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Agency theory (Jensen & Meckling 1976) has provided useful insight into the financial dealings between an enterprise (principal) and its stakeholders (agents). It is unlikely that the economic interests of these parties will be exactly the same because it is human nature to maximise one’s own benefit even at the expense of others. (Peacock, p278) Question:
Explain how agency theory may be applied in explaining the relationship between small business and a financial institution. Include, as part of the discussion, an explanation of the costs and benefits of the relationship that may be attributable to the existence of an agency relationship. (2500 words).
Around 96% of businesses in Australia are small businesses. The funds needed to run a small business are typically provided by large financial institutions, which are involved in the supplementation of business loans. By borrowing money from a financial institution an agency relationship is created between the lender and the borrower. By lending money to a small business, the financial institution assumes the role of the principal, authorizing the owner of the small business to act on behalf of the bank, and thus taking on the role of the agent. This however can lead to conflicts between the two parties as often the economic interests between the bank and the owner-manager often differ. Agency Theory can be applied to such a relationship, to help understand and potentially resolve conflicts of issue that may arise. A small business is defined by its size, that fact that it is independently owned and controlled by the owner, and where the owner-manager is the decision maker for all critical management decisions, who also takes the responsibility to carry the risk involved in the venture (Peacock, 2004). Small businesses range from individual- or family-owned retail outlets to specialised technical consultancies (ABS, 2013), and account for around 96% of all business in Australia (ABS, 2006).
Agency Theory describes the relationship between two parties: the principal, and the agent. The relationship is a contract where the principal engages the agent to perform a service on their behalf. The relationship comes into being when the agent is authorized to act on behalf of the principal, in the creation of a legal agreement (Peacock, 2004).
Discrepancies often arise in such relationships, where both parties may disagree on how their mutual endeavor is to be conducted, and Agency Theory can be a useful way to identify and resolve problems. Principals that afford their agents with a certain degree of autonomy can become frustrated when the agent appears to be serving their own interests. Problems can also arise when the principal and agent have different attitudes towards risk taking. This becomes an important issue when the principal is unable to confirm what the agent is doing. To limit such conflicts, the principal can offer incentives designed to limit irregular or unusual activities of the agent (Jensen & Meckling, 1976). However, incentives can be counterproductive if the agent is not averse to risk. In such cases, incentives may encourage agents to engage in unnecessary risks (Holmstrom & Milgrom, 1991).
Applying Agency Theory to describe the relationship between a financial institution and small business would cast the financial institution as the principal and the small business as the agent. Where the financial institution has lent the money to the small business, the small business represents the bank in the use of its funds, as the financial institution still owns the money. The bank has authorized the small business to use their money on their behalf, on the understanding that it will be used in the both parties’ best interests.
Problems may now arise between these two parties, as it is unlikely that both have exactly the same economic interests, as it is human nature to maximize one’s own benefit (Peacock, 2004). This...
References: Australian Bureau of Statistics (ABS) 2006, Australian Industry, cat. no. 8155.0, ABS, Canberra.
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