Management Theories and the Financial Crisis of 2008 - Literature review Example

Table of Contents 1.0.Introduction 2 2.0.Literatures review 3 3.0.Implications of the literatures 7 4.0.Practice Relevance 9 5.0.Conclusion 12 6.0.References 13 1.0. Introduction The financial crisis of 2007 and 2008, given the various explanations of housing bubbles and debt derivatives that made a number of financial institutions to lend money to creditors who could not pay back has some foundations on the underpinnings of agency theory and to some extent, bad management theories and faulty business strategies. To begin with, opponents of agency theory look at the entirety of the theory as a conflict of interest arising between the agent and princiapls (Berlin 2002). This conflict of interest is also instigated by bad management theories thus making agents not to act in the best interest of the principals. While Ghoshal (2005) integrates agency theory and the 2008 financial crisis in what her terms as ‘the corporate scandals in the United States’ (p. 75), the theory comes into play when agents fail to act in a manner that suits the expectation of the principals. The aftermath of such confusion is that investment banks are now making attempts to recoup funds but the economy where values of products have depreciated makes such move difficult. In as much as agency theory, the 2008 financial crises and bad management theories are concerned, there are some moralities involved but plausible contexts such can be put is that there are technical problems that require technical review. This is the point of departure for this essay; critically analyzing the link between the agency theory, the 2008 Global Recession and Ghoshal's article. The thesis statement is essential for management and organizations especially where cases of insufficient regulations, fragmented ownerships, distortive incentive frameworks and bad management theories are in continued practice. 2.0. Literatures review At least scholars agree that there is connection between bad management theories, financial crisis of the 2008 and the agency theory (Feldman and Orlikowski, 2011; Jarzabkowski and Feldman 2010; Ghoshal, 2005). Therefore a literature search into their connectedness starts by assessing arguments posited by each school of thought. According to agency theory, separation of control and ownership should lead to minimized value of firms as a result of expropriation of the more so big shareholders and minority shareholders. This is how Jarzabkowski and Feldman (2010) link financial crisis with the agency theory. That is, the principalities of agency theory failed to provide for mechanisms that establish strong and sound frameworks that could protect investors. What Jarzabkowski and Feldman argue about is the high profile accounting irregularities, collapses, remuneration excesses, corporate corruption and inadequate disclosures practices that tended to instigate the 2008 crisis. Looking at their argument from a wider perspective; it is that banking crisis in most cases follows collapses in assessing prices especially when there is a sign of a bubble. While this argument shows ascendancy of financial markets and the intellectual domination as posited by the agency theory into an almost obsessive concern for the issues related to accountability and controls that are involved in the dispersal of ownership of the corporate companies, the dynamisms of management and organisations stretch more than this argument. To underscore the statement, Feldman and Orlikowski (2011) for instance argue that the efficient market hypothesis and standard neoclassical theory precludes any existence of bubbles thus undermining the position held by Jarzabkowski and Feldman. Conversely, this is what Ghoshal (2005) terms as “ideology-based gloomy vision” (p. 82). The sequence of activities in the 2008 financial crisis and the agency theory and bad management theories have been strongly linked by Tina et al. (2010) and Barley (2008). Tina et al. study a wide range of crises in 18 countries among them 4 industrial and 6 emerging ones. A common precursor to most of the crises was credit expansion and financial liberation. Ghoshal (2005) looks at credit expansion and financial liberation from the perspective of Hirschman (1970) article “The Search for Paradigms as a Hindrance to Understanding” where Hirschman believes that managers who follow management theories get lured into unrealistic financial liberations. In a more restrictive approach, the discussion linking agency theory, Ghoshal’s analyses and the 2008 financial theory should assume the position held by Fama and Jensen (1993). That is, as far as agency theory is concerned, Fama and Jensen believe directors must allocate efforts to ratify decisions and monitor resource utilization so as to reflect the tenets and demands of agency theory and bad management theories. This position assumes that in as much as there are elements of bad management theories such as what Ghoshal (2005) terms as “the Creeping Spread of an Ideology in Management-Related Theories” (p. 84), such has no link with the 2008 financial crisis because agency theory still gives principals to ratify some of the decisions made by agents and this is where Barley (2008) comes in. Contrariwise, reactions from Valery et al. (2010) show that it is unrealistic to look at agency theory, bad management theories and financial crisis of 2008 as a single entity. The cornerstone of this assertion is that in accordance with agency theory, the principal has the mandate of limiting divergence from the interests and this is done by establishing necessary incentives for the benefit of agent and by taking care of monitoring costs designed to limit opportunistic actions undertaken by the agent therefore the aspects of the so called bad management theories and the financial crisis not relating. Conversely, Tina et al. (2010) concur that Agency theory is entirely concerned with listed companies and adds that this is done with unitary boards having operations in market systems. The best way to look at the link between the three aspects is to bring in the very risky mortgages which were provided in United States, of which the risk was covered up by securitization. When housing bubbles in United States started there was a decline in prices. This made it clear that there were large amounts of sub-prime mortgages existing within the system. In addition to that, the price of credit began to increase since the perceived credit risk of the institution went up. Connecting this to agency theory, powers and duties of directors as stipulated in agency theory has direct relationship to the risky mortgages witnessed immediately before the financial crisis of 2008. Johnson et al. (2003) even argue that powers and duties vested upon directors allow them to construct incentives and rules that can align the behavior of shareholders and mangers which negatively affects the financial position of the company. Bartunek (2002) further posits that when such powers and duties are inherent among directors then the fundamental assumptions of a universal separation of control and ownership upon which the agency theory rests will have been upheld. This argument had earlier been discussed by scholars such as Pass (as cited in Greenwood et al. 2008) adding that in United States which has been regarded as archetype of market based corporate system of governance has directors who are allowed to construct incentives and rules that can align the behavior of shareholders and mangers. It is not within the realm of modern corporations and to larger extent management of such organization when Pass argues that it is allowed for directors to construct incentives and rules that can align the behavior of shareholders and mangers. The point of disconnect with bad management theories and the 2008 financial crisis is that it is not necessary to align only the interests of management and shareholders since such alignment must consider that of customers. Arguments as that of Pass make the scrutiny between the 2008 financial crisis, Ghoshal’s article and the agency theory be compared in terms of the universal banking and financial firms’ compensation schemes as postulated by Golsorkhi et al. (2010). To begin with, by Golsorkhi et al. mention agency problems financial firms face and such provides useful framework under which to view some issues discussed by Ghala (as cited in by Golsorkhi et al. 2010) as well as those exposed by the 2008 financial crisis. For instance, Ghala asks whether financial institutions should be permitted to operate investment and commercial banking within a single entity. While Ghala posits that managers are always misled by bad management theories to do this, during the initial stages of the 2008 financial crisis, investment banks (in this case those who were regarded as stand-alone) who were not affiliated with any other bank faced serious challenges. While this is the connectedness between Ghoshal’s article and the 2008 financial crisis, one of the issue that has a linkage with this argument is the problem of agency theory as far as compensation of financial institutions are concerned. In as much as Oliver (2011) noted that compensation scheme to executives plays a major role in modern organisations, the practice castigated the 2008 financial crisis in the sense that it could only operate in manufacturing industries but not the financial. To underscore this statement, Paul and Walter (1983) once argued that commercial banks have the responsibility of considering what he terms as “debt culture” (p. 37) and in so doing, align their interests with that of customers. 3.0. Implications of the literatures From the literatures that try to connect the 2008 financial crisis, Ghoshal’s article and the agency theory it is noted that that these literatures are specific in their approach; firstly that Ghoshal is reluctant about the theories advocating for excessive risk taking and secondly, that agency theory finds two issues regarding excessive risk taking that enables corporate governance to boost stock prices of the financial farms. This view is in tandem with research done by Valerie and Chris (2000) arguing that when organisations adopt reasonable management practices including theories then there is likelihood that they will engage in the reduction of real risk-rates of interests thus avoiding events that instigated the 2008 financial crisis. Accordingly, Ghoshal addresses risk management practices which in the first place failed during the crisis. Therefore just like Valerie and Chris (2000) argue above it is worth concluding that the failure of risk management was a corporate governance failure. Secondly, Dunning and Pitelis (2008) help the research have a strong and positive correlation between the 2008 financial crisis, risk management and principalities of agency theory. Dunning and Pitelis clarify what Valerie and Chris (2000) try to point out. That is, agency theory negates the fact that corporate governance arrangements need boards of directors to be specific regarding risk appetite and strategy of their companies. Therefore linking this to Ghoshal’s article, the literatrures imply that agency theory can only be fruitful if risk management is also considered. Conversely, risk management and management theories are necessities of good governance because it is through them that contemporary organisations can constrain agency theory besides promoting prudent and efficient management. Combining ideology-based gloomy vision with the process of self-fulfilling prophecy as Ghoshal (2005) argues, one can believe that it implies or rather describes poor decision making and risks associated with elements of agency theory where agents acts as opportunists who have hidden interests or associate with the company but with bounded rationality. While this is not in agreement with position held by Zajac et al. (2012), the implication brought by Zajac et al. is what can be seen as unidirectional implications---risk managers did not expect the magnitude of the crisis. Back to agency theory, agents will themselves make attempts to satisfy their motives rather than making attempts to maximize profits within the company. Connecting this statement with strategy formulation as suggested by Ghoshal, scholars such as Klaas et al. (2010) have ideas---agency theory is clear in its implications and underpinnings; there should be clear monitoring and control role from directors failure to which issues realized by major banks in United States in the 2008 crisis will not be stopped. Understanding such failures and Ghoshal’s article motivated Klaas et al. (2010) to analyse the risks associated with agency theory and combine such with bad management theories. As discussed in the literature review where banking within a single entity happened, the implication of Klaas et al. (2010) research is that firms tend to mitigate risks in two ways; first, setting risk control measures and secondly, shifting the risk onto other organisations and a good example of such when banks sold mortgages to other banks within a few months of selling mortgages to specific home purchasers. Finally, researches such as Gottschalg and Zollo (2007) and Eisenhardt and Martin (2000) imply that managers in most financial institutions failed to conceptuaise the mathematical underpinnings of agency theory, bad management theories and those used to spread risks. Furthermore, the same managers had limited information regarding real estate markets going by what happened in United States during the 2008 crisis where bankers were not sure when they were reaching a give price level that was too inflated for any possible sustenance until it was too late to do that. This explains in part the position held by Feldman and Orlikowski (2011) as far as managers increasingly engaged in risks behaviours is concerned. 4.0. Practice Relevance Agency theory and Ghoshal’s article cannot be argued to completely complement the tenets of corporate governance and or management and organisation practices. To begin with, this research recognizes that indeed agency theory had an implication on the 2008 financial crisis. In addition, the paper has recognized and supported views of Ghoshal (2005) regarding bad theories that negatively affect management and organisation practices. However, this is not a concluding remark. Practice impact and relevance of the paper is anchored on agency theory which derives from economics and finance, stewardship theory originating from the hypothesis of agency theory, transactional theory embedded on organizational and economic theory and finally stakeholder theory touching on societal perspective. Starting with agency theory, this is the theory that tends to make managers misuse their power therefore as Augier and Teece (2007) note, these managers must be monitored besides having management process being on routine checks. This is not to argue that proponents of agency theory mislead corporate governance or the entirety of management practice but a question of agency costs. With agency cost, Ghoshal explains this aspect by referring to directors who are regarded by management practice as stewards of such organization therefore expected to act on the best interest of their principals. To conceptualise the fact that agency theory might not suit actual practice of contemporary management practices this paper traces the two financial crises experienced in Australia (Oliver et al. 2011). That is, the collapse of the State Owed Banks and further credit losses that were incurred by the four banks that were publicly listed shows that practice is uninformed by bad management theory. In as much, it is important to recognize the fact that agency theory does not in its totality fail management practice or weak in its practice as Barney (1991) once noted. What we are having is a theory which is deductive in its methodology. To explain this point, it is necessary to give the difference between market-based governance mechanisms, external and board-based mechanisms. With regard to market governance, agency theory shows the openness of financial disclosures as important aspect to the operation of stock market. This is the issue that Augier and Teece (2007) and Ghoshal ignore in their analyses. This understanding also disputes Tina et al. (2010) argument regarding this theory. He presents his argument by citing 'the managerial labour market' (p. 47). He believes that the theory allows directors to operate as single entity thus plunging organizations into what was seen in 2008. This point of departure is not right since it is the Annual General Meetings that gives shareholders opportunity to bring accountability issues before the directors therefore a control mechanism is still valid in this theory. Conversely, pessimistic assumptions made by scholars with regard to stewardship theory are misleading since the theory agitates for complete overhaul of organizational structures so as to streamline management practices. For instance, Berlin (2002) argues that what drives proponents of steward theory is self-interest that does not consider other interests. This is incorrect because the assumption that executives’ aims are opposed to shareholders is equally wrong. Ghoshal (2005) supports this assertion by arguing that this theory makes a suggestion on the potentially negative effect of a responsibility between chief executive and a chairman. The roles, Ghoshal adds, should be combined so as to protect a vital aspect of high performance. Notably, the articles such as Ghoshal (2005) about theories of management practice tend to deviate from the main issue. That is, failing to recognize the contribution of some of these theories---stewardship being poignant since this theory questions the pessimistic assumptions of agency theory thus making the study understand human natures. Just Douglas MacGregor makes a contrast between theory Y and theory X managers, this theory helps modern corporate governance and management practices understand problems inherent in such practices. Douglas MacGregor’s views are in tandem with assertions from Stakeholder theory and even dispute Ghoshal’s ideas when he brings the aspect of “delightful organizations” (p. 87). While Ghoshal dispute the actual practicalities of some of the theories including Stakeholder such assertions does not qualify the title, “Bad Management Theories Are Destroying Good Management Practices.” In as much, this essay concurs with Ghoshal regarding some of the theories and Stakeholder being one of such. This theory presents elements that are difficult to operationalize thus making the theory to underscore statement made by Gottschalg and Zollo (2007) regarding ‘Interest alignment rents and competitive advantage.’ The recent profusion of interest in management ethics can be traced to be the effects of this theory. The point is excessiveness of executive pays as well as negative effects on employees undermine the legitimacy of working with this theory. This point has some connectedness with what Ghoshal says about bad management theories and management practices that these theories are anchored on increasingly dysfunctional ideologies of what constitutes ownership. 5.0. Conclusion The criticism of negative assumptions of theories is not considered in this essay to anyway, relate to management practices or conclusions made by articles reviewed thus far. Secondly, this essay finds that the only strong relationship between agency theory, the 2008 financial crisis and Ghoshal’s article is that the crisis puts the theories reviewed in questions. For instance, it has been noted that boards of major financial institutions failed to control their organisations from taking risky decisions and protecting the firm against the meltdown. In addition, it is risky to agree with assertions made by Ghoshal’s article especially when he believes that these theories are bad for management practices. This is because regulatory interventions suggested by Ghoshal may not be prudent since they are victims of unforeseeable repercussions. Similarly, this essay cautions against maximizing the value of shareholders as the only objective for financial firms. This is because the essay recognizes weaknesses inherent in these theories and therefore allowing such is tantamount to disregarding the socialization of losses especially when a systematically significant private organization becomes insolvent or illiquid. Finally it is worth noting the imperfections found with agency theory. This theory assumes perfect rationality or rather creates no room for non-financial motivations. Nevertheless, this essay considers that the link between agency theory, the 2008 financial crisis and Ghoshal’s article has been merited. If management practices have succeeded in anything, it will be because of the theories and its relationship with the crisis. 6.0. References Augier, M. and D. J. Teece (2007), ‘Dynamic capabilities and multinational enterprise: Penrosean insights and omissions,’ Management International Review, 47(2), 175–192. Bartunek, J. 2002. Corporate scandals: How should Academy of Management members respond? 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