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The Principal-Agency Problem

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The Agency Problem is all around us.  Can you recognize it?  What is the Principal-Agency Problem?

Here is a simple definition

A conflict arising when people (the agents) entrusted to look after the interests of others (the principals) use the authority or power for their own benefit instead.

It is a pervasive problem and exists in practically every organization whether a business, church, club, or government. Organizations try to solve it by instituting measures such as tough screening processes, incentives for good behavior and punishments for bad behavior, watchdog bodies, and so on but no organization can remedy it completely because the costs of doing so sooner or later outweigh the worth of the results. Also called principal-agent problem or principal-agency problem.

So, think of any context where owners (principals) are separated from managers.  The owners entrust the agents (managers, executives, politicians, etc) to act (be an agent) in the best interest of the principals.  It’s a perfect world.

What could possibly go wrong?

In Politics

From the news today… Rod Blagojevich is found guilty on 17 of 20 counts.  Rod will  be the fourth Illinois governor thrown in prison. Democrats Otto Kerner, Dan Walker and Republican George Ryan all found their way behind bars. Ryan is still serving time in federal prison.  Rod is about to join the club.

From the nywebtimes:

Reached by The Times, Roth added Blagojevich’s conviction is not enough for the harm he has caused to Illinois. “He has long been an embarrassment to our state,” said Roth. “We need more reforms to correct the problems he created, such as campaign financial caps, special elections and the ability to recall elected officials.”

U.S. Rep. Adam Kinzinger, R-Manteno, said in a media release, “Rod Blagojevich never seemed to understand the difference between serving the public and serving his personal self interests. The evidence presented and verdict confirms that he was found guilty of 17 of the 20 counts including wire fraud, attempted extortion and attempting to sell President Obama’s old Senate seat, but far worse, he abused and shattered public trust. The shame and national embarrassment Blagojevich cast onto our state has only created further financial bearing.”

So, what is the solution proposed above?  More reforms, more rules, more regulations.  Do you really think you can legislate ethics?  Such approaches treat the symptom and not the cause of poor ethical behavior.

The agency problem in the business world

What about the Agency Problem in the business world?  Here is a more elaborate definition of the Agency Problem in the business context:

Every business organization is in a constant state of conflict between preservation and performance. At the performance end of the spectrum is the drive to find and execute Gold strategies, and at the preservation end of the spectrum is the institutional imperative.

The institutional imperative is the inward-looking tendency to want to preserve or marginally expand on existing strategies, resource commitments, power structures, and pay levels. It is the group manifestation of the agency problem—just as many individuals seek to gain maximum personal benefit (power and money) with minimum personal risk (peace of mind), so does the group seek to make its own existence as comfortable as possible.

The institutional imperative is not a static or benign force that simply impedes progress by cramping innovation and decision-making. It is a dynamic force that can push an organization into making consistently poor choices with respect to growing economic profits, choices that in the short run may seem to benefit stakeholders other than investors, but that in the intermediate and long run sap the organization of its ability to perform at a high level.

The institutional imperative drives companies to adopt toothless performance objectives, to pursue underperforming business models, to keep assets with poor returns, to expand into markets with unattractive economics, to build “competitive advantages” lacking economic benefits, to tolerate bloated corporate functions, and to reward mediocre or poor executive performance.

Every CEO has to deal with the institutional imperative. A few may even give into it, conceding that the self-interested objectives of the institution will generally be allowed to trump the hard work, superior creativity, and execution necessary to achieve great performance.

But most CEOs recognize that defeating, or at least beating back, the institutional imperative is essential to achieving excellence. There are three manifestations of the institutional imperative that CEOs especially need to overcome: strategic myopia, cross-subsidies, and lack of transparency

So what’s the solution?

Just to sum up, the Agency problem is really about the ability of people to control their self-interest in the context of being an agent for someone else.  It usually involves power, money, self-promotion, ambition.  As the definition above states it [ the Agency Problem) exists everywhere in every organization whether a business, church, club, or government.

On first take, to address both the political and business manifestation of the Agency Problem the proposal is generally  to enact additional legislation (politics) or to have long lists of rules and best practices for corporate governance.  From the quote above… “We need more reforms to correct the problems he created, such as campaign financial caps, special elections and the ability to recall elected officials.”

Does anyone really think that making more rules is going to solve the problem?

The key to the solution is the human bond and relationship between the Principal and the Agent.  If that bond does not exist then some people ( especially those without a conscience ) will do whatever it takes to abuse the relationship to their advantage.  In politics it is to break the public trust.  In a business it is to undermine the financial outcome of the investors.  In a non-profit it is to compromise the mission of the organization.

If the solution is a personal bond and trust then the solution is hard in national politics since there are so many people involved.  This solution in business is perhaps more applicable – depending on the size of the business.  In a business, the buck really stops with the Board of Directors.  And the key to addressing the Principal-Agency problem is to get the Board correct and it’s not always about best practices and long lists of rules.

Below you can find an article from McKinsey on the make up of Boards that are better suited to address the Agency problem.  As for the Agency problem with regard to politics the only solution will be if human beings become no longer human.  This in part means to lose human beings incredible and insatiable desire for power, money, and status.  This is what drives progress, and at the same time, undermines it all.

Resources:

The answer, I believe, after years of examining and advising scores of boards, is that such best practice isn’t good enough, even if your board is stacked with highly qualified members. Without the right human dynamics—a collaborative CEO and directors who think like owners and guard their authority—there will be little constructive challenge between independent directors and management, no matter how good a board’s processes are. As a result, the board’s contribution to the company’s fortunes is likely to fall short of what it could and should be. Deficiencies in boardroom dynamics are a concern also for executives who are not directors but report to them, because it makes it harder for those executives to develop healthy and productive relationships with their boards. What’s more, for executives who aspire to serve on boards one day, it’s essential to learn the importance of the right human dynamics and what it means to be a good corporate director.

Identifying the contours of such a fluid interpersonal exchange isn’t easy. But executive and nonexecutive directors can apply three tests to assess the human dynamics of their own boards.

Read the full paper from McKinsey
Boards: When best practice isn’t enough

Can there be Redemption at Motorola?
https://frrl.wordpress.com/2011/07/01/principal-agent-redemption-at-motorola/

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Written by frrl

June 28, 2011 at 4:05 am

One Response

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  1. […] decides what the culture will be and who benefits? This gets back to the Principle-Agency problem (read). In any corporation or organization there are always two constituency groups – the owners […]


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