Agency theory is about the conflicts that arise between the Principal

and the Agent because of differences in the goals resulting in additional costs to the
firm thereby eroding the wealth of the firm and its shareholders. Study by Berle and
Means (1932) has brought into focus the divergence in the profit maximizing and cost
minimizing ideals of the firm’s behavior. This causes agency costs, since managers
and owners, having conflicting objectives, try to control each other (Shankman,
1999). Owners’ expect managers/agents to operate the businesses with planned
outcomes to enhance shareholders’ wealth, which the managers may not do (Ghatak,
Healey & Jackson, 1998). This necessitates the implementation of governance
structures in large business firms to safeguard the interests of shareholders (Jensen &
Meckling, 1976). Fama and Jensen (1983) assume a two-tier form of firm control
based on the premise that firms are actually groups of connected fiefs and each fief
has its own specific interest and culture and views the purpose of the firm differently.
As the number of shareholders (owners) and the complexity of operations increase
re prone to pursue their own interests due to lack of monitoring (Mizruchi,
1983). Shleifer and Vishny (1986) argue that managers may act too cautiously in
making investments thereby eroding shareholders’ wealth. This is also due to
differences in the risk perceptions between the agent and owners (Arnold & Lange,
2004). The implicit effect of all these result in increase of agency costs.
In the banking firms a different set of agency conflicts arises owing to the interaction
of three sets of interest groups; Managers, shareholders and creditors. Shareholders
often have conflicts with managers because managers seek quick profits that increase
their own wealth, power, reputation and rewards, while shareholders are more
interested in a slow and steady growth over time (Mayur & Saravanan, 2008). Since
banks operate under different statutes, the transaction and borrowing costs increase
due to information asymmetry; increased monitoring and limiting managers’ powers
(Hughes & Mester, 2008).
According to agency theorists, the purpose of studying the agency theory is to identify
points of conflict among the key players and suggest the following mechanisms of
Corporate Governance to reduce it:
a) Separate roles for CEO and Chairman: this avoids managerial opportunism
and agency loss (Jensen & Meckling, 1976; Donaldson & Davies, 1991).
b) Provide financial incentives to managers: these include fixing executive
compensation and levels of benefits linked to shareholders’ returns; Issue of
stock options etc.
c) Inclusion of more independent directors on the board (Baysinger &
Hoskinson, 1990).
d) Direct intervention by shareholders and the threat of firing the
underperforming managers (shareholder activism)
e) An active market for corporate control: The threat of a hostile takeover
disciplines managerial behavior and induces managers to attempt to maximize
shareholder value.
2) Stewardship theory: Stewardship theory has a more social-oriented perspective
on Corporate Governance. Although agency theory appears to be the dominant
6
paradigm underlying most governance research and prescriptions, researchers in
psychology and sociology have suggested theoretical limits of agency theory because
of its focus on only economic assumptions (Hirsch, Machael & Friedman, 1987).
There are non-economic assumptions supporting stewardship theory (Doucouliagos,
1994). The dominant non-monetary motive, which directs managers to accomplish
their job, is their desire to perform excellently because their reputations are at stake
(Davis et al, 1997; Burkart, Gromb, & Panunzi, 1997). Drawing from Maslow’s
hierarchy theory, self actualization motivates manager to successfully perform
challenging tasks and gain recognition (McClelland, 1961). Based on this premise,
stewardship theory favors boards having a majority of ‘specialist’ executive directors
rather than a majority of ‘non-specialist’ independent directors who will supplement
the organizational knowledge resources.
3) Resource dependence theory: This theory focuses on the resources the directors
can provide to the firm for its effective operations and profitability. As per Pfeffer and
Salancik (1978) boards have a critical role to play in achieving economic efficiency
and since some directors may have access to some strategic resources required by the
firm, they may be appointed to the board. Gales and Kesner (1994) suggest that
directors may also bring in specialized skills and expertise which will help them to
cope with uncertainty by connecting with external resources (Alchian, 1950).
Williamson (1964) held that environmental linkages could reduce transaction costs
associated with environmental interdependency. Scott and Davis (2007) extend this
concept to alliances between organizations to share knowledge and resources to
pursue joint activities for mutual benefit.
4) Stakeholder Theory: Stakeholder is a term originally introduced by the Stanford
Research Institute (SRI) referring to “those groups without whose support the
organization would cease to exist”. Stakeholders of a firm include suppliers, buyers,
public policy decision makers, social groups and Government (Freeman, 1984). The
conventional view that the success of the firm is dependent only on maximizing
shareholders’ wealth has limitations due to negative externalities imposing external
costs on the society. This theory states that the success of the firm is dependent on the
relationship that a firm has with its stakeholders. The potential stakeholders may be
divided into two groups: (1) the primary stakeholders - shareholders/investors,
7
creditors, customers, suppliers and employees; (2) secondary stakeholders - the
government, trade associations, political groups and the community. Stakeholder
theory states that, managers and entrepreneurs must take into account the legitimate
interests of those groups and individuals who can affect or be affected by their
activities (Donaldson & Preston, 1995). Watts and Zimmerman (1983) suggest that
firms should carry out socially responsible activities to reduce the risk of
governmental intrusions that may affect firm value. The underlying emphasis of this
theory is that managers should have broad stake holder orientations rather than narrow
shareholder orientations.
The main assertion of agency theory is that there is divergence between the interests of managers
and those of the owners of business organisations, and that it is essential for managerial bodies to
incorporate an effective mechanism in their decisions in order to ensure that their actions
effectively safeguard shareholders’ interests (McDonnell et al. 2001).
Agency theory focuses on improving the efficiency of business performance from the
perspective of the shareholders. Agency theory argues that within an organisation, managerial
bodies should fulfil their roles as stewards and should have high concern for the welfare of the
organisation in all situations in which conflicting interests exist, and that if they do not have this
focus, the organisation may be managed in the interests of managers as agents rather than the
interests of shareholders as owners.
In agency theory, the approach of under-contextualisation is found to be restricted to two bodies:
managers and shareholders. There are several cases analysed using agency theory that
demonstrate the positive relationship between CG practices and improved business performance
of firms (Tricker and Tricker, 2012). The theory has also determined that good corporate
performance is not only based on CG practices, but that the nature of institutional investments
also determines the level of performance of firms.
According to Grant (2008), agency theory deals mainly with minimising conflicts that arise
between management and shareholders. The implication of agency theory are positive and
normative. Agency theory protects the rights of management personnel as well as those of other
stakeholders. The elimination of conflicts of interest in business organisations saves some costs
of agency management (Academic Conferences, 2008), including monitoring cost, residual cost
and bonding cost. In organisations, agency problems can sometimes occur due to unequal
distribution of information. Here, agency theory supports the prevention of agency problems and
provides a strong base for balancing the interests of different parties.
As proposed by McDonnell et al. (2001), agency theory has a common role for companies
38
around the world. CG practices focus on the role of the board in ensuring managerial compliance
with the objectives of the organisation (McDonnell et al. 2001). In the views of Doh and Stumpf
(2005), the business processes of organisations involve different kinds of corporate issues related
to CG processes. Agency theory deals with these CG issues (Doh and Stumpf, 2005) by
suggesting that the agency relationship is in the form of a contract where service functions are
performed with the contribution of multiple parties. In this process, the delegation of authority is
linked to the decision-making process. In the day-to-day operations of the business, shareholders
do not have any explicit control. In the governance of business mechanisms, CG practices play a
significant role in determining business functions (Doh and Stumpf, 2005). The agents in
business organisations work as civil servants, who need to fulfil the social responsibilities of the
business.
Htay et al. (2012) state that agency theory provides several guidelines for the corporate sector,
suggesting that in a good CG system, a high degree of transparency can be maintained in
business organisations, by requiring managers to properly disclose information to ensure that the
business is pursuing the interests of all stakeholders. Poor corporate governance can damage a
company’s corporate image, while in periods of economic crisis, system risks are generated for
management teams, so an effective CG mechanism is required to secure corporate image (Htay,
et al, 2005).
Agency theory would appear to have some limitations. Arguably the main one is that it assumes
that there are only two entities: corporate management and stakeholders. In this way the
corporate management serves as a proxy for its employees and even its supply chain. Similarly,
the stakeholders role (usually considered as those with direct equity in the company through
either loans or stockownership) serve as proxies for the consumers. Both are quite imperfect. In
the first case management and employee (either direct or indirect through union representation)
interests are often if not oppositional then certainly not in accord over many topics including
wages, working hours, and benefits. While both groups want the company to be holistically
healthy, the extent to which this is desired in terms of direct profits and/or dividends can differ
39
greatly as it is often a function of lower employee rewards and higher expectations. Similarly,
stock holders want a company to be profitable, which may be a very different thing than
providing the best quality goods and services possible, as would be in the direct interests of the
consumers. The other problem with this theory (and many others) is that it does not recognize
other agents such as the general public and regulatory agencies. There is no structure in the
theory to explain or demonstrate their influence on the process.
2.2.2. Stakeholder Theory
Stakeholder theory recognises that following CG practices in an effective manner is determined
through the functions of different actors within an organisation and through their interaction with
and involvement in the organisational decision-making process. According to Kakabadse et al.
(2005), the core of stakeholder theory states that business organisations need a good relationship
with stakeholders and so business people need to govern the processes and outcomes of the
business in a secure manner. The major function of CG applications in a business organisation is
to grant high value to the interests of all legitimate stakeholders.
The central focus of stakeholder theory is on the decision-making process of managerial bodies
(Kakabadse et al.,, 2005). As per this theory, the prime concern of managers consists of the
obligations towards the stakeholders of the business. There are several strategic options available
to management and it is their duty to select options that safeguard the interests of its stakeholders
(Kakabadse et al., 2005). This theory reflects the future-oriented view of the business by
focusing on fulfilling legal, moral, social, technological and ecological requirements of the
business. This theory rejects profitability as the sole corporate goal of the firm. Rather, it is
primarily concerned with stakeholders’ value (Kakabadse et al. 2005). Stakeholder theory gives
priority to morally acceptable social goals over the corporate objectives of business. While
stakeholder value tries to consider the larger concept of stakeholders there is no distinction
between those in subsidiary roles (e.g. employees), versus those of the regulatory/public interest
concerns, versus the general consumers. As issues of cost, quality, and safety all intersect
sometimes inversely) with profit generation for shareholders, lenders, and management, the
theory poorly describes areas of overlap and incompatibility.
2.2.3. Stewardship Theory
It has been argued by McDonnell et al. (2001), that stewardship theory also provides a good
background for implementing CG practices. In this theory, managers, as the controllers of an
organisation, should act as stewards. Stewardship theory promotes partner-style working
relationships between board members and the management team (McDonnell et al. 2001). It is
the responsibility of the board members to add extra value to the organisational process by
supporting management in their strategic decision-making.
Aduda et al. (2013) state that being stewards, the directors and managers in business
organisations must be trustworthy and so must show good stewardship of organisational
resources. This theory states that superior corporate performance is highly dependent on the
duties and functions of inside directors and corporate leaders (Aduda et al. 2013). The
decisionmaking process of senior managers should be governed so that they can fulfil all CG
obligations
responsibly.
Stewardship theory suggests that managers in organisations have autonomy, through which the
costs of monitoring can be minimised and the corporate behaviour of managers and directors can
be properly controlled (Aduda et al. 2013). In CG practice, efficient decision-making of
managers is essential, and it is the duty of managers to govern business activities with effective
leadership practices.
The main challenge with stewardship theory is that it assumes that the agents involved in
stewardship are completely unconstrained. In reality there are always not only multiple factors
but often multiple layers of factors that serve as both hard and soft constraints. These relate to an
extremely wide range of factors from budgets, schedules, and union agreements (as examples of
hard constraints) and precedence, safety norms, and diversity (as examples of soft constraints).

The separation of ownership and control is one of the key features of modern
corporations, and corporate governance has become necessary to mitigate the principal–
agent problem (Berle & Means, 1932). The agency problem was first highlighted by
Adam Smith in the eighteenth century and explored by Ross (1973), with the first
detailed description of the theory presented by Jensen and Meckling in 1976. Fama and
Jensen (1983a, b), Williamson (1987), Aghion and Bolton (1992) and Hart (1995)
further explicated this problem over the next two decades. The agency theory evolved
from the economic literature and has developed into two separate streams: the positivist
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agent and the principal agent. Both streams concern the contracting problem of selfinterest as a
motivator of both the principal and the agent, and they share common
assumptions regarding people, organisations and information. However, they differ in
terms of mathematical rigour, dependent variables and style (Jensen, 1993). The agency
relationship is described by Jensen and Meckling (1976) as a contract under which one
or more persons (the principals) engage another person (the agent) to perform some
service on their behalf, which involves delegating some decision-making authority to
the agent.
According to this theory, shareholders who are the owners of the corporation appoint
managers or directors and delegate to them the authority to run the business for the
corporation’s shareholders (Clarke, 2004). The agency relationship between two parties
is defined as the contract between the owners (principals) and the managers or directors
(agents) (Jensen & Meckling, 1976). On the basis of the agency theory, shareholders
expect the managers or directors to act and make decisions in the owners’ interests.
However, managers or directors may not necessarily always make decisions in the best
interests of the shareholders (Padilla, 2002). The separation of ownership and control
produces an innate conflict between the shareholders (principals) and the management
(agents) (Aguilera et al., 2008). This conflict of interest can also be exacerbated by
ineffective management monitoring on the part of shareholders as a result of
shareholders being dispersed and therefore unable, or lacking the incentive, to carry out
necessary monitoring functions. Consequently, the managers of a company might be
able to pursue their own objectives at the cost of shareholders (Hart, 1995).
Thus, two problems involving the agency theory occur in the agency relationship. The
first problem is that, because it is difficult or expensive for the principal to verify what
the agent is actually doing, the principal cannot verify that the agent has behaved
appropriately. The second problem is that, because of differing attitudes towards risk,
the principal and the agent may favour different courses of action (Eisenhardt, 1989).
Shareholder efforts to monitor the agent—for instance, shareholder engagement and
incentive schemes or contracts—lead to additional costs for the company (Solomon,
2010). Grant (2003) argues that the main purpose of shareholders (principals) is to
maximise their value (interest), whereas the main purpose of agents is to expand and
grow the corporation because success will reflect favourably on management.
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According to Hart (1995), a corporate governance issue occurs in an organisation in the
presence of two conditions. First, there is a conflict of interest or agency problem
between members of the company. Second, the conflict of interest or agency problem
cannot be dealt with through a contract. Hart observes that there are several reasons why
contracting might not always be possible. In particular, it is impossible for a contract to
cover all eventualities in relation to the firm. In addition, there are costs associated with
negotiating contracts and enforcing them. This conflict can exist between or among
owners, managers, workers or customers, which means that there will not always be
comprehensive contracts governing participants in companies (Ramsay, 1997).
Effective corporate governance can reduce agency costs and tackle problems related to
the separation of ownership and control. It can be viewed as a set of mechanisms
designed to reduce agency costs and protect shareholders from conflicts of interest with
agents (Fama & Jensen, 1983a). The objective of corporate governance mechanisms,
then, is to encourage management to make the same decisions that owners would have
made themselves, such as investment in positive net present value (Shleifer & Vishny,
1997). From the perspective of the agency theory, corporate governance is viewed as a
monitoring or control mechanism that is sufficient to protect shareholders from conflicts
of interest with agents (Fama & Jensen, 1983b). Gursoy and Aydogan (2002) argue that
the problems of the separation of ownership and control on the one hand, and cost
agency on the other, could be reduced by the quality of corporate governance because it
promotes goal congruence (Conyon & Schwalbach, 2000). However, Jensen (2001)
highlights that these issues will increase if the corporate governance structure is weak.
Therefore, the aim of the agency theory is to determine the most cost-effective
governance method for tackling any possible agency issues (Dey, 2008).
According to the agency theory, corporate governance mechanisms are needed to
mitigate the problems associated with the theory, which is designed to provide the basis
of corporate governance through the use of internal and external mechanisms (Weir,
Laing & McKnight, 2002; Roberts, McNulity & Stiles, 2005). The objectives of
corporate governance mechanisms are to ‘protect shareholder interests, minimize
agency cost and ensure agent–principals interest alignment’ (Davis, Schoorman &
Donaldson, 1997, p. 23). According to Shleifer and Vishny (1997) and Kiel and
Nicholson (2003), the agency theory suggests that the separation of the positions of
chairman and CEO leads to higher performance. Fama (1980) contends that the
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appointment of non-executive directors to a board is designed to control management
issues and is intended to have a positive effect on firm performance (Fama & Jensen,
1983b; Jensen & Meckling, 1976). Yoshikawa and Phan (2003) and Barnhart and
Roseinstein (1998) emphasise that larger boards seem to be less helpful and more
difficult to coordinate, which results in a negative effect on performance.
5.2.2 Stakeholder theory
The stakeholder theory has been developing continuously over the past three decades.
One of the first theorists to present the stakeholder theory as inherent in management
discipline was Freeman (1984). He also proposed a general theory applicable to firms,
which is based on the premise that firms should be accountable to a broad range of
stakeholders (Solomon & Solomon, 2004). Freeman (1984, p. vi) defines stakeholder as
‘any group or individual who can effect or is effected by the achievement of
corporation’s purpose’. Thus, the term stakeholder may cover a large group of
participants; in fact, it applies to anyone who has a direct or indirect stake in the
business (Carroll & Buchholtz, 2002). Stakeholders include shareholders, employees,
suppliers, customers, creditors and communities in the vicinity of the company’s
operations, in addition to the public (Solomon, 2010).
According to Wheeler and Sillanpaa (1997), the stakeholders that should be taken into
consideration in the governance structure include investors (including banks), managers,
employees, customers, business partners (suppliers and subsidiaries), local
communities, civil society (including regulators and pressure groups) and the natural
environment. The relationship between the company and its internal stakeholders (such
as employees, managers and owners) is framed by formal and informal rules that have
been developed in the course of the relationship. The stakeholder theory supports the
contention that ‘companies and society are interdependent and therefore the corporation
serves a broader social purpose than its responsibilities to shareholders’ (Kiel &
Nicholson, 2003a, p. 31).
Donaldson and Preston (1995) suggest that the literature on the stakeholder theory can
be seen as having three branches: descriptive, instrumental and normative. The
descriptive branch considers how managers deal with stakeholders and how they
represent stakeholder interests, the nature of a company, the way managers think about
managing, the way board members think about the interests of company constituencies
113
and how some companies are actually managed. The instrumental branch is concerned
with the organisational consequences of taking into account stakeholders in
management, examining the connections between stakeholder management and
achieving traditional corporate goals such as profitability and growth. The normative
branch addresses the purpose of a company, including the identification of moral or
philosophical guidelines linked to the activities or management of that company.
Thus, the aim of the agency theory is to concentrate on shareholders’ rights and the
separation of ownership from control so that a company can maximise the wealth of its
shareholders. The stakeholder theory focuses not only on shareholders, but it has been
expanded to take into account the interests of many different stakeholder groups,
including interest groups with social, environmental and ethical considerations (Clarke,
2004; Letza, Sun & Kirkbride, 2004). This is consistent with the views of the OECD
(2004), which defines corporate governance as a set of relationships between a
company’s management, its board, its shareholders and other stakeholders.
This view is commonly referred to as the stakeholder model of corporate governance,
whereby stakeholders may include customers, suppliers, providers of complementary
services and products, distributors, and employees. Thus, the theory holds that
corporations should be managed for the benefit of all who have a stake in the firm. For
example, Berman et al. (1999) document that a strategic stakeholder model used by
companies to address the concerns of stakeholders will improve company performance.
Wright et al. (2003, p. 267) argue that ‘stakeholder involvement in corporate
governance must rely on a culture of trust, community and consensus rather than of
individualistic opportunism as in a shareholder-based system’. The stakeholder theory
serves to build good relationships between firms and various internal and external
stakeholders in the broader environment, as it is essential for the implementation and
improvement of effective governance mechanisms and processes (Christopher, 2010).
The stakeholder theory is particularly important for managers in a corporation, who
have critical networks of relationships other than those with the owners, managers and
employees who are part of the agency theory (Freeman, 1999). Kaplan and Norton
(1996) argue that a company should develop relationships with customers by improving
customer services, thereby enhancing its financial performance. Atkinson, Waterhouse
and Wells (1997) emphasise that employees and communities also need to be included
114
in relationships in order to enhance financial performance. Recently, the stakeholder
approach has become acceptable in the areas of accounting and finance (Solomon,
2010). Indeed, according to the stakeholder model, corporate governance is mainly
concerned with how effective different governance systems are in encouraging longterm
investment and commitment among the various stakeholders (Maher & Anderson,
2000). Thus, the stakeholder theory is an important theory in terms of corporate
governance (Abu-Tapanjeh, 2009). Clearly, the influences and functional mechanisms
relating to stakeholders can affect a firm’s ability and performance (Clarkson, 1995).
Corporate governance research discusses the stakeholder theory in relation to the
responsibility that firms have to the wider community. This theory has gained in
influence through suggestions that the practice of stakeholder management positively
contributes to firm performance (Donaldson & Preston, 1995), with researchers finding
a strong and consistent relationship between corporate governance and firm
performance as a result of the stakeholder theory’s implementation (Udayasankar, Das
& Krishnamurti, 2005). For instance, stakeholder relations have also been found to have
a significant effect on firm performance, and Hillman and Keim (2001) establish a
positive relationship between managing effective stakeholders and enhancing value for
shareholders. Hillman and Keim argue that examining the link between stakeholders on
the board and stakeholder performance could show a direct correlation with the
financial performance of the firm.
According to Clarke (2004), if corporate managers are there to maximise the total
wealth of the organisation, they must take into account the effects of their decisions on
all stakeholders. Pesqueuy and Damak-Ayadi (2005) indicate that the practice of
stakeholder management will result in higher profitability, stability and growth, and will
thus affect firm performance. Consequently, good corporate governance must focus on
creating a feeling of security that a company will consider the interests of stakeholders,
as the board of directors is responsible for the company as well as its stakeholders
(Ljubojevic & Ljubojevic, 2011). According to Jensen (2001), the stakeholder theory
solves the problems caused by multiple objectives, as this theory seeks to maximise
value in the long term. Moreover, if management decisions do not take into account the
interests of all stakeholders, the firm cannot maximise its value.
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In summary, the integration of the agency and stakeholder theories highlights the
special role of the company toward shareholders and all other stakeholders. Hill and
Jones (1992) contended that the stakeholder-agency paradigm explicitly focused on the
causes of conflict between managers and stakeholders. In addition, the stakeholderagency theory
highlights the concepts underlying the alignment of management and
stakeholders interests in the conflict of such interests. The agency theory calls for
governance mechanisms to provide sufficient monitoring or control methods to protect
shareholders from conflicts of interest with agents. The stakeholder theory, however,
enables fostering good relationships with a range of stakeholders and emphasises
corporate efficiency in a social context; it also underpins the corporation’s purpose of
maximising shareholders’ wealth.
Therefore, using both theories is the most effective approach as compared to other
governance theories, because it involves combining all the elements of corporate
governance to improve firm performance. This study will rely on the agency theorystakeholder
theory that fits the nature and scope of the empirical work. Hence, the
stakeholder-agency theory could provide some useful insights into the current research