Agency Theory & Small Businesses

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Word count: 2251
Background:
Agency theory (Jensen & Meckling 1976) has provided useful insight into the financial dealings between an enterprise (principal) and its stakeholders (agents). It is unlikely that the economic interests of these parties will be exactly the same because it is human nature to maximise one’s own benefit even at the expense of others. (Peacock, p278)
Question:
Explain how agency theory may be applied in explaining the relationship between small business and a financial institution. Include, as part of the discussion, an explanation of the costs and benefits of the relationship that may be attributable to the existence of an agency relationship. (2500 words).

Around 96% of businesses in Australia are small …show more content…

But as the small business is an extension of the people owning the business, the business is free to act in their own best interest, which may not necessarily match the principal’s best interests. (Peacock, 2004).

Due to these risks, interest on loans and bank fees are often much higher for small businesses than for medium to large businesses (OECD). Financial institutions prefer to lend money to small business on a short-term basis. This is due to the fact that the longer the loan, the greater the risk for the bank, as over time businesses change and develop, and the opportunity for the borrower to take more risks increases. To protect themselves, banks have standardized lending contracts that limit the scope and direction of the small businesses (Peacock, 2004).

Building a good relationship with the financial institution is vital, as they are able to help small business owner-managers in times of hardship (NWI times). To ensure a good and close relationship between the financial institution and a successful small business operation, the availability of information from the owner-manager is crucial. It is necessary that the financial institution is provided with accurate and timely financial information, such as financial statement (Sidorenko, 1998). Mitchell & Rajan (1994) suggest that if information given to the financial institution were more accurate and economies of scale exist in the production of information that is not easily

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