Analysis of Ghoshals Agency Theory and the 2008 Global Recession - Article Example

Name: XXXXXX Course: XXXXXX Institution: XXXXXX Date: XXXXXX Instructor: XXXXXX Ghoshal, Agency Theory and the 2008 Global Recession Introduction Management practice in the last half of the 20th century to present decades has increasingly been influenced by theories of business and management. As part of the wider endeavor to bridge science (or theory) and practice, academic economists have promoted several theories which embody certain ideologies, attempt to offer causal explanations and include a set of prescriptions on which models of management and subsequently management practice has been increasingly been anchored. A predominant theory of business and management which has had enormous influence on management is Jensen and Mecklin’s agency theory. Jensen and Mecklin challenged the existing management models of the 1970s which had resulted in stagflation and declining productivity whose symptom was lackluster stock market performance. They posited that the problem was due to a misalignment between the interests or goals of principals (shareholders) and their agents (executives) and as a remedy they prescribed bringing these interests into synch (Jensen and Meckling 1976). Therefore, at the heart of agency theory is the relationship between the principal and the agent, where the former engages the latter to perform some service on their behalf which involves delegating some decision making authority. However, four decades later, a segment of business scholars are increasingly attributing or assigning blame for corporate malfeasance or failures in corporate governance as manifested in several crises such as Enron, Tyco and most recently the 2007 financial crisis which triggered global economic recession on a scale comparable to the Great Depression of 1929 (Fahlenbrach and Stulz 2009). Ghoshal (2005), writing before the financial crisis and after the Enron and Tyco scandals, ominously warns of the negative consequences of the adoption and application of some business and management theories claiming that good management practices were being destroyed by “bad management theories”. Ghoshal (2005) singles out agency theory and attempts to illustrate how the endeavor to make management a science has delinked ethics and morality from management which potentially hold severe negative consequences for corporate governance. In this essay, I will evaluate Ghoshal’s assertions by exploring the links between his arguments in the article Bad Management Theories are Destroying Good Management Practices, agency theory and the 2007-2009 financial crisis which triggered the 2008 global recession. The essay will essentially argue that Ghoshal’s prediction is not isolated through a review of literature on agency theory and financial crises or failures in corporate governance manifested through corporate scandals which buttress Ghoshal’s arguments. I will first give a brief summary of Ghoshal’s main arguments and provide an overview of agency theory from literature by critically discussing the import of its prescriptions on business management practices. In the next section of the essay, I will then briefly provide an overview of and examine the causes of the 2007 financial crisis from a management perspective to demonstrate the culpability of the adoption and application of principles of agency theory or as Dobbin and Jung (2010) describe it, the “misapplication of Michael Jensen.” In conclusion, the essay will argue for the validity of Ghoshal and other’s arguments using the crisis as an illustration of agency theory based problems. Review of the Literature Ghoshal’s Arguments Ghoshal’s (2005) main argument is that corporate scandals can be rooted in the epistemology of business scholarship. He particularly argues that the adoption of the ideas embedded in agency theory, a theory which he claims has delinked ethics and morality from management in the endeavor for scientific compliance, has had several negative implications and consequences for management practice. By delving into the epistemology of agency theory, Ghoshal argues that the negative assumptions about people which form the gloomy ideological base of agency theory and other management theories have influenced management practice (Pfeffer 2005). Through double hermeneutic in social sciences where the theory explains as well as influences behaviour, managers’ worldview has been influenced by agency theory. Using surveillance of employees as an example, he shows how mistrust is fermented and cyclically perpetuated in an organization by surveillance (Ghoshal 2005). The end result of the adoption of the ideas of agency theory and other management related theories such as transaction and game theory according to Ghoshal is a ruthless, hard-driving, command and control focused and shareholder-value obsessed win-at-all-costs business leader. This induces some of the management behavior characteristic of failures in corporate governance. As a prescription, Ghoshal proposes that business academics should take the lead by reinstituting moral and ethical concerns in the practice of management and teaching with a wider variety of more positive and optimistic theories as opposed to the current deterministic and pessimistic theories (Ghoshal 2005). Business students should be taught theories on how to build delightful, ethical and moral organizations instead of simply teaching isolated courses on corporate governance. The dominant voice in Ghoshal’s article is that of business scholars- a perspective he explicitly states as he introduces his argument. He frames the root of the problem as intellectual and appears to place blame squarely on the shoulders of business scholars who he accuses of inadvertently (negatively) influencing business management practice through the double hermeneutic. The implication of the intellectual voice of the article is to discount the influence of the business environment, regulatory changes or even political events for the failures in corporate governance (Pfeffer 2005). The impression that I obtain from Ghoshal’s thesis is that the greed, mismanagement and other behaviors which precipitate corporate malfeasance such as Enron, Tyco and the financial crisis is fundamentally an issue of what business leaders or students are taught in business schools or the widespread adoption of the principles of agency theory in business management academic circles. Agency Theory To better evaluate Ghoshal’s argument and its links with agency theory, one must critically review the literature on agency theory. Agency theory was articulated in 1976 by Michael Jensen and William Meckling in the article Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Jensen and Meckling define the 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 (Jensen and Meckling 1976, p. 5).” They viewed the poor performance of company stocks as a result of what a defective management model where the interests of the principals and the agents were misaligned or out of synch. Therefore business executives (agents) made choices which maximized their own welfare rather than that of the shareholders (principals) by engaging in empire building- building large diversified empires primarily to shield them from economic downturns instead of maximizing shareholder profit (Dobbin & Jung 2010, p. 30). To resolve the agency problem, Jensen and Meckling (1976) offered prescriptions for how the principal should control the agent to avoid self-seeking behaviors or managerial opportunism and self-interest. They propose the restructuring of the contractual relationship between the principal and the agent to “provide appropriate incentives for the agent to make choices which will maximize the principal’s welfare (Jensen and Meckling 1976, p.7).” The prescriptions offered included altering incentives to executives by including stock options as part of their pay. This would naturally provide them with the motivation to maximize shareholder value since they own equity in the business and therefore align their interests with those of shareholders as principals. Two other prescriptions which I will use to tie Ghoshal’s argument to the financial crisis is to use debt to finance new endeavors which was designed to eliminate the practice of using profits to acquire new business and expand empires by executives and the appointment of outside board of directors. The prescriptions of agency theory, it was argued, would encourage risk taking and entrepreneurial behaviour which would maximize shareholder profits. To monitor risk and discipline executives, agency theorists proposed smaller and more accountable boards independent of top management teams (Dobbin & Jung 2010). From the literature, it is evident that the prescriptions of agency theory were widely embraced in the 1980s. Executive compensation packages were revolutionized, companies dediversified their investment portfolios, new ventures were financed with debt and outside board directors were appointed in addition to reductions in the size of boards (Sharpe 2010). To establish the link between Ghoshal’s arguments, agency theory and the global financial crisis, it is important to first briefly consider the financial crisis particularly from a management perspective. The important questions to ask are whether there is evidence, as argued by Ghoshal, that agency theory affected the behaviour of business managers or agents in the run-up to the sub-prime mortgage crisis. But first, a brief overview of the crisis should help put things into perspective. Causes of the 2007 Financial Crisis The 2007 financial crisis that triggered global economic recession in 2008 was the biggest economic crisis of a magnitude or scale only comparable to the great depression of 1929. From a management perspective, it is considered a case study and a vivid illustration of the culmination of failures in corporate governance. The origin and main cause of the financial crisis is the burst of the housing bubble in America. While before 2000 only prime (credit-worthy) borrowers could obtain residential mortgages, advances in technology and statistics enabled enhanced quantitative evaluations for the credit risk of a class of more risky residential mortgages (Schwarcz 2008, Demyanyk and Hemert 2009). Credit was cheap, and having run out of prime borrowers to lend it to, banks turned to the subprime market. Subsequently, bankers offered increasingly offered subprime mortgages fuelled by rising housing prices in the early 2000s. High housing prices meant that subprime borrowers could refinance their houses with even larger loans as the values of their houses appreciated- the housing price bubble created by increased demand for houses (Acharya and Richardson 2009). The risk of these mortgages was covered up by securitization as financial innovations allowed the creation of new, sophisticated financial instrument products derived from cash flows of the underlying assets and tailored to meet the different risk thresholds of different investors. However, in 2007, the housing bubble started to burst as house prices started to decline and interest prices rose. It suddenly became apparent that there were large amounts of sub-prime mortgages in the financial system. Securitization of subprime assets had facilitated the spread of these financial instruments in the system from banks to investment banks and other financial institutions. Underwriting standards for subprime mortgages had fallen to increasingly lower standards as high risk borrowers could now obtain mortgages (Demyanyk and Hemert 2009). As a result, confidence declined in all financial institutions due to uncertainty over the extent to which each institution was exposed to these subprime mortgages (Smith 2010). The price of credit, interest rates, began to increase as the perceived credit risk of these institutions rose and it became expensive for financial institutions to reissue their debts. The subprime mortgage industry would collapse as awareness increased over the existence and magnitude of risky mortgages and the process of buying them came to a halt. Subprime borrowers increasingly defaulted on their mortgage payments as housing prices continued to fall and the values of mortgage backed securities declined, leaving banks straddled with toxic assets from which they could not recover their money as prices fell (Demyanyk and Hemert 2009). Many subprime borrowers had discovered that the value of their houses had fallen below the amount of the mortgages and this provided struggling homeowners with an incentive to simply walk away from their homes and send the keys to the banks. Defaults on mortgages led to over 1 million foreclosures. Many investment banks and other financial institutions were no forced to write off losses on their mortgage portfolios triggering a decline in stock markets (Smith 2010). The first major investment bank that had invested in subprime mortgage backed securities to be affected by the crisis was Bear Sterns. It was acquired by J.P Morgan for merely 5% of its value from the previous year. As the crisis escalated, national mortgage investment banks Fannie Mae and Freddie Mac which held over $5 trillion in mortgage and mortgage-backed securities were nationalized by the Federal Reserve to rescue them from bankruptcy (Smith 2010, Colander et al 2009). Panic spread quickly through the system as Lehman Brothers and Merrill Lynch collapsed in quick succession. Lehman Brothers had filed for bankruptcy, the largest such filing in United States history while Merrill Lynch was acquired by the Bank of America for merely 60% of its value from a year earlier (Smith 2010, Demyanyk and Hemert 2009). The Federal Reserve was also forced to make huge loans to keep insurance giant AIG afloat as its credit rating was downgraded, an effect of underwriting subprime mortgage backed securities and subsequently making out payments on possible losses from these securities. Investment banks Goldman Sachs and Morgan Stanley reformed to become bank holding companies under strict government regulation (Demyanyk and Hemert 2009, Achrya and Richardson 2009). The ripple effect of the subprime mortgage crisis in the United States was to trigger global economic recession due to the collapse and steady decline of all major stock markets globally. Numerous economic stimulus programs were set up to pump billions into the economy to keep the financial system standing. Banks in Europe began hoarding cash and were unwilling to lend each other, leading to a credit freeze that saw the collapse of several major financial institutions in Europe (Demyanyk and Hemert 2009). Many jobs and assets were subsequently lost in a downward spiral of global recession. Agency Theory and the Financial Crisis Having discussed some of the causes of the 2007 financial crisis, it is important to now analyze it from a management perspective. I find the definition of Smith (2010) enlightening as he analyses the foundation of the crisis as an agency theory problem where the CEOs of these financial institutions did not act in the best interests of their shareholders by increasingly acquiring subprime mortgage backed securities. This circles back to the original problem presented by Jensen and Meckling (1976) of misalignment between principal and agent interests. The agency theory problem is that investment banks did not act in the best interests of their shareholders and ultimately, their actions resulted in shareholders losing money. Dobbin and Jung (2010) concur with Smith (2010) and to some extent Ghoshal by arguing that the financial crisis was a result of the adoption of the prescriptions of agency theory. However, Dobbin and Jung’s perspective is that these prescriptions were misapplied. Specifically, they argue that while prescriptions such as altering incentives to foster entrepreneurialism and risk taking were adopted, the principles addressing monitoring and executive self-restraint were not properly applied. For instance, executives were not required to hold more equity consistent with Jensen and Meckling’s proposal. Subsequently executives were encouraged to increasingly assume speculative risk since they stood to lose little if these risks did not pay off in the long term. Executives (as agents) benefit when the stock price rises but when the price declines, they experience no reduction in real wealth (Dobbin and Jung 2010). This played out in many of the banks which collapsed during the crisis such as Lehman Brothers, Fannie Mae and Freddie Mac where managers were apparently comfortable investing in very risky ventures which even though they promised high returns, had no downside risk to their wealth. Furthermore, managers were not required to hold on to the stocks for more than one day (Fahlnebrach and Stulz 2009). This essentially defeats the purpose of incentives tied to performance in resolving the agency problem. Ghoshal’s arguments are therefore buttressed by other scholars such as Pfeffer (2005:2007), Nyberg et al (2010) and Sharpe (2010) who appear to unanimously agree that the influence of agency theory was probably to foster greed and excessive risk taking- essentially failures in corporate governance. Pfeffer (2005) in response to Ghoshal essentially agrees with all of his arguments and makes several assertions such as that economics training actually affects behavior by reinforcing self-interest and inducing a tendency to succumb to corrupt behavior. Nyberg et al (2010) have used statistical models which demonstrate that although stock options as prescribed by agency theory indeed motivates risk taking, it doesn’t necessarily motivate smart risk taking. Another prescription which effectively exacerbated the financial crisis (which I had earlier mentioned) was debt financing. Many mortgage lenders during the crisis had excessively leveraged their investments and when the mortgage-backed securities collapsed, they were encouraged to try even riskier moves to try and salvage the situation- an effect on another cause (lack of financial skill) which I will now turn to (Sharpe 2010). Beyond incentives, Sharpe (2010) analyses another cause of the financial crisis stemming from agency theory prescriptions- the composition and functions of boards. Agency theory prescribes the appointment of outside board of directors or directors who are outsiders as an endeavor to create independent boards that would reduce agency costs. However, when the board is composed of individuals who are not qualified to assess the strategic viability of the corporations they direct or lack the financial expertise and literacy to effectively evaluate and understand the business of the corporation, their role as competent monitors of executives is compromised (Dobbin and Jung 2010). Banks such as Merrill Lynch and Citigroup are provided as examples which had directors lacking financial skill, a factor that contributed to their woes as they had significantly acquired complex securities that translated to billions of dollars in losses. Regarding the functions of boards, Sharpe (2010) states that the tasks boards are charged with are insufficient for the purpose of providing the oversight needed to prevent financial failure. Sharpe argues that directors need more “knowledge” than “information”, therefore the current corporate structure which focuses on providing directors with information about the firm’s financial performance rather than knowledge about the strategic direction of the firm contributes to their failure as knowledge is a better indicator of future success or failure. Practice Relevance Having reviewed Ghoshal’s arguments and the literature on agency theory and the financial crisis, I have found very strong links between them which essentially suggests that Ghoshal may have actually predicted the financial crisis and subsequent instances of corporate malfeasance which may come to pass. There are clear elements of adoption of and adherence to the prescriptions of agency theory in the causes of the financial crisis which support the hypothesis that theory does in fact affect behavior. I have noted that the literature reviewed suggests that failures in corporate governance can essentially be traced back to the training and indoctrination of managers in business management academic schools (Grey 2004). Evidence has proven that as demonstrated in the financial crisis, theory indeed affects behavior through double hermeneutic as argued by Ghoshal (Daily et al 2003, Colander 2009). Subsequently, there is a need for the development and propagation of theories which can help overcome the pessimistic and pretense-of-knowledge based theories that dominate business scholarship (Grey 2004). Ghoshal (2005) suggests that business school academics should teach less pessimistic theories and encourage pluralism in corporate governance research to mitigate the harmful effect theories can have on behavior. I would add to this that business school academics take advantage of the growing empirical evidence which discredits the assumptions and premises of these theories and embrace the challenge of falsifying them while simultaneously opening up to new ideas and propositions which are the building blocks of theory (Grey 2004). I agree that the links between Ghoshal, agency theory and the financial crisis matters as it shows that theory affects behavior. Conclusion The central thesis of Ghoshal’s article is that failures in corporate governance can be traced back to the epistemological roots of the theories that influence business management practice. He claims that the influence of these theories has been to delink ethics and morality from management in the endeavor for scientific compliance and has had several negative implications and consequences for management practice. The end result of the adoption of the ideas of agency theory and other management related theories such as transaction and game theory is to induce management behavior characteristic of failures in corporate governance. In this essay, I have demonstrated the links between Ghoshal’s arguments and agency theory and illustrated it by discussing the 2007 financial crisis that triggered global recession in 2008. I have demonstrated how some of the causes of the crisis can be attributed to the prescriptions of agency theory and how agency theory has in turn affected the behaviour of managers. As a remedy, I argued that there is a need for the development and propagation of theories in business scholarship which take into account these shortcomings and which can help overcome the pessimistic and pretense-of-knowledge based theories that dominate business scholarship. I propose that business school academics should take advantage of the growing empirical evidence which discredits the assumptions and premises of these theories and embrace the challenge of falsifying them while simultaneously opening up to new ideas and propositions which are the building blocks of theory. References Acharya, VV& Richardson, M 2009, ‘Causes of the Financial Crisis’, Critical Review: A Journal of Politics and Society, Vol. 21, No 2-3, pp 195-210. 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Fahlenbrach, R & Stulz RM 2009, ‘Bank CEO Incentives and the Credit Crisis’, Working Paper No. 603, National Centre of Competence in Research Financial Valuation and Risk Management. Ghoshal, S 2005, ‘Bad Management Theories are Destroying Good Management Practices', Academy of Management Learning & Education, Vol. 4, No. 1, pp 75–91. Grey, C 2004, 'Reinventing Business Schools: The Contribution of Critical Management Education', Academy of Management Learning & Education, Vol. 3, No. 2, pp. 178-186. Jensen, MC & Meckling, W 1976, ‘Theory of the firm: Managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, Vol. 3, pp 305-360. Nyberg, AJ, Fulmer, IS, Gerhart B & Carpenter, MA 2010, ‘Agency theory revisited: CEO return and shareholder interest alignment’, Academy of Management Journal, Vol. 53, No.5, pp 1029-1049. Pfeffer, J 2005, ‘Why Do Bad Management Theories Persist? A Comment on Ghoshal’, Academy of Management Learning & Education, Vol. 4, No. 1, pp 96–100. Schwarcz, SL 2008, ‘The Subprime Mortgage Crisis’, SMU Law Review, Vol. 61, pp 209-217. Sharpe, NF 2010, ‘Rethinking board function in the wake of the 2008 Financial Crisis’, Journal of Business & Technology Law, Vol. 5, No.1, pp 99-111. Smith, A 2010, ‘Agency theory and the financial crisis from a strategic perspective’, International Journal of Business Information Systems, Vol. 5, No.3 , pp 248-267. Read More