To restore trust and integrity, firms must ignore agency theory and align their own interests with their customers.
Agency theory leads to poor conduct
Agency theory, originally put forward by Milton Friedman, denounces corporate social responsibility, and argues “the manager is the agent of the individuals who own the company”. It has become increasingly prevalent since the mid-1970s and is the main driver of firms’ short-term focus and aggressive behaviour. It states that shareholders are the owners of firms and that Boards and management are their agents. Given this, it argues that their duty is to act solely in shareholders’ interests and to maximise their financial return.
Recently, however, there has been growing criticism of agency theory. In March, Andrew Bailey, the CEO of the Financial Conduct Authority (FCA), identified it as a major cause of the senior management remuneration problems that contributed to the financial crisis. While the recent article, ‘Managing for the Long Term’, featured in the Harvard Business Review questioned both its legal basis and its value.
Agency theory, by its nature, damages trust and integrity, certainly when applied to financial services firms. There are five key aspects to this:
- To the exclusion of others: By prioritising shareholders alone, it dismisses the interests of other stakeholder groups, not least customers. For example, the FCA insists that firms must put customers ‘at the heart of their business’, but agency theory forbids this.
- Mandating a tick box approach: According to agency theory, the only caveat to Boards and management pursuing shareholders’ interests is that they should not break the law. This means firms may abide only by the letter of the law, not its spirit, following a strict tick box approach rather than any broader principles of good conduct.
- ‘See you in court’: The logic of this approach leads to a high appetite for litigation in defence of shareholders’ interests. This drives regulators towards adopting an enforcement-focused strategy.
- Reward trumps risk: The trade-off between risk and reward is a fundamental reality of financial services, with the search for higher yields involving greater risk. However, agency theory encourages firms to pursue the highest reward (for shareholders), irrespective of the consequent risk being carried by customers or the firm.
- ‘Jam today’: Finally, agency theory prioritises short-term profits, which reflects the increasingly short periods of time shareholders hold their investments. This emphasis is further encouraged by quarterly reporting requirements.
All these aspects of agency theory tend to push financial services firms towards poor conduct in relation to their customers and an antagonistic relationship with regulators.
There are strong arguments that agency theory may well have played a significant role in banks’ mis-selling of Payment Protection Insurance (PPI) and the time it took to secure redress. In different ways, it might also help explain many other episodes of misconduct over the last two decades.
Longer horizons, broader interests
On many levels, the way forward is easy to map. It involves a greater emphasis on customer understanding, engagement and retention by placing greater weight on their interests throughout the life of any given financial product or service.
However, this approach would mean ignoring agency theory or, as a minimum, a major extension of the horizon over which shareholder interests are measured. This would be a huge shift away from current practice but it is a necessary step to re-establish trust and integrity in financial services.
For more information, please contact Gavin Stewart.