Term of the Day - 20 March 2024

Today’s Term is “Agency Theory”.

Agency theory, within the context of corporate governance, examines the relationship between principals (such as shareholders) and agents (such as managers or executives) who act on behalf of the principals in the management and operation of a company. It explores how conflicts of interest and information asymmetries between principals and agents may impact the behaviour and decision-making of agents within the organization.

Key aspects of agency theory in corporate governance include:

1. Principal-Agent Relationship: Shareholders, as principals, delegate decision-making authority to managers, as agents, to run the company's operations and maximize shareholder value.

2. Conflicts of Interest: Agency theory identifies potential conflicts of interest between shareholders and managers, such as when managers prioritize their own interests or pursue personal goals at the expense of shareholder wealth maximization.

3. Alignment of Interests: Effective corporate governance mechanisms, such as performance-based incentives, executive compensation structures, and board oversight, are designed to align the interests of agents with those of principals and mitigate agency costs.

4. Monitoring and Accountability: Corporate governance mechanisms also include monitoring and accountability mechanisms, such as board oversight, audits, and disclosure requirements, to ensure that agents act in the best interests of principals and comply with legal and ethical standards.

Agency theory provides a framework for understanding and addressing the challenges inherent in the principal-agent relationship in corporate governance, ultimately aiming to enhance transparency, accountability, and value creation for shareholders.