In the last blog we looked at the monitoring mechanisms that are used to reduce the agency costs. In today's blog we look at Bonding and Incentives as a mechanism to reduce the agency costs.
To understand this mechanism of reducing agency costs - it is important to realize that it’s not just the principal who has gains by reducing the agency costs, the agent too would benefit from this. Incentives are the most common of the bonding mechanisms that agents use to bond closer to the principal. Generally, the agent aligns the incentives such that their self-interest is aligned so that they behave consistent with the interest of the principals.
The most common of these is the agent's compensation package. The Principals would prefer an incentive that fully penalizes agents for shirking and opportunism; however in many cases it is the environmental risks that really define the outcome. Thus the agents wouldn’t be comfortable with this structure. The fixed salary format in fact would free the agent from any of the alignment possible with the principal and might not find the buying in easy from the principals.
Research has found that, managers with significant ownership interest in their firms are less likely to engage in behaving in ways that are not in synch with the principal's interest. Last but not the least it is important to look at incentive structure not just limited to payments as incentive - promotions too are an important factor.