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The Principal–Agent Problem in Finance

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Despite its prominence in economics today, the study of incentives is relatively new. Included in this field is the study of the principal–agent relationship. The principal is one who, within predefined terms, assigns a task to an agent, who performs the task on the principal’s behalf. If the agent’s incentives are not aligned with those of the principal and the principal cannot monitor the agent’s actions, the agent has both the motivation and the ability to act undetected against the principal’s interests. This scenario is referred to as the “principal–agent problem.”

Early in the history of economics, researchers focused primarily on the behavior of market participants on an aggregate level. Ronald Coase is widely credited with taking the analysis one level deeper in the 1930s with his examination of the firm. In the 1950s and 1960s, economists began to examine how differences in incentives among members of a given team cause the various members to act differently from each other, sparking the subdiscipline of economics known as “optimal contract theory.”

At the same time, another set of economists, including Robert Wilson and Kenneth Arrow, were exploring the nature of risk sharing among groups of people with different preferences for risk. Such studies brought to light a set of difficulties that can occur when parties to a contract involving risk transfer alter their actions after the contract is agreed upon. This area of work came to be known as “agency theory.”

These two lines of study share a common thread: Each party to a contract must recognize that the other parties may change their behavior after the contract has been struck. The key question is how to structure the contract to minimize potential problems. These two fields eventually merged, and from this union, the principal–agent model and the study of the principal–agent problem were born.

For the principal–agent relationship to be problematic, two ingredients are needed: conflicting incentives and private information. Without the former, the principal may simply leave the agent to his or her own devices; without the latter, the principal need only structure the contract to cover each realization of private information ex post.

It is not surprising that the financial services industry finds itself rife with potential principal–agent problems. The interconnectedness of the industry has created a myriad of agency relationships in which monitoring is difficult, and many of these relationships involve risk transfer or risk sharing within groups. Consequently, ethical standards within the field must be high, lest the power of participants’ own incentives drive them to act counter to their fiduciary duty to their clients.

Unfortunately, strong ethical standards have not been upheld. As several studies have shown, many participants in the finance industry who have witnessed wrongdoing do not report it and, worse yet, many would engage in illegal activity to get ahead if they were sure they would not be caught. These patterns exist even though other studies have shown that trust is the attribute that is most important to investors when hiring investment managers—even more important than an ability to achieve high returns.

Examining the literature that discusses such problems in two important areas of finance, asset management and the banking industry, is an important step in promoting the introspection needed to reevaluate the industry’s practices.

About the Author(s)

Sunit N. Shah