Agency theory free essay sample

Introduction â€Å"It is the things towards which we have the stronger natural inclination that seem to us more opposed to the mean† Aristotle (2004, p. 47) The documentary ? Inside Job? portrays a riveting account of a financial industry festered with greed and conflicts of interest. As bankers gambled creatively with the life savings of laymen investors, ratings agencies and regulators closed their eyes to the full picture, whilst scholars supported the development of over the counter derivatives designed to safeguard the ever-increasing rate of subprime mortgages. Beginning in mid-2007 the largest American financial crisis since the Great Depression began to unfold (Jickling 2010) with thousands of homeowners defaulting on their mortgages (Pinyo 2008). The consequences were to be felt around the world and the Global Financial Crisis (GFC), as it came to be known, soon had national governments scrambling to ? bail out? private institutions in effort to keep the financial industry afloat and mitigate the fallout from digressing into pandemonium (Shah 2010, Sidelsky 2009). Inevitably, the pressing questions of governments, media and the public alike were how could it have gone this wrong and who was to be blamed? Shots were fired left, right and center, targeted at a range of factors from regulation and credit agencies to financial innovation and central banks. Particularly, the intertwined aspects of executive remuneration and the auspices of corporate governance (CG) were targeted as having failed to safeguard the company and incentivized risk-taking. The attacks were not only directed at ? institutional constructs? , a recurrent character was also the greedy banker and his apparent disregard for ethics and morality in pursuit of his own gain. As we enter the ? post-crisis? era, governments and regulators seek to redevelop regulations and standards to prevent the recurrence of a GFC. Generally however, their focus only addresses what is visible (Dobbin et al. 2010). The purpose of this thesis is to delve deeper and review the underlying theoretical construct of best practice CG mechanisms utilized today, agency theory (AT), a construct that has also been criticized as ? green lighting? a higher propensity towards risk, along with unethical and immoral behavior (Ghoshal 2005). This thesis therefore poses the questions: Did the agency theory prescriptions of corporate governance and directors’ financial literacy impact the risk profile of Scandinavian banks during the Global Financial Crisis? And are there differences in the moral and ethical perceptions of business majors in comparison to other majors? Based on hypotheses derived from AT and through the utilization of data on Scandinavian Banks‘ Thomas Rudiger Smith 7 M. Sc. FSM Master Thesis: Agency Theory Its Consequences board of directors and incentive plans, the thesis addresses the first part of the research question by investigating whether AT prescriptions contributed to the risk-taking behavior that propelled the GFC. Subsequently, the second part of the research question is analyzed on the basis of hypotheses grounded in the popular criticisms of AT in begetting immoral or unethical managers, and seeks to answer this question through a survey of ethical perceptions. Ultimately the result of the research question is discussed with a view to management education and moral philosophy. Prior to investigating these issues, it is important to understand the motivation driving the aims of this thesis. 2 Motivation The GFC has not only been a contentious topic for regulators, bankers and the media, business schools have also debated the causes and consequences in effort to find ways to better prepare their students for future challenges1. This debate, in combination with previous research on agency theory in banking (Smith et al. 2009) sparked the author‘s initial interest through the simple question â€Å"What role have agency theory prescriptions played in the crisis? †. What started as a simple question has evolved into this thesis, wherein the consequences and side-effects of the AT perspective is reviewed due to its prominent role in business education (Dobbin et al. 2010) and its potential relationship to the GFC. What further augmented the interest was the perceived simultaneous incapability of agency theory as a descriptive theory of CG (Dalton et al. 1998) in combination with its strong normative capability, and potential side-effects. Essentially the question that remained after the review of scholarly writings on agency theory, was whether the side-effects of encouraging risk-taking and the presumed postulation of creating immoral managers in fact was true, and if so, what would this mean for management education. Out of this emerged the research questions under investigation here, for which the obvious choice for data collection was the banking industry as both greed and excessive risk-taking have been argued as causes of the crisis (Shah 2009). The specificity of the area of interest however meant that as opposed to much of the current business research on the GFC, this thesis has never intended to provide input for how financial regulation should be formulated. Rather, the goal has been to highlight the potential consequences for management education, given the lack of research herein even though many future bankers will be the product of business schools. Additionally, the specificity of the research questions means that Discussions on the impact of the financial crisis on management education were observed at a CEMS Executive Board meeting in Singapore in May 2010. CEMS is an alliance of 26 leading world-wide business schools. 1 Thomas Rudiger Smith 8 M. Sc. FSM Master Thesis: Agency Theory Its Consequences the structure must be qualified properly before commencing, as it handles two simultaneously independent and intertwined questions. The subsequent section will thus introduce the thesis structure. 3 Structure As a result of the research questions and the data collections, the structure of the thesis will make a topical split when deemed necessary to avoid confusion between the treated data and hypotheses. The structure for the thesis will therefore set out accordingly, first by outlining the context of the GFC, thereafter assumptions and limitations will be presented in order to demarcate the research area. Subsequently, the theoretical background will be introduced, first highlighting the core theoretical Figure 1 Structure foundation of agency theory and subsequently moving into the two different consequences under investigation – risk-taking and ethics. Hereafter the hypotheses for each consequence will be introduced, which will be followed by a joint methodology section. Thereafter the thesis is divided, first focusing solely on risk-taking and governance mechanisms, their analysis and partial conclusion, followed by the analysis of the second strand, the ethical hypotheses. Finally once all hypotheses have been investigated, these two strands will be integrated in the discussion and the findings will be summed up in the conclusion. Throughout the thesis, a graphical representation of the structure (Figure 1) will indicate shifts from one section to another. Having outlined the motivation and structure, the following section seeks to qualify the predominant focus on governance and greed with respect to the GFC and their connection to the economic theory. Thomas Rudiger Smith 9 M. Sc. FSM Master Thesis: Agency Theory Its Consequences 4 Greed, Governance the Financial Crisis 4. 1 Greed The populist cause of the GFC is greed, (Pinyo 2008, Guina 2008) wherein investment bankers gambled with customer funds (Shah 2010). Credit was cheap, needed to be lent out and with no more prime borrowers, bankers went to sub-prime borrowers to cash in more money (Jarvis 2009). The gamble was almost a safe bet provided housing prices kept rising, but when the housing bubble began to constrict and interest rates rose, sub-prime borrowers began to default (Jickling 2010, Time 2011). Though acknowledged as a contributing factor (Anderson 2008), the events preceding the GFC are too multifarious to be attributed to greed alone. 4. 2 Governance 4. 2. 1 Distorted Bonus Bonanza A bonus culture that effectively espoused excessive risk-taking did not help. The potential for upside gains were significant and the downside costs negligible, or so it seemed (Sidelsky 2009). As noted by Krugman (2008) in the New York Times, „The pay system †¦lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion?. Variable pay packages that tied managerial wealth to the wealth of shareholders were commonplace. Rajan noted back in 2005 that these created distorted incentives and promoted risk taking, even proclaiming that „They may create a greater probability of a catastrophic meltdown? (p. 318). Lord Turner, head of FSA, would later support Rajan in claiming that the bonus culture indeed had an effect on the financial crisis (BBC 2010). Their arguments were also supported academically by Bechmann and Raaballe on a sample of Danish banks (2010). Rajan (2005) and Blundell-Wignall et al. (2008) argued that the inherent problem of incentive schemes was that they were not risk adjusted, effectively accentuating risk-taking behavior. The hefty bonuses accumulated by bank managers were also targeted for criticism in the post-GFC finger-pointing game, as politicians either questioned or sought regulatory action on bonus levels (Arentoft 2010, Condon 2010). However Sidelsky (2009) contended that bankers, though also selfinterested, acted largely in accordance with the adage of the system – profit maximization. Thomas Rudiger Smith 10 M. Sc. FSM Master Thesis: Agency Theory Its Consequences 4. 2. 2 Corporate Governance Failure Closely related to the issue of bonus schemes is the perspective that contemporary CG has failed in safeguarding the firm (Jickling 2010, Blundell-Wignall et al. 2008). Foong (2009) also pointed to weak CG mechanisms to explain the effectual failure of the market. OECD (2010) provided similar critique, describing a system that failed to provide and cultivate sound business practices. Professor Hasung Jang posited that like the 1997 Asian financial crisis, shortcomings in CG was a root cause of the GFC (Jang in Sharma 2008). Others point specifically to the general ineffectiveness of boards to stem incessant risk-taking behavior (Dobbin et al. 2010, Abdullah 2006). The governance best practices that may have failed, the distorted bonus culture and the greedy manager share common ground through the perspective of agency theory, a facet that remains unaddressed by regulators. 4. 3 The Connection to Economic Theory A less espoused argument for the cause of the GFC attacks the underlying economic theory that underpins the development of established governance mechanisms and may have adversely impacted the moral compass of business managers. Dobbin et al. (2010) noted that the political responses to the GFC have focused on the regulatory environment, ignoring the contributions of economic paradigms, particularly agency theory, in promulgating the wealth maximization environment that abetted the crisis. Daianu (in ALDE 2008) argued that the theoretical underpinnings of policies were problematic in general, and the principal-agent problem in particular fuelled the crisis. Policies based upon economic theories that expect humans to be rational and discount complex realities to achieve perfect models have essentially failed (The Times 2010). Priester (in ALDE 2008) criticized the proclivity of business models towards short term wealth maximization as „fundamentally flawed? on the grounds of being both „economically obsolete? and „morally indefensible? (p. 38) by transferring all power to the shareholder. From an ethics perspective, he further argues that the permeation of economic theory has dehumanized business and only heralded innovation for the purpose of private gains, when in fact â€Å"innovation [is] for-or-about [serving] the substantive interest of the Human Person† (p. 38). In essence, the crisis may not only be a consequence of poorly constructed institutions of control, but rather of poorly constructed financial theories supporting and dictating the development of Thomas Rudiger Smith 11 M. Sc. FSM Master Thesis: Agency Theory Its Consequences these institutions (Kou 2009). Therefore this thesis investigates whether the agency theoretical prescriptions added to more risk with regards to the GFC and whether it creates immoral managers. Before delving into the theoretical background, hypotheses, methodology and data testing, it is relevant to define the appropriate assumptions as well as demarcate the research area through some limitations. 5 Assumptions Throughout the thesis a number of assumptions are made, none of which are believed to distort the overall picture, though they may in fact have an influence on the generalizability of the thesis (Bryman et al. 2003). For both areas it is assumed that the constructs measure the intended effects. Through the qualification of measures by previous studies investigating similar variables, the assumption is assessed to be fair. It is additionally assumed for both data sets that Agency Theory is part of education and financial literacy ergo also means a familiarity and understanding of agency theory. This assumption although grand in its scope is not unrealistic, as noted by Zajac et al. (2004) and Dobbin et al. (2010). A more questionable assumption is made with regards to the impact of education. Although some like Albert et al. (2010) highlight that education has lasting effects, it is impossible given the research design to discern between self-selection and actual impact of education. The relationship between formation and actions must therefore be treated with regards to this assumption. 6 Limitations As with any other, this thesis is limited by timeline, scope and scale which confines the ability to investigate all possible variables and contributing factors. Unlike AT, alternative models of CG, such as stewardship and stakeholder theory (Lan et al. 2010), have yet to gain a solid foothold in the practical literature and enactment of CG (Daily et al. 2003)2. As such, reflecting the real life context, the thesis does not directly investigate these alternatives, though they are referred to as points of discussion. Amongst the many potential consequences of agency theory, this thesis will focus on two due to their perceived relevance to the GFC. As noted, whilst it is acknowledged that there were many 2 An overview and short critique of these models and the director primacy model is available in Appendix 17. 1. Thomas Rudiger Smith 12 M. Sc. FSM Master Thesis: Agency Theory Its Consequences contributing factors to the GFC, the intention of this thesis is to empirically analyze the consequences of agency theory. As such, the GFC serves as the context for analysis rather than the object of investigation. The banks are not disregarded however, given that their societal role makes the application of AT prescriptions within the industry all the more intriguing. Nevertheless it is acknowledged that the findings of this thesis related to CG will be derived from a distinct and heavily regulated industry, which may limit their utility (Battilossi 2009). Upon investigating the second research objective, it is accepted that temporal limitations made the assessment of moral philosophy development challenging and the cogency of results may be restrained by the difficulty in establishing the degree to which individual moral development is influenced by business education and not also self-selection (Pfeffer 2005). Overall however these primary assumptions and limitations, by virtue of their academic support and conscious inclusion, are not believed to fundamentality compromise eventual findings. Having established these caveats, the thesis will return to outlining the connections between the presented causes of the GFC and economic theory. But before qualifying the consequences of AT on risk and morality, it is imperative to first delineate the concept itself. 7 Theoretical Background 7. 1 Agency Theory The 1976 article ? Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure? by Jensen and Meckling helped establish AT as the dominant theoretical framework of the CG literature, and position shareholders as the main stakeholder (Lan et al. 2010, Daily et al. 2003). The adoption of the agency logic increased during the 1980‘s as companies started replacing the hitherto corporate logic of managerial capitalism with the Figure 2 Structure perception of managers as agents of the shareholders (Zajac et al. 2004). The subsequent stream of Thomas Rudiger Smith 13 M. Sc. FSM Master Thesis: Agency Theory Its Consequences literature would break with the tradition of largely treating the firm as a black box and the assumption that the firm always sought to maximize value (Jensen 1994). AT addressed what had become a growing concern, that management engaged in empire building and possessed a general disregard for shareholder interest, what Michael Jensen called â€Å"the systematic fleecing of shareholders and bondholders† (1989, p. 64), through providing prescriptions as to how the principal should control the agent to curb managerial opportunism and self-interest (Perrow 1986, Daily et al. 2003). As the market reacted positively to this change in logic, with time the agency approach became institutionalized in the practice of CG, within business education, research and media (Zajac et al. 2004; Shapiro 2005, Lan et al. 2010). Out of the agency logic grew two closely related streams of research; the mathematically complex Principal-Agent literature and the more practice oriented Positive Agency Theory (Shapiro 2005). Common to both is shareholder primacy, wherein the principal is positioned both as the residual claimant and main stakeholder. Although the influence of Principal-Agent theory cannot be denied (Asher et al. 2005), the practical and empirical nature and implications of Positive Agency Theory on CG situate this stream as the main concern of this thesis. 7. 1. 1 Foundations As any theory, AT is based in a number of assumptions about man, which have a significant impact on the formation of the theory (Davis et al. 1997). The most common belief is that AT is based in the economic model of man (e. g. Brennan 1994, Perrow 1986, Shapiro 2005). Jensen and Meckling denounce this interpretation however, by arguing that the theory is grounded in what they call REMM – the Resourceful, Evaluative, Maximizing Model (Jensen et al. 1994). They argue that the REMM most closely replicates human action, and that the economic model of man is a simplified version that does not reflect the spectrum of human behavior. However, the extent to which these two models are actually different is questioned by Brunner (1996) and Tourish et al. (2010), who treat them as equals (see also table 1 for comparison and overview of assumptions). Their arguments are based in the fact that the REMM, although accepting that wealth may not be the only goal, will willingly substitute goods for monetary rewards (Baker et al. 1988). In addition, despite the fact that the REMM can act with altruism, it can only do so simultaneously with individual self-maximization3. As such pure altruistic behavior without ulterior 3 Self-interested altruism although creating a possibility of other-regarding behavior – does only so given a positive Thomas Rudiger Smith 14 M. Sc. FSM Master Thesis: Agency Theory Its Consequences motives cannot take place. Thereby the REMM is largely similar to the economic model of man, which assumes that humans are rational, selfishly motivated and will behave opportunistically, even ruthlessly, whenever advantageous (Ghoshal 2005, Daily et al. 2003). Herein, actions are undertaken according to selfinterest (Fama 1980) and opportunistic behavior is fostered when monitoring contracts and relationships becomes difficult and costly due to bounded rationality and information asymmetry (Perrow 1986, Donaldson 1990). Opportunism is therefore central to this view of man, where an actor‘s promise to do a certain action is worthless if the circumstances of the promised action changes before the action is carried out (Heath 2009). As such, changes in behavior are also driven by changes in incentives (Prendergast 1999) and behavior is directed by maximizing self-interest under game-theoretical like conditions (Perrow 1986). Human Assumptions REMM Economic Man Bounded Rational Rational Maximizer based on thorough evaluation Maximizer Self-Interested Self-Interested Actions driven by Incentives Motivated by incentives Opportunistic if beneficial Opportunistic with guile Will substitute goods if beneficial (not driven exclusively by extrinsic rewards) Altruistic if beneficial Resourceful – innovative when facing constraints and opportunities Focus on extrinsic rewards Not other-regarding (Resourceful) 4 Table 1 Comparison of REMM and Economic Model of Man Regardless of whether Jensen and Meckling‘s (1994) postulation that the REMM guides AT, Table 1 shows that the REMM in fact have few differences from the Economic Model of Man (Brunner et al. 1996). Bearing in mind the lack of self-interested altruism and the slightly stronger focus on extrinsic motivators in the Economic Model of Man, arguments against this representation of benefit to the individual. Thereby self-interested altruistic behavior can potentially be reduced to an intrinsic motivation (Brunner et al. 1996). 4 The Economic Man is like the REMM perceived to be resourceful, yet the literature is generally less focused on this aspect of his/her behavior as opposed to the other notions (Brunner et al. 1996). Thomas Rudiger Smith 15 M. Sc. FSM Master Thesis: Agency Theory Its Consequences human behavior must then also be applicable to the REMM model (see section 7. 3. 1) With the understanding that man is self-interested, ever opportunistic and driven by incentives, AT addresses the effect of having this man as a manager in the modern corporation by providing prescriptions to taming him. But what is the modern corporation in the eyes of AT and what are these effects and prescriptions? 7. 1. 2 The Modern Corporation, Effects Prescriptions in Agency Theory 7. 1. 2. 1 The Modern Corporation is Separation of Ownership and Control The model of the modern corporation used in AT is driven by the development in the mid 20th Century, where the corporation grew in size, complexity and in the need for external capital. This, combined with an increased stock market, a limit on managerial wealth and a need for efficient risk allocation (Fama 1980, Fama et al. 1983, Demsetz et al. 1997), meant an increase in the diffused ownership of companies amongst shareholders. As shareholders have a willingness to bear risk but do not necessarily possess the interest and time to actively manage the company (Brealey et al. 2008), a contractual relationship is created wherein an agent (manager) will manage the risk and control the company on behalf of the principal (shareholder), who is the residual claimant, risk bearer and owner of the company (Jensen et al. 1985, Fama et al. 1983). As such, the modern corporation is reduced to a ? nexus of contracts‘ between principals and agents and the separation of ownership and control is created (Jensen et al. 1976). 7. 1. 2. 2 The Effect of Conflict of Interest and Moral Hazard Given the separation of ownership and control, and the diverging risk profiles of the participating parties (Eisenhardt 1989, Jensen 1989), it cannot be expected that risk-averse managers (agents) will act in the interest of risk-neutral shareholders (principals) as it may not be in the manager‘s selfinterest to pursue shareholder wealth maximization (Bonazzi et. al. 2007, Lan et al. 2010, Demsetz et al. 1985). Jensen et al. (1985) argue that the three prominent problems with management that cause the conflict of interest are, 1) the choice of effort, 2) differential risk exposure, and 3) differential time horizon. The agency problem in separating ownership and control is therefore the assumed diverging goals of the ? cooperating parties? – the residual claimant and manager (Donaldson 1990, Hendrikse 2003). This inevitably increases the incentives for moral hazard and opportunistic Thomas Rudiger Smith 16 M. Sc. FSM Master Thesis: Agency Theory Its Consequences behavior as self-interest guides action (Demsetz et al. 1985). Moral hazard is central to AT, and is also referred to as hidden action or opportunistic behavior (Hendrikse 2003). However, hidden action refers specifically to the information asymmetry in the contractual relationship (Arrow 1968, Eisenhardt 1989), whereas opportunistic behavior is an inclination in the human (Jensen 1994)5. Moral hazard on the other hand, is the combination of these two terms together with the above described conflict of interest (Hendrikse 2003) and refers to the actual actions taken by the agent once the contract has been entered. The imperfect contract (Prendergast 1999) in the agency relationship makes the observation of true effort very difficult and as such causes the hidden action problem of asymmetric information (Arrow 1968). This inherently leads to an encouragement of moral hazard (Perrow 1986), where the principal will not know whether the agent has acted in accordance to the principal‘s interest (Shapiro 2005, Hendrikse 2003). It is therefore to be expected that the self-interested agent will shirk on the contract and carry out actions that are not in the interest of the principal (Hendrikse 2003, Eisenhardt 1989). Although moral hazard presumably is present in all types of relationships, Boyd et al. (1998) researched the possibilities for moral hazard in banking and found two possible areas of moral hazard. One is the relationship between the bank and their borrowers, the other is the moral hazard created from the cushion of the deposit insurance (John et al. 2000, Demsetz et al. 1997), as the deposit insurance reduces the interest from monitoring whilst simultaneously increasing the incentives for risk taking (Macey et al. 2003). Moral hazard is the exact problem that AT is designed to address through various mechanisms – most notable incentives and monitoring (Eisenhardt 1989). 7. 1. 2. 3 The Creation of Agency Costs The problem of moral hazard leads to costs for the firm associated with administering the contract, hereunder contracting, transaction, moral hazard and information costs – namely agency costs (Gomez-Mejia et al. 2005, Jensen et al. 1985). The level of the costs will depend on the ability of the principal to find an appropriate solution to reducing information asymmetries through measuring managerial performance, determining effective incentives, as well as implementing rules and Adverse Selection follows the same patterns as Moral Hazard, but deals with the selection of contracts and staff, and are more focused on pre-contractual areas of opportunistic behavior. Although a central part of agency theory, this section has less relevance for this thesis, and has therefore been described in the appendix 17. 2. 5 Thomas Rudiger Smith 17 M. Sc. FSM Master Thesis: Agency Theory Its Consequences regulations to limit unwanted behavior or moral hazard (Brickley et al. 1994, Gomez-Meija et al. 2005). Whilst achieving zero agency costs is practically impossible, as the marginal costs of doing so will eventually be higher than the accompanying benefits of perfect alignment (Jensen et al. 1976), monitoring and incentives intends to minimize them (Eisenhardt 1989, Jensen et al. 1985, Shapiro 2005)6. 7. 1. 2. 4 Monitoring and Incentives as Prescriptions of Agency Theory The proposed mechanisms for curbing moral hazard are generally monitoring and incentive contracts (Jensen 1993, Daily et al. 2003), where the board of directors (BOD) comprises the main monitoring mechanism. According to AT, they should act on behalf of the shareholders and hold foremost responsibility for the functioning of the firm, with the goal of reducing information asymmetries through ratifying and monitoring important decisions (Fama et al. 1983, Heath 2009, Shapiro 2005, Fama 1980). The BOD is therefore also responsible for controlling resource allocation and accompanying risks (Tufano 1998). The monitoring system provides an ex post control system (Jensen et al. 1976, Fama et al. 1983), where the extent of the monitoring in place will depend on the proclivities of management for opportunistic behavior and the costs and benefits related to its implementation (Jensen et al. 1976). The more effective the board is in obtaining information about agent behavior, the more likely the manager will be to act in the interest of the shareholder, and therefore fewer resources need be spent on aligning the interests through incentives (Hermalin et al. 1988, Eisenhardt 1989). Besides the BOD, incentives can be similarly employed to limit moral hazard on the part of the manager. The conflict of interest addressed earlier is in part caused by differing risk preferences, where managers are risk averse and shareholders risk-neutral. This often leads to contrasting predilections, where the manager will make less risky investments than preferred by the shareholders (Shapiro 2005, Eisenhardt 1989). This conflict can be mitigated by introducing a compensation scheme, in the form of a risk premium (Prendergast 1999), where rewards are based on outcome, commonly stock price (Hendrikse 2003). By tying part of managerial wealth to shareholder wealth, the incentive system can be utilized to create alignment between management and shareholders (Lan et al. 2010, Aulakh et al. 2000, Stroh et al. 1996). 6 Empirically speaking the possibility to accurately measure agency costs is near impossible, but the conceptual presence of these costs is what leads to the prescribed measures (Daily et al. 2003). Thomas Rudiger Smith 18 M. Sc. FSM Master Thesis: Agency Theory Its Consequences In this way, the wage becomes a bribe and a condition from the principal to the agent in order to induce certain behavior aligned with the principal‘s interest (Prendergast 1999). However, a noted problem with performance based pay is that „dysfunctional behavioral responses where agents emphasize only those aspects of performance that are rewarded? is present (Prendergast 1999, p. 8). As such, just as the principal may learn which incentives work the best, the agent learns which aspects of performance the principal is interested in and primarily seeks to optimize these exact aspects (Shapiro 2005, Brickley et al. 1994). The consequence becomes a system where everything is driven towards meeting measurable targets and not necessarily towards creating real value and growth (Porter 1992). A summation of the modern corporation in the eyes of AT, the effects and the prescriptions can be made as follows; ? The Modern Corporation = The Separation of Ownership Control and a Nexus of Contracts, where shareholders are the owners. ? The Effect of Separation of Ownership and Control = Conflict of Interest, Moral Hazard Agency Costs. ? The Prescriptions of Control = Monitoring Incentives. Upon understanding AT, its assumptions and focus on shareholder primacy, it is relevant to also critically question these. Particularly, how do the AT prescriptions impact the risk-taking in banking? 7. 2 The Consequence of Risk Taking Aligning managerial interests with that of shareholders may seemingly make sense. However the usage of outcome based incentives packages and a shareholder aligned board as prescribed by AT may lead to increased risk levels (John et al. 2000). In order to comprehend why, one has to understand the consequence of the diverging risk interests between shareholders and debtholders. Here option theory can provide a relevant reasoning. Figure 3 Structure 7. 2. 1 Equity as a call option According to option theory, equity can be viewed as a call option on the firm‘s assets (Brealey et al. Thomas Rudiger Smith 19 M. Sc. FSM Master Thesis: Ag