Agency theory and corporate governance

Abstract

PurposeThe effect of corporate governance on firm performance has long been of great interest to financiers, economists, behavioural scientists, legal practitioners and business operators. Yet there is no consensus over what constitutes an effective corporate governance mechanism that induces agents or managers to consistently act in the interest of share value optimisation. The purpose of this study is to develop a model to resolve an on‐going issue in financial economics: how can CEOs be effectively monitored by the board of directors?Design/methodology/approachA survey of the literature on corporate governance and the relationship between board composition and financial performance leads to the development of the proposed model, which is based on a framework which takes into account the probability of success representing a CEO's ability, and the active monitoring function (which is represented by the numbers of control visits) carried‐out by the directors.FindingsThe design of the model is aimed at identifying an optimal level of monitoring, which will maximise share value, to guide internal and independent directors.Research limitations/implicationsThe model has limitations: it does not address the input of other directors and it focuses solely on the monitoring function, even though boards also play important roles in providing information and advice to management.Originality/valueThe finding of this study contributes to the Agency Theory debate, in essence that the board monitoring of CEO will improve the performance of the CEO and avoid possible conflict of interests.