The Principal–Agent Problem in Finance

Abstract

The relationship between a principal and the agent who acts on the principal's behalf contains the potential for conflicts of interest.The principal-agent problem arises when this relationship involves both misaligned incentives and information asymmetry.In asset management, factors contributing to the principal-agent problem include managers' compensation structures and investors' tendency to focus on short-term performance.In the banking industry, myriad principal-agent relationships and complex instruments provide a fertile breeding ground for incentive conflicts, many of which were highlighted by the recent financial crisis. ©2014 The CFA Institute Research FoundationThis literature review addresses these concerns to provide a better understanding of principal-agent relationships, and the associated potential problems, in finance. Evolution of the Principal-Agent Problem.Initially, most economists concerned themselves principally with the mechanics of markets; guided by Adam Smith's "invisible hand," these markets generally function without a hitch (Laffont and Martimort 2002).As economics matured as a science, this analysis grew ever more granular over time.As Ronald Coase notes in his seminal paper "The Nature of the Firm" (1937), in the 1930s, the new trend among economists was toward beginning their analysis at the firm level rather than at the industry level.His work was a catalyst for much of the progress in this transition.Coase explores the question of why firms exist in the first place, as opposed to having every individual in an economy simply contract separately with every other.He concludes that it is rational for firms to exist when the costs of executing transactions on the open market exceed those of organizing the same transactions in a group setting (Coase 1937).Coase addresses individual worker incentives, monitoring, and the use of "authority" within an organization.The work of Coase and his contemporaries, however, maintained a high-level view of the firm and did not delve deeply into the incentives of individual workers or the conflicts those incentives might create.As economic thought continued to progress, analysis shifted from firmlevel behavior to intra-firm mechanics.Initially, models assumed that the individual members of a firm had identical utility functions, so all members of a given team had no motivation other than to work in tandem.It was not until the late 1950s and early 1960s that attention began to focus on the diversity of incentives across members of a given team, the inability to fully monitor all employees' behavior, and the problems that this combination causes for delegation (Laffont and Martimort 2002).The study of these conditions initiated the subdiscipline of economics known as "optimal contract theory," which examines the conflict that can occur as a result of the delegation of tasks to an agent in the presence of incomplete information.Contract theory addresses two distinct sets of questions: those that arise before a contract is struck, including optimal methods of behavior, such as signaling and screening; and those that arise post-agreement, including actions caused by misaligned incentives, such as shirking behavior.Meanwhile, in the 1960s and 1970s, another set of economists, including Kenneth Arrow and Robert Wilson, explored risk sharing among groups of people with different attitudes toward risk (Eisenhardt 1989).Wilson (1968), for example, examines what happens when a syndicated group of individuals needs to make a joint decision with an uncertain outcome, such as the debt/ equity split for investing a joint $1 of capital in an uncertain venture.Spence

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