scholars in academics that theories of corporate and organizational governance need to take into consideration the possible effects of human behavior and decision making on management practice (Watson 2006). 5.0 Conclusion It can be concluded that Agency theory was one of the Global financial crisis chief causes. The main tenet of Agency theory that organizations are in existence to maximize shareholder value was shown to have been the main excuse used to rationalize unethical behavior. Greedy executives took advantage of share option incentives designed to protect shareholders from executives pursuing their own interests to carry out various fraudulent activities. In other cases executives rationalized fraudulent activity as it was serving the interests of the shareholders. Unless Agency theory is improved by integrating it with other theories the likelihood of scandals like Lehman Brothers and Enron recurring is still possible. However, it must be noted that no one management theory can address all the problems of running an organization. Every theory must be applied to problems that it is most appropriate for. References Albrecht, W. S., Albrecht, C. C., & Albrecht, C. 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