Analysis Impact of Principal Agency Relationship Finance Essay

INTRODUCTION

Principal-Agent Relationships for Investment Purposes

Principal-Agent relationships occur in many forms in business. Understanding these relationships is crucial for investors in order to make better investment decision.

Theory of Principal-Agent Relationships

The relationships between and among multiple stakeholders is complicated and provides many opportunities for one party to gain at the expense of another party. The Theory of Principal-Agent Relationships recognizes that there can be friction between relationships when one person acts for someone else.

Principal-Agency Relationships Defined

Agency Theory refers to analyses associate with the Principal-Agent Relationship which occurs whenever one person acts in the interests of another. Many situations create a principal-agent relationship between two people. Explicit relationships include those situations where one person acts in the interests of another through contractual agreements. For example, when owners of a corporation hire a manager to run the company using his/her expertise and experience, a formal contract is created where the managers act in the interests of the owners in exchange for compensation such as a salary, stocks, and even perquisites. Some principal-agent relationships do not operate formally but exist as though there is agency. For example, employees and managers in a corporation do not have a formal agency relationship. This is because the managers do not themselves compensate the employees for working on behalf of the managers. However, at some point in their relationship, the managers must rely on the employees without monitoring them all the time. This relationship can still be defined and governed by theories of agency (www.brighthub.com) BACKGROUND AND ANALYSIS

Principal-Agent Relationships and the Conflicts That Can Arise Within Them

Principal-Agent Relationships exist whenever one person or party works in the interests of another party. Some of these relationships arise through obligatory contractual relationships and some can be informal or even hidden relationships that only reveal themselves at a point in the future. The set of contracts model of Modern Corporation demonstrates that many stakeholders are affected, both formally and informally, by the corporate body. One of the moral problems managers of a firm face is which stakeholders to satisfy to keep the corporation profitable while at the same time remaining cognizant of the ethical dilemmas of maximizing shareholder wealth to the detriment of other stakeholders. Is the primary purpose of the principal-agent relationship to take into account only the owners' interests? What would the owners think of reducing shareholder wealth to satisfy moral obligations to other stakeholders? The principle of self-interested behavior states that the managers of a firm will act in their own self-interest (www.brighthub.com). What happens when acting in their own self-interest creates moral problems to both stockholders and stakeholders?

An Example of Principal-Agent Conflict

Suppose a company enjoyed a particularly profitable quarter with record sales and retention of a large amount of cash from normal operations. This windfall is the direct result of the employees, the owners' agents, who worked hard to maximize corporate and, consequently, shareholder wealth. The managers of the firm must decide what is the best use for the extra cash lying around as a liquid asset? The managers have decided that the money should be used for one of two purposes: employee wage increases to reward the hard work that created the extra income or a payment of a large dividend to the shareholders as a reward for investing the capital necessary to make the extra income. The principle of self interested behavior would suggest that the stockholders would want the dividend option since it means more wealth for them. Employees, however, would prefer the wage increases for the same reason. The self-interest principle would also suggest that the managers making the decision would want the wage increases because it would mean more money in their pockets. This example illustrates the conflicts that can arise in principal-agent relationships. In fact, imagine that as and incentive to make the firm as profitable as possible, part of the managers' compensation package includes shares of stock in the firm. The complexity of agency theory becomes clearer still because the managers will benefit from either a wage increase or a dividend distribution. The shrewd manager will do a little calculating to determine which alternative or combination of the two alternatives will maximize his/her self-interest (www.brighthub.com).

Characteristics

One of the most important characteristics of Islamic financing is that it is an asset-backed financing. As compare to conventional financing, the banks and financial institutions normally deal in money and monetary papers. In Islam, however, money should not be used as a subject matter of trade to generate profit (except in some special cases); rather it is only a medium of exchange. Thus, profit is generated when something is sold for money or when different currencies are exchanged, one for another. The profit earned through dealing in money (of the same currency) or the papers representing money is considered as interest (riba) and therefore prohibited. Consequently, unlike conventional financial institution, financing in Islam is always based on illiquid assets which create real assets and inventories. Looking into this perspective, of course, the most suitable and ideal instruments of financing in Shariah are musharakah and mudarabah. Under these two instruments, the money contributed by the financier is converted into the assets having intrinsic utility. Thus, profits are generated through the sale or trading of these real assets. Similarly, financing on the basis of salam and istisna' also creates real assets. The financier in the case of Salam receives real goods and makes profit by selling them in the market. In the same way istisna' financing also created real assets through manufacturing process, in which the financier earns profits. Financial leases (ijarah), murabahah and bay' bithaman ajil, however, are not originally modes of financing in the Shariah (www.hijrahmedia.com). But, in order to meet some needs, these instruments have been restructure in a manner that they can be used as Islamic financing methods, in the sectors where musharakah, mudarabah, salam or istisna' are not workable due to some reasons or another.

Several western scholars have argued about remarkable shift in Islamic banking practices from the theory

This argument came actually from Islamic economists. The problem is that they and their Western imitators put the carriage before the horse. They theorized a model that turned out to be unrealistic and inconsistent with financial intermediation. The Model they theorized is the two-tier Mudarabah but the practice used Murabahah and leasing on the use of funds side of the banking transactions. Both modes are more consistent with financial intermediation while Mudarabah is more of a venture capital approach rather than financial intermediation process. Obviously Mudarabah succeeded on the funds mobilization side, in investment deposits because banks are regulated financial institutions, businesses are different. This means that the theory was wrong. Yet many Islamic economists stick to it in a dogmatic manner because they accuse Murabahah to be less Islamic. This struggle is apparent in the five-year discussion of the newly adopted law of an Islamic banking in Kuwait. The law finally went along with permitting the Islamic bank to enter directly in business venture on its own initiative. In spite of the restrictions and the discretionary authority the central bank may exercise, this approach loosen specialization and allow the Islamic bank to compete with business and to have its own stores for goods and services instead of remaining a financial intermediary only (www.financeinislam.com).

FINDINGS

Mudarabah is essentially an agreement between a financier and an entrepreneur the principals. However, taking account of the modern social structure and context, the pioneers of Islamic banking brought in an intermediary between the principals and created a two-tier mudaraba. This modified form of mudaraba was introduced into conventional commercial banking in the form of profit-and-loss-sharing (PLS) investment accounts and financing arrangements. The earned profit (which is an uncertain and unpredictable return on capital) was to replace the interest (a pre-determined fixed return) in the conventional setting. This, however, was not acceptable to the conventional banking authorities (www.islamicbanking.nl). Therefore, except in a few countries where rules were relaxed or special banking laws were enacted, it was not possible to establish and operate Islamic banks in most countries of the world. In such countries Islamic financial institutions, which did not come under deposit bank regulations, were introduced. In both cases, while the deposit/investment side worked on mudaraba basis, mudaraba was only one of several modes used for financing. Though a preferred one in theory, in practice it became one of the least used. The most used forms are modes of trade, and this has led to questions of morality and ethics. In addition, Islamic banks are unable to provide all the financing services expected of a commercial bank (A¾A¾, Commercial Banking in the presence of Inflation: 1999). "In Islam, there is a clear difference between lending and investing A¾ lending can be done only on the basis of zero interest and capital guarantee, and investing only on the basis of mudaraba. Conventional banking does not A¾ and need not A¾ make this differentiation." But a system catering to Muslims "has to take this into consideration" and "provide for two sub-systems A¾ one to cater to those who would 'lend' and another for those who wish to invest." The first sub-system would cater to those who wish to put their money into a bank for safety and transaction convenience; and the bank would provide all current account facilities and short-term loans and advances (Saleh, Nabil A., 1986).

ISSUES, CHALLENGES AND PROBLEMS

Issues in implementation

The implementation of this system requires the cultivation of new attitudes on the part of all the participants. This is a tall order but is an absolute necessity if we are to create a truly riba-free economy. It requires more from each participant, but it also offers more both to the individual and to the society as a whole. From the investor it requires the full understanding that he/she/it may incur loss and that he will have to wait longer to know the results, but it promises a truly riba-free income and possibly better profits. From the entrepreneur it requires complete and accurate bookkeeping and full disclosure of all his/her/its accounts and the sharing of his bounty with his financiers, but it provides him with capital without collateral and the guarantee that in case there is a loss he will not be required to make it up, provided he had been honest in his dealings and his books will substantiate it. The intermediary is both a banker and an entrepreneur. As an entrepreneur, he too is required to be honest in his dealings, and accurate and transparent as to his bookkeeping and accounts (www.islamicbanking.nl). Bankers are trained to be very cautious, because their first concern is to guarantee the safety of the funds deposited with them. But in this system they are relieved of that concern because the investors have agreed to take the risk, and therefore if they persist with the banker's attitude they will miss many opportunities at the investors' expense. On the other hand, too much adventurism can bring about low profits or even loss, and that may lead to the loss of customers. They must have an entrepreneur's natural talent to spot profitable projects and to avoid bad ones, and should develop it into a professional tool. The intermediary's staff will have to be carefully picked and trained to bring out inherent entrepreneurial talent. Such intermediaries will have ample reward, as they will share in the profits. It requires a new culture, a culture of entrepreneur-financiers and of professionally run partnership companies. The system is heavily dependent on proper and accurate bookkeeping, accounting and auditing. That requires the availability of trained bookkeepers and their wide use, as well as professionally responsible and well-trained accountants and auditors. They are the bedrock of the system. The system requires a high level of integrity from these personnel, and it is in the interest of all the participants in the system to respect it. Substantial investment is necessary in the training of such personnel, and legal protection is necessary to safeguard the independence of the auditors. The comprehensive system presented in the four books groups the entire spectrum of business activities into three broad categories: at one end is the one-man-owned-and-operated small enterprises, including the ones financed or supported by loans and advances from commercial banks, and at the other end are the large enterprises financed entirely by shareholders and managed by professionals. In between are the proposed participatory-financed enterprises. The size of the enterprise is an important factor in this categorisation, and the type of financing and the type of organisation must generally match the size. Presently in all developing countries A¾ to which group most of the Muslim economies belong A¾ the distribution is highly skewed towards the smaller end. To achieve a better and stable economy, it is necessary to bring about a more even distribution (www.islamicbanking.nl). The mudaraba principle is applicable to a range of situations, from a simple local two-person partnership to a multiparty international corporation. A shareholder company works essentially on the mudaraba principle. But the participatory financing scheme envisaged in this article aims at the middle section of this range. It brings in the intermediary, and provides the investors with a unit trust type of investment opportunity. The scheme is ideally suited to medium scale new enterprises. However, it is possible to modify it slightly and bring in some of the running businesses too into the participatory financing system. The enterprise is a running business and has debts owing to, say, a commercial bank. In this case, the investment bank/company will pay up all the debts and go into partnership with the enterprise, as in the first case, with this amount as its capital contribution (Yasseri, Ali, 2000). In establishing the new institution of mudaraba-based investment and finance, using the participatory financing scheme as described above, it is preferable to start with medium size running businesses. This will provide a stable base for the new institution to test the theory and to gain experience.

CONCLUSION

Principal-Agent Relationships range from the simple to the complex. In corporations, the set of contracts view of the firm illustrates the complexity of multiple agency relationships across many stakeholders. When an investor values a firm, the evaluation always takes into account the risk associated with the separation of ownership and control. Investors must ask: what assurances are in place to make certain agents in the firm are working for the best interest of the owned. In order to bring about a riba-free economy, the country's banking system has to be riba-free, its commercial enterprises have to be financed by equity capital, and its investments have to be on a profit and loss sharing basis. This article has dealt with investment and financing, and has introduced a mudaraba-based system called participatory financing that takes into account present-day realities. This is a new institution specifically developed to address the concerns of Muslims. It has no parallel in the conventional economy, but the individual tools and techniques it uses are ones tested and proved in the conventional setting. Thus, while re-invention of the wheel has been avoided, proving the viability of the new institution and benefiting from it are challenges specific to Muslims. It is for the Muslim intellectuals, professionals, investors, entrepreneurs, and other concerned individuals, institutions and organisations to take up the challenge. Conflicts arise in Principal-Agent relationships when alternatives faced by the agent can affect his/her own personal interests. Some principals go to great lengths to monitor and limit the power of agents to ensure that the principal's interests are properly adhered to. However, it is nearly impossible to monitor and limit the agent to a point where no conflicts are possible. In addition, these steps taken by the principal may limit the agent so much that he/she can not ensure that the interests of the principal are acted upon in a manner where positive outcomes are maximized.

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