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Impact of Agency Theory Essay

Pages:8 (2453 words)

Sources:7

Subject:Finance

Topic:Agency Theory

Document Type:Essay

Document:#36993165


Agency Theory

Agency theory refers to the relationship with the principle and the agent, where the principle delegates its financial decision making to the agent. In most cases, the agent is the owner/executive of the company while the principle is the shareholder. Challenging scenario arises as there are two distinct sets of interest which cause decision making problems. Due to this complex and intricate relationship, conflicts of interest arises sometimes where the agent puts his interest before the principle’s causing problems to the principle sometimes. This is known as Principle-Agency Problem. It has long affected the key decisions related to the firm where the agent and principle both have asymmetric interest, causing any one party to suffer at an extreme case.

To remove the problem, the theory states that the goals of managers and the shareholders should be aligned and certain frameworks and practices should be adopted to overlook the decisions like employees’ stock ownership and monitoring by the board of directors (Lumen). These can serve fruitful as they make the agent more cautious while taking important decisions as it can have an impact on their self-interest too (Kuypers, 2011). However, in most cases it is argued that the goals can never be fully aligned in the real world, creating agency problem (Kuypers, 2011).

Since, the nature of this relataionship is such that scandals have arisen in the past due to these problems as this relationship is exploited in self-interest. Some have argued that the scandals and agency risk exist primarily due the awareness of this theory which shouldn’t be thought in the first place. This education encourages an agency mindset where the whole firm sometimes act in corrupt and selfish ways to attain their interest and disregarding the interest of the principle (Heath). Sometimes pursuing of self-interest can be a misunderstanding as the agent and principle both have different capacity for taking risks, understanding of growth and other factors which sometimes misguide the principle about the agent creating conflicts on critical decision making of the firm.

Just like most other firms, Wells Fargo’s decision making is impacted due to Agency theory in many ways as the firm has certain factors and ways of performance, it gives room for agency theory to impact its decision. It impacts the profitability, return on investment, operating expense, shareholder value and other financial performance through influencing the key decision making that goes around these factors. Wells Fargo have a decentralized set up, which gives the autonomy to the employees to take decisions on their own (Pennsylvania, 2017). Setting up of tough sales goals in another aspect in which agency theory might impact the decisions of the firm while, the director’s hiding of the problems in the past, gives the employees more strength and confidence to pursue wrongdoings in their self-interest (Pennsylvania, 2017). Wells Fargo have gone through this problem in the past where the agents have acted in their self-interest and caused the bank to suffer hugely through opening of fraudulent accounts, not just once, but millions of times and raised the concern to the public as well as the principle as to the conduct and internal environment of the bank, threatening the position of the bank.

Firstly, the decision involving risk has a conflict of interest where the agency theory impacts it. The managers have the tendency to not maximize shareholder value and other decisions as both have different interest. Secondly, the decision making of new frameworks and eradicating the agency costs again impacts the profitability and return of investment. Not just this, it also impacts the ownership as in some cases, the ownership is diluted when there the employees are given the share in the firm. There are opportunity cost, operating cost and other factors are involved while on the other hand, and there can be benefits to that too in the form of improved financial performance. These decisions are also impacted by agency theory. Sometimes, harsh targets and goals are also set to push the employees work in the self-interest of the principle, setting a strict and punitive environment of goal setting, all of this in the name of agency theory. There are numerous ways that the decisions are impacted by the agency theory and the conflict that arises because of this theory.

Decisions Regarding the Risk Tolerance

Agency problem impacts the decision regarding how much risk has to be endured and what strategies to adopt. Since, in Banking sector the goals and interests of the agent and principle are asymmetrical, it is highly probable that the agent would want to not indulge in higher risk and have less capacity for risk tolerance…

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…or neglecting the goals of the employees. Since it’s clear that both have different self-interest as the pressure of achieving higher sales is put up on the shoulders of the employees who feel extremely burdenised and pressured as not achieving those goals will have drastic consequences for him.

In this kind of environment where the employees have higher autonomy over the decisions they make to achieve the targets, it is highly probable that agency theory can cause agency-principle problem where they might start making false accounts to satisfy the goals target as happened in the past with Wells Fargo and caused disruptions due to the decentralization of the decision making, not overlooking the procedures and key decisions and only focusing on the target or the outcome, caused fraudulent practices within the bank previously.

The decisions around how to make the agents work for them are influenced through agency theory where both the principle and the agent has to compromise on a framework that doesn’t cause peril to any one party (Heath). Since here, the principle’s tough goals were very unfair and unrealistic for the employees who had to resort to other measures to fulfil it. It is one of the important decision impacting the financial statements as well, as fraudulent cases aren’t shown in the books, but that bloated and hoax image of the bank’s growth was evident in the statements.

Conclusion

Agency theory have long impacted the firms through its key decisions being in the hand of agent who’s supposed to make those decisions in the interest of the principles’ rather than his own. There are problems and complications that have always persisted and many big scandals like that of Enron and even Wells Fargo’s happened because of the agency-principle’s conflicting interest, that went way ahead of being normal, at a very large scale harming the others’ interest. It is highly imperative that the ethical foundation within the firms are strong to base the decision making on the principles of ethics communicated to all the executives and the management level employees to instill within them the spirit of acting ethically and morally in the highest interest of the firm. So it’s not always about acting in one’s own self-interest, it should be base ethically for the greater interest as if the firm will be more profitable,…


Sample Source(s) Used

References

Demsetz, R. S. (1997). Agency Problems and Risk Taking at Banks.

Heath, J. (n.d.). Uses and Abuses of Agency Theory. Business Ethics Quarterly.

Kuypers, A. (2011). How is dealt with the agency problem and what is the role of the board of directors in it?

Lumen. (n.d.). Agency and Conflicts of Interests. Lumen. Retrieved from https://courses.lumenlearning.com/boundless-finance/chapter/agency-and-conflicts-of-interest/

Murray, I. (2016, September ). Wells Fargo and the Principle Agent Problem. Competitive Enterprise Institute.

Palia, D. (2007). “Agency Theory in Banking: An Empirical Analysis of Moral Hazard and the Agency Costs of Equity. Banks and Banks System.

Pennsylvania, W. U. (2017, August 08). Wells Fargo: What It Will Take to Clean Up the Mess. Wharton University of Pensylvannia.

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