Demonstrate three things that can be learned about a firm that you are interested in through the application

of agency theory.

Eshara Dias

How can a firm ensure its employees are working for the best interest of its owners? In the course of this essay, I will be using my placement firm Morgan Stanley to look into the Principal Agent Model. The three research questions raised are: 1) The problem of incomplete contracts 2) Why does self interested behaviour occur even though incentives are offered?

3) How hidden action and information can result in a decision taken which is not in the best interest of the principal Solutions to these agency problems will be arrived at in the conclusion To explore the first question, the Principal is the firm; i.e. Morgan Stanley while the Agent is its employees. What can or cannot be contracted? It is unrealistic to draw up complete contracts since documenting all the actions that a firm wants to encourage and discourage its employees to undertake are difficult. In order to ensure that the employees only engage in value adding activities to the firms strategy, it is essential to provide sufficient incentives to align both principals and agents interests. These incentives are provided based on various performance measures. In Morgan Stanley, the salary and pension are explicitly stated in the contract. However, bonus pay, promotion prospects and threat of firing are implicit. Implicit contracts occur from interpretations of patterns of past exchanges, vicarious learning as well as through various factors that each party may take for granted (Robinson and Rousseau 1994: 246). These incentives attempt to align interest of the employees with that of Morgan Stanley in order to prevent Moral Hazard1. To avoid Moral Hazards such as frauds and rogue trading which can be committed by senior management and traders (i.e. agents), Morgan Stanley offers stock options (to tie performance to shareholder wealth) and high bonuses. They are also given high salaries which are Efficiency Wages to make their jobs more valuable and thus prevent them from undertaking actions which are harmful to Morgan Stanley. However, while I was at Morgan Stanley I witnessed a Moral Hazard. At the year end, the Managing Director (MD) of each department is allocated a pool of
1

Moral hazard is the condition under which the agent acts in a manner which is not in the best interest of the principal due to misalignment of interests

money to distribute as he/she likes among the department staff as bonuses. This is the firms bonus distribution policy which is part of the implicit contract.

Although bottom level employees can be entitled to receive a bonus if their performance has been above standard, I observed that reality is different. In many teams, since the MD does not know the employees below the managers, they do not receive bonuses although some of them have been working hard. This information does not pass up the chain of command, therefore usually Vice Presidents (VP) and managers end up receiving bonuses. As a consequence, the bottom level employees tend to change the teams that they are in more frequently hoping that in another team they would get noticed by its MD. This leads to a lag in the teams performance when the new employee is still training to replace the switched employee, and leads to a team members not being specialised with many years of experience in one department of the company. Although the principal (Morgan Stanley) has put in place bonuses to motivate better performance, the distribution method is not only biased, but is also de-motivating the bottom level employees and incurring higher training costs. I suggest that to avoid this moral hazard the MD should not get the entire lump sum to distribute. Instead, the MD could receive 75% of it to distribute among the VPs and managers, while all the managers in the team are allocated the residual 25% to distribute as they like among their subordinates. Alternatively, there can be meetings with the MD and the employees every quarterly to give reports on their activities. However, since this is time consuming, I feel that the first option is the best method to prevent employees switching teams.