Wednesday, October 16, 2013

Eugene Fama explained. Kind of. Part 1: Corporate governance

Nobel Fever has broken out here at Not Quite Noahpinion, so let’s continue with some overlooked corners of the laureates’ œuvres. According to Google Scholar, Fama and Jensen (1983) is Fama’s third most cited paper, yet it isn’t mentioned at all in the scientific summary put out by the Economic Sciences Prize Committee of the Royal Swedish Academy of Sciences, which, if I remember correctly, sometimes does mention work that is not directly related to what the prize is being awarded for. In this case it is particularly tragic because Fama’s corporate governance papers are very good, and considered by some* to be much better than his asset pricing work. (A phrase which rhymes with “feta pining” is sometimes whispered in connection with the latter.)

I am talking about a pair of papers published back to back in the same issue of the Journal of Law and Economics in 1983; this is the other one. They are joint work with Michael Jensen, who is well known for his later corporate governance work and who is also the Jensen of “Jensen’s alpha” (these guys were generalists, of sorts). Go read them right now. They are very good, there is no math, I have linked to ungated versions, and their explanation is probably clearer than mine.

Both problems are about the separation of ownership and control, a feature seen in most organizations, both for-profit and non-profit. The academic study of organizations dates back to at least 1889, or even 1776, but who still reads Adam Smith?

If the owner of an enterprise exercises full control over its operations, as is the case in a sole proprietorship with few or no employees, there is no agency problem: the manager–owner can be trusted to make whatever decisions will maximize his profit (or whatever he is maximizing, when it is not a for-profit firm), and will even make appropriate tradeoffs between the short term and the long term.

In the real world, that’s not practical. Despite what Adam Smith might have preferred, modern firms (both for-profit and non-profit)—or even the commercial partnerships in the Middle Ages that Weber studied—are too large to be owned by one person or even a family and too complicated to be managed by a large group of stakeholders. If contracts could be perfectly specified and made contingent on every eventuality, there wouldn’t be a problem: the management contract would specify what the manager has to do no matter what happens, and the contract would be written to maximize profits. Of course this is even more unrealistic than thousands or millions of shareholders collectively making all the decisions of a firm.

Fama and Jensen’s analysis starts with the role of residual claims. Some claimants on a firm are promised fixed amounts that they will receive when the cash flows are paid out. For example, a bank or a group of bondholders that makes a loan to a business will only receive the amount that was actually borrowed, plus interest. The firm might go bankrupt, but hopefully in all probability the bank will simply be paid what it was promised. This means that by and large, they won’t care too much about the firm’s management decisions. Only the residual claimants, who in a typical corporation are the shareholders, need to fret about the firm’s management from day to day. In turn, they will bear most of the risk associated with the firm’s operations, and also receive the rewards if the firm is better managed than expected.

At a granular level, the agency problem is about making decisions. Fama and Jensen split up the decision process into decision management, which involves initiating decisions (coming up with the idea) and implementing decisions (actually doing the work), and decision control, which involves ratifying or approving decisions and monitoring that they are carried out faithfully. We now end up with three roles: residual claimant, decision management and decision control.

Some undertakings are “noncomplex”: the necessary information can be concentrated in a few people. Examples include small firms, as well as large firms with relatively simple decisions such as mutual funds and other mutual financial firms. In noncomplex organizations it can be optimal to combine decision management and decision control to economize on decision costs, but then you would have the foxes watching the henhouse. Who looks after the interests of residual claimants? The answer is that when decision management and decision control are combined, you would often restrict residual claims to a small group of people who either are managers or trust them, for example family members and close business associates. Partnerships and small corporations with stock transfer restrictions examples of what Fama and Jensen call “closed corporations”. The tradeoff is that you reduce the possibility of risk sharing and some efficiency is lost that way.

In more complex organizations, decision management would be separated from decision control. The information necessary to make decisions may be diffused among a lot of people, who would each be responsible for initiating and implementing decisions in their little area, but a few people—the managers, who would also be the residual claimants or close family members or business associates—could handle decision control, ratifying and monitoring the decision managers.

In large corporations with a lot of assets, you need more residual claimants to share risk, which in turn makes it impractical for all the residual claimants to participate in monitoring, and the agency problems associated with combining decision management and decision control are worsened. For such organizations, Fama and Jensen hypothesize, decision management and decision control will tend to be separated. In the largest corporations, this separation is complete, and residual claimants have almost zero participation in decision control.

Fama and Jensen also survey a variety of organizational forms that have different tradeoffs between the three roles and ways in which separation is achieved, for example with expert boards and through the market for takeovers. In financial mutuals, a large body of customers are also owners, and decision control is delegated to a professional board of directors, but an additional control function exists in the ability of each residual claimant to quickly and easily terminate his or her claims by redeeming the claim.

In nonprofit organizations, there are no residual claimants as such, which Fama and Jensen justify as a means of reducing the conflict between donors and residual claimants. Who would want to give a donation what will ultimately end up in the pockets of residual claimants? The solution: eliminate the latter. In US nonprofits, decision control is typically exercised by a board of directors that consists of large donors.

In the Roman Catholic Church, control is not exercised by donors (parishioners), but by the church hierarchy itself, and ultimately the Pope, with almost no separation between decision management and decision control. The solution is vows of chastity and obedience that bind the hierarchy to the organization, in exchange for lifetime employment. Fama and Jensen go on to claim that Protestantism is a response to the breakdown of this contract, and that “the evolution of Protestantism is therefore an example of competition of among alternative contract structures to resolve an activity’s major agency problem—in this case monitoring important agents to limit expropriation of donations.”

* weasel words, I know. Sorry.


  1. Interesting paper about how agency theory was misapplied:

  2. Speaking of Jensen and Nobel prizes, this might interest you.

  3. In 1924 Veblen, in Absentee Ownership, dealt with this issue (and others) in his own idiosyncratic manner. The book is still worth reading.

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  5. Anonymous2:49 PM

    Uh... Hate to ask, but what rhymes with feta pining?

    1. Anonymous9:24 PM

      data mining

      As Fischer Black said about Fama-French factors, there is no theory it is just...