Incentives, cooperation and the nature of the firm (2)
The firm can reduce many of the transaction costs associated with contracting by using team production. Team production, however, comes with another set of problems. Team members – the employees working for the firm. – must be monitored and given incentives to avoid shirking, or working at less than the expected rate of productivity. Taking long work breaks, paying more attention to their own convenience than to work results, and wasting time when diligence is called for are examples of shirking. A worker will shirk more when the costs of doing so are shifted to other team members, including the owners of the firm. Hired managers, even including those at the top, must be monitored and given incentives to avoid shirking.
Imperfect monitoring and imperfect incentives are a problem with team production. It is part of a larger class of what economists call principal-agent problems. A person taking a car to an auto mechanic confronts this problem. The mechanic wants to get the job done quickly and make as much money on it as possible. The car owner wants to get the job done quickly also, but wants the problem fixed in a lasting way, at the lowest possible cost. Because the mechanic typically knows far more about the job than the customer, it is hard for the customer to monitor the mechanic’s work. There is a possibility, therefore, that the mechanic may charge a large amount for a “quick fix” that will not last.
The owner of a firm is in a similar situation. It is often difficult to monitor the performance of individual employees and motivate them in a way that will encourage high productivity. Nonetheless, the ability of the firm to use resources effectively and succeed in a competitive market depends crucially upon resolving these problems. To keep costs low and the value of output high, a firm must discover and use an incentive structure that motivates managers and workers, and discourage5 shirking. The problem extends all the way to the top.
Even top-level executives hired to manage a firm do not have the same objectives as owners – who care mainly about profit maximization – unless, of course, the managers are the owners. So the judgments of executives, too, are influenced by what is in their personal best interests. They want perks, personal job security, and other benefits that may not be consistent with profit maximization for the firm. The problem becomes more serious as firms grow larger and acquire more managers and employees. Ultimately, it is the job of the owners, as residual claimants, to develop an incentive structure to minimize the principal-agent problem. For the owner, the saying “the buck stops here” always applies.
Capital Management
Banks and capital markets both act as conduits for savings to be channeled to the most productive sectors of an economy. Here, productive means those sectors in which businesses can generate the highest economic returns. Bank management plays a similar role internally. Capital is a scarce commodity and management need to ensure that it is utilized effectively. External conditions are in a constant state of change and management must continually monitor the risk-adjusted returns from, and prospects for, specific businesses.
Bank management are responsible for the allocation of capital to those businesses with the highest returns and for taking capital out of businesses generating inferior returns, by restructuring such businesses to generate acceptable returns or through disposals.
The adoption of BIS standards as defined in the Basel Accord to specify minimum bank capital-adequacy levels has had a marked impact on bank approaches to capital management. Developments in finance theory have also helped managers understand the functions of capital and issues involved in its allocation better. Advances in technology have made it possible to apply at least some of these theoretical developments in a practical world. Despite this progress no-one who has studied this subject would deny that significant flaws, both theoretical and practical, remain.
Shareholder value advocacy, embodied in Anglo-Saxon capitalism, has gained considerable support in countries such as Germany, France and Italy where it has not been given the highest priority in the past. As a result capital management has gained a much higher profile in recent years. Recent is a relative term but in this context means approximately 25 years.
Capital management is complex not least because it has to find ways to accommodate the above flaws and come up with practical, effective ways to determine capital allocation. The old adage that a fool can ask more questions than a wise man can answer springs to mind. It is easy for capital managers to get bogged down in the morass of the underlying theoretical and implementation issues. The key questions for them to answer today, however, boil down to how much capital their bank needs, how it should be allocated between different businesses and what constitutes an acceptable return on this capital.