Week 1 Introduction to course and agency theory
Corporate Governance (CG): describes how a firm is directed and controlled to align stakeholders’
interests (e.g., shareholders, employees, management, and society).
➔ Good CG can lower financing costs, reduce risk of scandals, and improve resource allocation.
Why It Matters=
• For the firm:
– Better access to external (financial) resources
– Lower cost of capital
• For suppliers of finance
– Reduced risk of crisis and scandals
– Better firm reputation
• For society
– Better allocation of scarce resources
– More sustainable ways of operating
Corporate Governance Mechanisms: Internal and external structures, processes, and incentives
designed to align the interests of managers and shareholders (e.g., board composition, CEO incentives,
shareholder activism).
➔ Effective governance mechanisms protect shareholder interests and improve performance
➔ The mechanisms are aimed at influencing behavior of the agent, the principal and other
stakeholders
➔ CG-mechanisms can be internal or external
Corporate Governance Mechanisms
Internal External
• Board of Directors • Block holders
• Board Committees • Providers of Debt
• Top Management Team (TMT): • Market for Corporate Control
• Workers’ Councils • Auditors
• Incentive Structures • Media
• Management Information Systems • Financial Analysts and Proxy Advisors
(Accounting/Control) • Other Gatekeepers and Reputational Agents
• Country-Level Rules and Regulations
Agency Theory Basics=
• Principal–Agent Relationship
o Owners (principals) delegate authority to managers
(agents).
o Agents may have private information and/or self-
interested goals, leading to the agency problem.
o Assumes agents are self-interested and require
monitoring or incentives to act in the firm’s best interests.
• Agency Costs
o Monitoring Costs: E.g. board oversight, audits.
o Bonding Costs: E.g. incentive contracts tying agent’s pay to firm performance.
o Residual Loss: Value lost if agents diverge from shareholder interests.
o Minimizing agency costs helps improve firm performance and efficiency.
• Information Asymmetry
o Adverse Selection (Ex Ante=based on forecast): Principals may choose the wrong agent if they
cannot fully evaluate a potential agent’s qualities before hiring, risking a mismatch between
expected performance and actual capabilities
o Moral Hazard (Ex Post= based on results): Once hired, agents might shirk or take undue risks not
easily observed by principals.
,• Decoupling
o When an organization adopts policies or structures that appear to comply with external demands or
norms but in practice do not fully implement or enforce them.
o Consequence; Pay and perks are not aligned with firm performance (e.g., high compensation
continues even if performance is poor).
o Suggests formal structures (e.g. a board) may exist but are not effectively enforced or empowered.
Applying Agency Theory to Cases=
❖ Identify where conflicts of interest might arise (e.g. a CEO pushing a pet project that does not
maximise shareholder value).
❖ Assess the effectiveness of monitoring and incentive structures (e.g. does the board have
sufficient expertise and independence? Is the CEO’s pay aligned with long-term firm performance?).
CEO Organisational Identification (Boivie et al., 2011): Refers to how strongly a CEO’s identity
overlaps with the firm’s identity.
Why It Matters
➔ Highly Identified CEOs see the company’s success or failure as reflecting on themselves personally.
o Lowers Agency Costs: Because they want to protect the firm’s reputation and performance, they
are less prone to self-dealing or excessive perks.
o This can effectively substitute for formal monitoring since the CEO is intrinsically motivated to act
in the firm’s best interest.
! Board independence and other monitoring tools may be less impactful when a CEO is highly
identified, but they can still serve as safeguards.
Application in Cases=
❖ Examine CEO background, commitment, and statements: A founder-CEO with substantial personal
investment might require fewer formal governance constraints.
❖ Monitor over time: Identification can change, particularly if new CEOs join from outside or if market
conditions shift.
Substitution vs. Complementarity in Governance (Misangyi & Acharya)=
• Core Idea: Governance mechanisms can function as either substitutes (one replaces the need for
another) or complements (they reinforce each other).
• Substitution Hypothesis: One governance mechanism (e.g. high-powered CEO incentives) may
reduce the need for another (e.g. rigorous board oversight).
➔ Suggests that not all governance mechanisms need to be equally strong if one is already
sufficiently addressing agency issues.
• Complementarity Hypothesis: Multiple governance mechanisms can reinforce each other (e.g. when
strong board monitoring and shareholder activism both align managerial interests with firm
performance).
➔ Highlights that multiple, well-aligned mechanisms can jointly enhance governance outcomes and
firm performance.
• Configuring Governance Mechanisms: Governance tools (board independence, CEO incentives,
external block holders, auditors, etc.) often work best in “bundles” tailored to the firm’s unique
environment.
Practical Insights=
– Firm Profitability often improves when a mix of governance mechanisms aligns (e.g., performance-
based pay + vigilant board + active external investors).
– No One-Size-Fits-All: A configuration that works in one industry or corporate life stage may be
ineffective elsewhere.
Resource Dependence Theory: Firms rely on external resources (capital, partnerships, political or
regulatory support).
➔ Boards with Resource-Rich Directors can help firms secure vital resources, reduce uncertainty, and
gain legitimacy.
, ➔ Boards may be structured to include members with specific expertise or connections (e.g., political or
financial) to reduce uncertainty and secure needed resources.
Application in Cases=
❖ In cases, review board composition for directors who bring strategic connections or expertise.
❖ Consider how external pressures (regulatory or competitive) affect resource needs, prompting the
selection of certain board members (e.g. political figures in heavily regulated industries).
Relationships Between Variables CEO identification=
• Main Effect of CEO Identification on Agency Costs
➔ High CEO identification reduces agency costs by aligning the CEO’s personal identity with firm
success, making them less likely to decouple pay from performance.
• Moderation: CEO Identification and Board Independence
➔ When CEO identification is high, it can weaken the effect of board independence on reducing
agency costs. If the CEO already acts in the firm’s best interest, additional board oversight adds
less value
• Substitution vs. Complementarity
➔ CEO organizational identification can substitute for certain monitoring mechanisms. However, in
many cases, firms benefit more when incentives, board oversight, and external pressure
complement each other rather than relying on a single control mechanism.
• Example: A highly identified CEO might not require strict monitoring, but if the CEO’s identification
weakens over time, or if external conditions change (e.g., new market pressures), having a strong
board or block holder oversight in place can still protect the firm.
Relationships Between Variables, Substitutes or Complements=
1. Main Effects
• Governance Mechanisms → Firm Profitability
Suggest that governance mechanisms are more impactful in combination rather than in isolation.
High profitability often arises when multiple mechanisms (e.g., CEO incentives, board
independence, blockholder monitoring) align.
2. Moderation Effects
• Contextual Influence
CEO incentives may be more (or less) effective depending on other factors, such as board
independence or the presence of external blockholders.
– Example: Performance-based pay has a stronger positive effect on firm outcomes when
the board actively monitors managerial decisions.
3. Mediation Effects
• If not directly discussed, focus remains on how combinations of governance mechanisms shape
firm outcomes. Some researchers propose that resource-rich boards (via resource dependence)
may mediate the link between governance structures and firm performance
Broader Implications=
❖ For Practice
o Bundled Governance: Firms should craft a portfolio of governance measures (incentives,
monitoring, external checks) rather than relying on any single mechanism.
o Adaptation: As the firm grows or the CEO changes, so too should governance structures.
❖ For Policymakers & Regulators
o Uniform regulations (e.g. one standard for board independence) may not be optimal across all
industries and firms.
o Understanding CEO identification and resource dependencies can inform better, more flexible
guidelines.
❖ For Different Industries
o High-Tech Start-ups: CEO’s identification often strong, but external monitors (venture capitalists,
independent directors) still crucial for funding and strategic advice.
o Heavily Regulated Sectors: External scrutiny (regulators, ratings agencies) complements internal
boards, ensuring compliance and reducing moral hazard.
Corporate Governance (CG): describes how a firm is directed and controlled to align stakeholders’
interests (e.g., shareholders, employees, management, and society).
➔ Good CG can lower financing costs, reduce risk of scandals, and improve resource allocation.
Why It Matters=
• For the firm:
– Better access to external (financial) resources
– Lower cost of capital
• For suppliers of finance
– Reduced risk of crisis and scandals
– Better firm reputation
• For society
– Better allocation of scarce resources
– More sustainable ways of operating
Corporate Governance Mechanisms: Internal and external structures, processes, and incentives
designed to align the interests of managers and shareholders (e.g., board composition, CEO incentives,
shareholder activism).
➔ Effective governance mechanisms protect shareholder interests and improve performance
➔ The mechanisms are aimed at influencing behavior of the agent, the principal and other
stakeholders
➔ CG-mechanisms can be internal or external
Corporate Governance Mechanisms
Internal External
• Board of Directors • Block holders
• Board Committees • Providers of Debt
• Top Management Team (TMT): • Market for Corporate Control
• Workers’ Councils • Auditors
• Incentive Structures • Media
• Management Information Systems • Financial Analysts and Proxy Advisors
(Accounting/Control) • Other Gatekeepers and Reputational Agents
• Country-Level Rules and Regulations
Agency Theory Basics=
• Principal–Agent Relationship
o Owners (principals) delegate authority to managers
(agents).
o Agents may have private information and/or self-
interested goals, leading to the agency problem.
o Assumes agents are self-interested and require
monitoring or incentives to act in the firm’s best interests.
• Agency Costs
o Monitoring Costs: E.g. board oversight, audits.
o Bonding Costs: E.g. incentive contracts tying agent’s pay to firm performance.
o Residual Loss: Value lost if agents diverge from shareholder interests.
o Minimizing agency costs helps improve firm performance and efficiency.
• Information Asymmetry
o Adverse Selection (Ex Ante=based on forecast): Principals may choose the wrong agent if they
cannot fully evaluate a potential agent’s qualities before hiring, risking a mismatch between
expected performance and actual capabilities
o Moral Hazard (Ex Post= based on results): Once hired, agents might shirk or take undue risks not
easily observed by principals.
,• Decoupling
o When an organization adopts policies or structures that appear to comply with external demands or
norms but in practice do not fully implement or enforce them.
o Consequence; Pay and perks are not aligned with firm performance (e.g., high compensation
continues even if performance is poor).
o Suggests formal structures (e.g. a board) may exist but are not effectively enforced or empowered.
Applying Agency Theory to Cases=
❖ Identify where conflicts of interest might arise (e.g. a CEO pushing a pet project that does not
maximise shareholder value).
❖ Assess the effectiveness of monitoring and incentive structures (e.g. does the board have
sufficient expertise and independence? Is the CEO’s pay aligned with long-term firm performance?).
CEO Organisational Identification (Boivie et al., 2011): Refers to how strongly a CEO’s identity
overlaps with the firm’s identity.
Why It Matters
➔ Highly Identified CEOs see the company’s success or failure as reflecting on themselves personally.
o Lowers Agency Costs: Because they want to protect the firm’s reputation and performance, they
are less prone to self-dealing or excessive perks.
o This can effectively substitute for formal monitoring since the CEO is intrinsically motivated to act
in the firm’s best interest.
! Board independence and other monitoring tools may be less impactful when a CEO is highly
identified, but they can still serve as safeguards.
Application in Cases=
❖ Examine CEO background, commitment, and statements: A founder-CEO with substantial personal
investment might require fewer formal governance constraints.
❖ Monitor over time: Identification can change, particularly if new CEOs join from outside or if market
conditions shift.
Substitution vs. Complementarity in Governance (Misangyi & Acharya)=
• Core Idea: Governance mechanisms can function as either substitutes (one replaces the need for
another) or complements (they reinforce each other).
• Substitution Hypothesis: One governance mechanism (e.g. high-powered CEO incentives) may
reduce the need for another (e.g. rigorous board oversight).
➔ Suggests that not all governance mechanisms need to be equally strong if one is already
sufficiently addressing agency issues.
• Complementarity Hypothesis: Multiple governance mechanisms can reinforce each other (e.g. when
strong board monitoring and shareholder activism both align managerial interests with firm
performance).
➔ Highlights that multiple, well-aligned mechanisms can jointly enhance governance outcomes and
firm performance.
• Configuring Governance Mechanisms: Governance tools (board independence, CEO incentives,
external block holders, auditors, etc.) often work best in “bundles” tailored to the firm’s unique
environment.
Practical Insights=
– Firm Profitability often improves when a mix of governance mechanisms aligns (e.g., performance-
based pay + vigilant board + active external investors).
– No One-Size-Fits-All: A configuration that works in one industry or corporate life stage may be
ineffective elsewhere.
Resource Dependence Theory: Firms rely on external resources (capital, partnerships, political or
regulatory support).
➔ Boards with Resource-Rich Directors can help firms secure vital resources, reduce uncertainty, and
gain legitimacy.
, ➔ Boards may be structured to include members with specific expertise or connections (e.g., political or
financial) to reduce uncertainty and secure needed resources.
Application in Cases=
❖ In cases, review board composition for directors who bring strategic connections or expertise.
❖ Consider how external pressures (regulatory or competitive) affect resource needs, prompting the
selection of certain board members (e.g. political figures in heavily regulated industries).
Relationships Between Variables CEO identification=
• Main Effect of CEO Identification on Agency Costs
➔ High CEO identification reduces agency costs by aligning the CEO’s personal identity with firm
success, making them less likely to decouple pay from performance.
• Moderation: CEO Identification and Board Independence
➔ When CEO identification is high, it can weaken the effect of board independence on reducing
agency costs. If the CEO already acts in the firm’s best interest, additional board oversight adds
less value
• Substitution vs. Complementarity
➔ CEO organizational identification can substitute for certain monitoring mechanisms. However, in
many cases, firms benefit more when incentives, board oversight, and external pressure
complement each other rather than relying on a single control mechanism.
• Example: A highly identified CEO might not require strict monitoring, but if the CEO’s identification
weakens over time, or if external conditions change (e.g., new market pressures), having a strong
board or block holder oversight in place can still protect the firm.
Relationships Between Variables, Substitutes or Complements=
1. Main Effects
• Governance Mechanisms → Firm Profitability
Suggest that governance mechanisms are more impactful in combination rather than in isolation.
High profitability often arises when multiple mechanisms (e.g., CEO incentives, board
independence, blockholder monitoring) align.
2. Moderation Effects
• Contextual Influence
CEO incentives may be more (or less) effective depending on other factors, such as board
independence or the presence of external blockholders.
– Example: Performance-based pay has a stronger positive effect on firm outcomes when
the board actively monitors managerial decisions.
3. Mediation Effects
• If not directly discussed, focus remains on how combinations of governance mechanisms shape
firm outcomes. Some researchers propose that resource-rich boards (via resource dependence)
may mediate the link between governance structures and firm performance
Broader Implications=
❖ For Practice
o Bundled Governance: Firms should craft a portfolio of governance measures (incentives,
monitoring, external checks) rather than relying on any single mechanism.
o Adaptation: As the firm grows or the CEO changes, so too should governance structures.
❖ For Policymakers & Regulators
o Uniform regulations (e.g. one standard for board independence) may not be optimal across all
industries and firms.
o Understanding CEO identification and resource dependencies can inform better, more flexible
guidelines.
❖ For Different Industries
o High-Tech Start-ups: CEO’s identification often strong, but external monitors (venture capitalists,
independent directors) still crucial for funding and strategic advice.
o Heavily Regulated Sectors: External scrutiny (regulators, ratings agencies) complements internal
boards, ensuring compliance and reducing moral hazard.
