Agency Problem and the Role of Corporate Governance

Agency Problem and the Role of Corporate Governance Revisited♣ Pallab Kumar Biswas∗ Abstract: This paper is an attempt to identify various agency relationships that exist in the economic and business life and the related problems that often arise due to such relationships. It also identifies the role of various corporate governance mechanisms in mitigating the agency problems. Though no individual corporate governance mechanism is a perfect one, a careful selection of individual and/or combination of these is likely to serve a better purpose when factors like level of capital market development, legal system of a country are simultaneously considered. Keywords: Agency problem, Information Asymmetry, Corporate Governance.

Introduction Since its development during the period of industrial revolution, large scale businesses continue to bring significant changes in financing, ownership and management patterns. New technologies are continually innovated requiring huge investment in the industrial unit. To supply this fund, people from different sections of the society are coming up with their savings. As a result, once a sole proprietorship business is turned into joint stock type of organization (Khan, Siddiqui and Hossain, 2004). In such a widely-held corporation, the risk bearing function of ownership and the managerial function of control are separate functions performed by different parties. These parties often pose conflicting nature of interests. For example, as Prowse (1999, pp. 115-116) argues, …shareholders’ preferences are to maximize the value of the firm’s equity, without regard for the value of its debt. Creditors, on the other hand, prefer to maximize the probability that they will be repaid, which often means the firm taking on less risky projects than the shareholders would prefer to have. Managers prefer to engage in activities that maximize their own return rather than that of outside financiers: this can vary from policies that justify paying them a higher salary (for example, by increasing the size of the firm), to the diversion of resources for their personal benefit, to simply refusing to give up

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A previous version of this paper is available at http://papers.ssrn.com/abstract=1250842. Pallab Kumar Biswas is a Ph.D. candidate at the University of Western Australia, Perth.

1 Electronic copy available at: http://ssrn.com/abstract=1287185

their jobs in the face of poor performance. Even different shareholders may have different objectives. In particular, large shareholders that have a controlling interest in the firm (“insiders”) would prefer, if they could, to increase their returns at the expense of smaller, minority shareholders (“outsiders”).

This causes the classic principal-agent problem between owners and managers where given the decision making discretion, managers could engage in non-value maximizing behaviour (Habib, 2004). This “agency problem” inherent in the separation of ownership and control of assets was recognized as far back as in the 18th century by Adam Smith in his Wealth of Nations1, and studies such as those by Berle and Means (1934)2 and Lorsch and MacIver (1989) show the extent to which this separation has become manifest in firms throughout the world. Substantial costs result from such divergence of interests among different parties. Corporate governance is considered as an effective mechanism of reducing these costs. In this article, attempts have been made to find the role of corporate governance mechanisms in mitigating agency problems. It is organized as follows. Different agency relationships and related costs are discussed in section two followed by a discussion of specific nature of agency problem in developing countries in section three. Following literature, corporate governance have been defined in section four. Section five discusses the roles of individual governance mechanism in mitigating agency conflicts. Discussion on the effectiveness of corporate governance mechanisms has been made in section six. Section seven concludes the paper.

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In the eighteenth century, Adam smith (1776) drew attention in the Wealth of Nations to an important governance issue in his commentary on joint stock companies : The directors of such companies however being the managers rather of other people’s money than of their own, it cannot well expected that they should watch over it with the same anxious vigilance which the partners in private copartnery frequently watch over their own … Negligence and profusion, therefore, must always prevail, more or less; in the management of the affairs of such a company (vide Jensen and Meckling, 1976). 2 Their thesis was that the separation of ownership from management had resulted in shareholdings being unable to exercise any form of effective control over board of directors, who were theoretically appointed by them to represent their interests.

2 Electronic copy available at: http://ssrn.com/abstract=1287185

Agency Relationship and Agency Costs Agency theory is concerned with contractual relationship between two or more persons. Jensen and Meckling (1976, p. 308) define agency relationship as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent.” Under this agency relationship, both the agents and the principals are assumed to be motivated solely by self-interest. As a result, when principals delegates some decision making responsibility to the agents, agents often use this power to promote their own well-being by choosing such actions which may or may not in the best interests of principals (Barnea, Haugen and Senbet, 1985; Bromwich, 1992; Chowdhury, 2004). In agency relationship, the principals and agents are also assumed to be rational economic persons who are capable of forming unbiased expectations regarding the impact of agency problems together with the associated future value of their wealth (Barnea et al., 1985).3 Such agency relationships are common everywhere in economic and business life and are an element of the more general problem of contracting between entities in the economy (Bromwich, 1992). For example, in the context of public corporation, there are contractual relationships between the shareholders and the board of directors, between the board of directors and the executives, and between the executives and their subordinates. In the above mentioned relationships, the former can be called the principal(s) and the latter can be called the agent(s). The main reasons behind the relationship, as prior literature suggests and Bromwich (1992) identifies, include: (i) to take advantage of economies of scale and scope; (ii) to exploit any asset specific advantage; (iii) to provide an ability to improve on the contracts otherwise available; (iv) to allow the advantage of transaction cost avoidance and (v) to maintain authority relationships including vertical integration.

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In the words of Barnea et al. (1985, p. 26), “rationality implies that every individual recognizes the selfinterest motivations of all others so that future decisions by agents based on their interests are anticipated and taken into account by principals”.

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The problem in the agency relationship occurs as the agent and the principal may be at variance with each other, and partial nature of agency contract (due to uncertainty and asymmetric information) can not fully prevent the participants in the agency relationships from pursuing their self-interests at the expense of other participants. Chowdhury (2004) identifies several possible reasons for such variance. These include: §

Perception of risk: The agent is generally assumed to a risk-averter and the principal to be a risk-seeker or risk-averter;

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Extent of Involvement with the organization: The agent might have a shorter duration with the organization than the principal;

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Limit of earnings: The agent’s earnings are fixed (in the absence of incentive payments) while the principal is the residual claimant;

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Management decision making: The principal does not directly take part in the management decision-making and control (i.e. ownership is separated from management);

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Information asymmetry: Information asymmetry occurs when one party (or economic ‘agents’) has more or better information than the other party. Usually, the agent has more information about the state of affairs of the company, including their own performance, than the principal (Marnet, 2008).

Barnea et al. (1985) discuss five broad classes of agency problems in finance: (a) on the job perquisite consumption; (b) risk incentive; (c) investment incentive; (d) bankruptcy costs and (e) information asymmetry. These agency problems are found in a joint-stock type of organization between shareholders and top management, controlling and minority shareholders, and shareholders and creditors. Often cited sources of conflicts among these parties include the externalities arising from asymmetries of information, differences in attitude towards risk and differences in decision-making rights.

In particular, agency problems between shareholders and management generally arise from a combination of asymmetric information and differences in sensitivity to firm-

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specific risk.4 Conflicts of interest between controlling and minority shareholders may arise as the controlling shareholders, much like controlling managers, can divert part of the firm’s resources for their own private benefit at the expense of non-controlling shareholders.5 In both cases (controlling managers as well as controlling shareholders), non-controlling shareholders suffer because these decisions reduce the cash flow and ultimately the value of the firm to them. Finally, the problem arises between creditors and shareholders because creditors don’t participate in the high profit firms beyond the contractually agreed debt service, but share in losses in case of insolvency. This asymmetry creates an incentive, once debt has been incurred, for shareholders to prefer the firm undertake more risky investment projects than creditors would like.

Bromwich (1992) classifies the nature of problems that may arise between the above mentioned parties into four categories: (a) Moral hazard with hidden action; (b) Moral hazard with hidden information; (c) Adverse selection and (d) Signaling models. Moral hazard with hidden action occurs when the agent can determine to a degree the outcome by his or her actions, and the other party (the principal) can’t directly observe the agent’s effort, or perfectly infer it from the firm’s information systems. Moral hazard not only includes acts like fraud and shirking, but also such actions, like risk-reward tradeoffs in project selection, which are not in the best interests of the principal (Beaver, 1989). A classic example of moral hazard can be fire insurance, where the insuree may or may not exhibit sufficient care while storing flammable materials (Kreps, 1990). In case of adverse selection, the agent knows something relevant to the transaction with hidden information which the principal does not know. In such case, the principal can not check whether this private information has been utilized in his or her best interests. Accounting4

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Heinrich (2002) uses the term “sensitivity to firm-specific risk” to refer to the process of decision marker’s ranking of alternative choices that differ in their riskiness. The ranking depends not only on the decision maker’s preferences (i.e. how the decision maker’s utility varies with the riskiness of his payoff; these preferences are immutable), but also on how the decision maker’s payoff varies with the riskiness of the chosen alternative. For managers, private benefits may include excessive perquisites, such as corporate jets and lavish headquarter building, or of self-aggrandizing rules without adding value to shareholders, or of delaying necessary restructuring decisions to avoid unpleasant confrontations with employees, unions, politicians and the media. For controlling shareholders, such private benefits may take the form of transfer pricing through which profits can be transferred to other firms in which the controlling shareholder has a large cash flow stake or of asset sales at bargain prices to firms owned by the controlling shareholders (Heinrich, 2002).

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oriented example of adverse selection is where firms of auditors offer services of different quality but those employing auditors can not distinguish such quality differences. To overcome the problem, audit firms may resort to advertising or to market signaling, where they seek to signal their quality by their actions. Moreover, such a firm may also seek to make known the formal qualifications of its members if it is generally believed that such qualifications are correlated with the ability to offer high quality services (Bromwich, 1992).

The consequences of the agent’s shirking are known agency costs. Agency costs refer to the decline in the firm’s value due to agent’s behaviour, which are in divergence with the owners. Jensen and Meckling (1976) argue that realizing the possibility of dysfunctional activity, the principal will seek to limit divergencies from his or her interests by incurring different monitoring and bonding costs.6 But even the incurrence of sufficient monitoring and bonding costs do not necessarily ensure that the agent will maximize the principal’s utility. Rather, there will be some residual loss arising from the inability to ensure that the agent acts fully in the principal’s interest, given existing monitoring and bonding devices.

The agency costs in any enterprise depend on the lack of information about the agent’s activities, and the costs of monitoring and analyzing the management’s performance, the costs of devising a bonus scheme which rewards the agent maximizing the principal’s welfare and the costs for determining and enforcing policy rules. They also depend on the supply of replacement managers.

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Monitoring costs are those costs that are incurred in relation to activities like imposing budget and operating restrictions and constraints on the agent, and linking agent’s compensation with the outcome of monitoring. Bonding costs, on the other hand, are incurred by the agent (upon approval by the principal) on activities such as accepting contractual limitations on the agent’s decision making power and agreeing to have accounts audited by a qualified auditor (Bromwich, 1992).

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Expropriation Problem in Developing Countries In developed countries, much of the debate has focused on the “principal-agent” problem between shareholders and managers and corporate governance has been seen as a device to protect the interests of shareholders as other investors are generally protected through contractual relations with the entity (OECD, 2007). However, in many developing and transitional economies “pervasive clientelism (“cronyism”) and/or weak judicial systems, and often poorly defined property rights, tend greatly to weaken effective contract enforcement. Poor contract enforcement in turn renders the distinction between “residual” and non-residual claimants of doubtful applicability in practice” (OECD, 2007, p. 155). In such countries, corporate ownership concentration is a general phenomenon and corporate ownership dispersion (prevailed in the US and UK) is an exception, not rule. Moreover, in order to increase the control over an entity beyond direct ownership, concentration is often reinforced further through mechanisms like pyramidal ownership structure7, cross-ownership and dual class shares (Berglöf and Pajuste, 2005; OECD, 2007). As a consequence, the key potential conflict in developing economies tend to arise between controlling shareholders and minority shareholders (domestic as well as foreign) and other investors. This type of conflict of interest can be termed as the expropriation problem as the dominant owner-managers often tend to deprive minority shareholders, and sometimes other investors, of their fair share of income from corporate resources by channeling those resources to his own account (Berglöf and Pajuste, 2005; OECD, 2007).

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A “pyramid” is said to exist when one company (at the top of the pyramid) holds “a dominant equity share (say 51 per cent, though less may suffice) in and thereby controls one or more other companies (the second “layer” in the pyramid) each of which may in turn have a dominant equity share in one or more additional companies (the third layer), and so on” (OECD, 2007, p. 167).

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Corporate Governance Corporate governance has been an integral part of business practices since the creation of corporate structure and the separation of ownership from management (Dallas and Patel, 2004). Since its inception, different authors have provided different definitions which often differ significantly in terms of objectives, goals and means and tools to achieve and realize it. From perception’s point of view, a fairly narrow definition of corporate governance is provided by Shleifer and Vishny (1997, p. 737), “corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.” In this definition, corporate governance is restricted to the relationship between a company and its shareholders which is the focal point of the traditional finance paradigm, expressed in ‘agency theory’ (Solomon and Solomon, 2004). A much broader functional definition is provided by the Organisation for Economic Cooperation and Development (OECD) (2004, p. 11) describing corporate governance as: “… a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.” This definition recognizes not only the relationship between company and shareholders but also a wide array of relationships between company and other stakeholders like employees, customers, suppliers and bondholders. Such viewpoint is generally expressed in ‘stakeholder theory’ (Solomon and Solomon, 2004). In his definition, Cadbury (2000, p. vi) emphasizes on corporate governance for the stability and equity of society by saying, “corporate governance is concerned with holding the balance between economic and social goals between individuals and communal goals. The governance framework is there to encourage the efficient use of resource and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations, and society.” Mallin (2007) identifies several key characteristics of corporate governance: (i) to ensure an adequate and appropriate system of control within an organization leading to safeguard of assets; (ii) to prevent any single individual from having too much power and influence; (iii) to establish appropriate

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relationship between company’s management, the board of directors, shareholders, and other stakeholders; (iv) to ensure that the organization is run at the best interests of the shareholders and other stakeholders and (v) to encourage increased transparency and accountability.

Corporate Governance for Agency Problem Control mechanisms are considered necessary to reduce divergence of agents’ interests from the principals’ interests. Corporate governance is probably the widest control mechanism used for efficient utilization of corporate resources. It is a hybrid of internal and external control mechanisms with a view to achieving efficient utilization of corporate resources. It is a network among various corporate players such as shareholders, managers, employees, lenders, government, suppliers, and consumers for increasing the value of the firm. Corporate governance and monitoring mechanisms are manifold and generally comprise external control mechanisms as well as internal control mechanisms. In table 1, attempts have bee made to create a list of corporate governance mechanism. Some of the important corporate governance mechanism are discussed briefly in the following sections (for empirical evidence, see Ho, 2005; Biswas and Bhuiyan, 2008).

Board of Directors and different board committees: The size and composition of the board of directors act as a corporate governance mechanism. Limiting board size is believed to improve firm performance because the benefits of larger boards (increased monitoring) are outweighed by the poorer communication and decision making of larger groups (Lipton and Lorsch, 1992; Jensen, 1993). The composition of a board is also important. There are two components that characterize the independence of a board, the proportion of non-executive directors and the separated (or not) roles of chief executive officer (CEO) and chairman of the board (COB). Non-executive or outside directors, through their expertise and independence, can play an important role at firm level through transferring knowledge as well as at country level through building constituencies for corporate governance reform (Berglöf and Claessens, 2006). As far as the separation

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between the role of CEO and COB is concerned, it generally believed that separated roles can lead to better board performance and, hence, less agency conflicts (for empirical evidences, see Rechner and Dalton, 1991; Yermack, 1996; Brown and Caylor, 2004; Haniffa and Hudaib, 2006). In contrary to this, Finlestein and D′Aveni (1994) find that board vigilance is positively associated with CEO duality, and association is stronger when both informal CEO power and firm performance are low.

Table 1: List of corporate governance mechanisms Internal Mechanisms

External Mechanisms

Monitoring Instruments § Ownership structure (i.e. identities of equity holders and their sizes of equity holdings) § Institutional shareholding – pension funds and mutual funds § Creditor (particularly bank) monitoring8 § Board of directors and different subcommittees – size and composition § Corporate bylaws and charters § Bilateral private enforcement mechanism § Internal managerial labour market § Monitoring by employees § Debt financing (leverage) § Dividend payment

§ Market for corporate control (both the hostile takeover market and the market for partial control through block trading) § External managerial labour market § Competition in the product and service market § Arbitration § External auditors § Regulatory framework of the corporate law regime and stock exchange § National legal and judicial systems that protect investors’ rights § Media and social control § Other mechanisms (corporate governance rating, corporate governance codes etc.)

Incentive Instruments § Executive/ Managerial compensation § Managerial ownership Source: Bushman and Smith (2001), Cuervo (2002), Weir, Laing and McKnight (2002), Denis and McConnell (2003), Gillan, Hartzell and Starks (2003), Correia Da Silva et al.(2004), Bai, Liu, Lu, Song and Zhang (2004), Cremers and Nair (2005), Goergen, Manjon and Renneboog (2005), Berglöf and Claessens (2006), Smith and Walter (2006), Imam and Malik (2007), Florackis (2008).

Besides the size and composition of the board of directors, various board committees representing the internal control system of an organization, particularly the audit committee and the remuneration committee, also prove to be important control mechanisms. For example, the audit committee assists the board of directors in overseeing and ensuring adequate functioning of internal control mechanisms, monitoring 8

Correia Da Silva et al. (2004) consider creditor monitoring as external governance mechanism. Similarly, Smith and Walter (2006) report institutional shareholding as external control mechanism. Gillan, Hartzell and Starks (2003) vies investor/shareholder monitoring as external mechanism.

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and focusing on reviewing financial risk and risk management (Bhuiyan, Hossain and Biswas, 2007). Hence, audit committee helps determine indicators of problems and address these problems, mitigate possible damage and enhance shareholder value (Haron, Jantan and Pheng, 2005).

Ownership Concentration: Theoretically, shareholders could take themselves an active role in monitoring management. However, given that the monitoring benefits for shareholders are proportionate to their equity stakes, an average shareholder has little or no incentives to exert monitoring behaviour. In contrast, shareholders with substantial stakes have more incentives to supervise management and can do so more effectively. As a result, institutional or large blockholders, find incentives to engage in monitoring activities through different shareholder activisms like voting at the Annual General Meeting on issues like membership of the board of directors, remuneration policy, engagement of the external auditor, budget and operating restrictions, shareholder resolutions, incentive schemes and contracts like share ownership and stock options, threat of dismissal in case of low income, sale of shares etc. (Bromwich, 1992; Shleifer and Vishny, 1997; Patel, Balic and Bwakira, 2002; Bushman and Smith, 2003; Correia Da Silva et al., 2004; Solomon and Solomon, 2004; Goergen et al., 2005). Monitoring by Banks: It is widely believed that debt servicing obligations help to reduce agency problems relating to free cash flow and information asymmetry particularly in case of privately held debt (e.g. bank debt) (Florackis, 2008). As lenders, banks requires such firm behaviour that ensures timely payment of their loans. Moreover, as Berglöf and Claessens (2006, p. 142) argue, “banks can compensate for some weaknesses in the general enforcement environment, as they have repeated dealings, have a reputation to maintain in lending, and can economize on monitoring and enforcement technology.” As a result, bank debt incorporates significant signaling characteristics that can mitigate informational asymmetry conflicts between managers and outside investors. For example, the announcement of a bank credit agreement conveys positive news to the stock market about the company’s credit worthiness (Florackis, 2008).

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Managerial Ownership: Jensen and Meckling (1976) suggest that managerial ownership can align the interest between the two divergent groups of claimants and, therefore, reduce the agency costs within the firm. According to their model, the relationship between managerial ownership and agency costs is linear. Subsequent studies, however, mostly report non-monotonic relationship between managerial ownership and agency costs (for example, Morck, Shleifer and Vishny, 1988; McConnell and Servaes, 1990; Short and Keasey, 1999).

Managerial Compensation: Periodic performance reviews and incentive compensation in the form of accounting-based bonuses, stock option grants, stock appreciation rights, or restricted stock can reduce a variety of agency problems (Habib, 2004). This is because, satisfied managers will be less likely to expropriate organizational resources for selfbenefit. Empirically, Hall and Liebman (1998) and Main, Bruce and Buck (1996) find that when stock options are included, a stronger pay-performance link can be identified. Aggarwal and Samwick (1999) report that executive’s pay-performance sensitivity for executives at firms with the least volatile stock prices is greater than that at firms with most volatile stock prices. Examining the relation of managerial rewards and penalties to firm performance in Japan, the US and Germany, Kaplan (1994a, 1994b) reports that poor stock performance and inability to generate positive income increases the likelihood of top management turnover in these countries. In another study, using time series data from the UK and Germany, Conyon and Schwalbac (2000) report a significant positive association between cash pay and company performance in both countries.

Dividend Payment: Dividend policy, another important corporate governance mechanism, often serves as substitute and/or mechanism to other corporate governance insturments (Correia Da Silva et al., 2004). Substitute’ in the sense that a high dividend payout policy often directs manages to generate sufficient amount of cash flows and thereby, enable them to distribute to the shareholders. On the other hand, ‘complementary’ in the sense that presence of large shareholders or a strong board of directors can impose such a high dividend payout policy and such a dividend policy is often used as a defence against hostile takeover (Correia Da Silva et al., 2004).

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Market for corporate control: Market for corporate control is an important external corporate governance mechanism. The role of this mechanism may be direct or indirect (Correia Da Silva et al., 2004). For example, the role is direct in case of hostile takeover. However, whether poorly performing firms are more likely to be the target of hostile takeover is not overwhelmingly supported in the literature. As indirect role, a mere threat of a takeover may increase the efficiency of management ex ante, or setting-up of antitakeover devices may coincide with reduction in share price (Correia Da Silva et al., 2004).

A market for partial control generally operates irrespective of the effectiveness of hostile takeover. Unsatisfied shareholders’ decision to sell shares in a non-performing company allows other shareholders with monitoring abilities to increase their stake in the organization in order to reinforce their position as (majority) shareholders. As a result, such block trading allowing the purchaser to achieve substantial control often triggers more favourable market reaction than those transactions which do not confer control to the purchaser (Correia Da Silva et al., 2004).

Managerial Labour Market: Career opportunities and potential for higher compensation provides incentive for effective managers, as opposed to ineffective mangers, to increase stockholder value and limit self-serving behaviour (Habib, 2004).

Effectiveness of Corporate Governance as a Control Mechanism Although corporate governance mechanisms or instruments are designed to alleviate agency problem within an organization, none of them are perfect due to several reasons. Monitoring and supervision is a costly business. As discussed earlier, an average shareholder has little or no incentives to exert monitoring managerial behaviour but to free ride (Berglöf and Claessens, 2006). These individual shareholders mainly rely on ‘exit’ rather than ‘voice’. If they are not happy with company performance, they are free to sell their shares and thus get rid of the problems (Chowdhury, 2004). Even institutional

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shareholders may not intervene because the existence of active secondary markets and the difficulties of intervention normally provide them with less costly option of simply exiting (selling their shares). Similarly, independence of non-executive directors is a difficult task to achieve. Forbers and Watson (1993) argue that corporate debt providers intervene only when the security of their investment is seriously at risk. Besides, poor enforcement of property rights in a country often results in incomplete monitoring mechanisms (Berglöf and Claessens, 2006). On the other hand, the effectiveness of incentive mechanisms is not without limitation. Walsh and Seward (1990) identify three shortcomings of pay-for-performance plans as an incentive mechanism: (i) managers can manipulate accounting rates of return through adopting favourable accounting policies and thus, ensuring their interests being served when their bonus plans are linked to the accounting rates of return; (ii) the motivational potential of rewards, irrespective of its size,

is likely to diminish whenever compensation is linked to such strict market

measures that are subject to many factors beyond a manger’s control; and (iii) incentive plans often focus only on desired outcomes without paying any attention to the means of achieving those. As a result, managers often get reluctant to achieve those goals. Moreover, it may be more beneficial for managers to maintain and increase firm size without any price impact in the market or to favour large shareholders than to go for the incentive contracts offered to them (Stulz, 1999).

Heinrich (2002) argues that governance mechanisms have benefits in terms of reducing agency costs as well as opportunity costs in terms of aggravating agency problems. He identifies two sources of opportunity costs in this respect. Firstly, governance mechanisms which reduce information asymmetries may simultaneously reduce differences in risk sensitivity and thereby destroy possible gains from insurance. Secondly, any governance mechanism which mitigates one agency problem (say between shareholders and managers) may simultaneously aggravates other agency problems (between controlling shareholders and minority shareholders or between shareholders an creditors). Both types of opportunity costs give rise to complementarity and substitution relationships between various governance mechanisms. Complementary relationship occurs when one mechanism reduces the opportunity costs (or raise the benefits) of the

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other at the margin and substitute relationship is said to exist when one governance mechanism raises the opportunity costs (or reduce the benefits) of the other. As a result, organizations generally choose specific combinations of internal and external governance mechanisms which reinforce each other in minimizing the agency costs.

Empirical results regarding the interaction between internal and external mechanisms have been mixed. Studies like Hadlock and Lumer (1997), Mikkelson and Partch (1997), Cremers and Nair (2005) suggest that there exists complementary relationship between internal and external control mechanisms. In contrary to these results, Huson, Parrino and Starks (2001) find that effectiveness of internal monitoring is not dependent on external monitoring. Weir et al.(2002), however, report that market for corporate control is an effective external control mechanism and can be used as the substitute for other control mechanisms.

The prevailed system of governance in any particular country affects the effectiveness of internal and external governance mechanisms. Broadly speaking, two distinct governance systems can be identified: one is the Anglo-American ‘market-based’ system and the Japanese and the other one is the German ‘relationship-based’ system. Table 2 presents a comparative overview of different corporate governance mechanisms used under these two systems. Table 2 suggests that the effectiveness of corporate governance mechanisms varies. The enforcement environment in a country has a large role to play in this respect. For example, countries where court systems function properly, large shareholder monitoring as well as formal protection of minority shareholders can be ensured through private litigation. However, in a weaker enforcement environment, promoting private mechanisms and empowering shareholders through information dissemination can serve a better role (Berglöf and Claessens, 2006).

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Table 2: Governance Mechanisms in Alternative Systems Corporate Governance “Anglo-Saxon”/ “marketMechanism based”/ “transaction-based”/ “arm’s length”/ “outsider” system Firm-level Mechanisms Stock Ownership Dispersed stock ownership, mostly by households and institutional investors.

“Japanese-German”/ “bankcentered”/ “relationship-based”/ “control-oriented”/ “insider” system Concentrated stock ownership or proxy control by banks.

Cross-Shareholdings

Little cross-shareholdings Substantial cross-ownership between firms and little bank between firms, substantial direct as ownership for firms. well as indirect bank ownership.

Market for corporate control

Existence of active market for Virtually non-existence of active market for corporate control. corporate control.

Involvement of bank

Minimal bank involvement in Direct and substantial bank firms’ operations and control involvement in firms’ operations activities. and control activities.

Disclosure and accounting requirements Shareholders activities

Policy-level Mechanisms Far-reaching disclosure and Limited disclosure and accounting rigorous accounting requirements. requirements in stock market. Existence of multiple barriers Existence of few barriers to large to large shareholder activity. shareholder activity.

Source: Adapted from Heinrich (2002)

Conclusion Agency problem is a natural outcome of joint stock type of organization. Monitoring, bonding and residual loss are the costs incurred due to the existence of agency problem. Nature of agency problem found in developed countries is different from that found in the developing nations. Different corporate governance mechanisms have been suggested in the literature and implemented by different organizations to solve such problem. However, it is not always possible to completely get rid of such problem as corporate governance mechanisms are not effective to the same extent and most often dependent on the existing legal system in a country. As a result, blind adoption of corporate governance instruments following other countries without considering the differences in legal systems may not result in desired outcome. Corporate governance is more likely to be effective in countries where different mechanisms are chosen considering factors like

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level of development of the capital market and effectiveness of legal system in protecting investors’ interests.

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