The Principal–Agent Problem in Finance via CFA 

 

Sunit N. Shah

 

Strategist

 

Pine River Capital Management

 

The relationship between a principal and the agent who acts on the princi-pal’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.

Introduction

 

Within economics, the study of incentives is a relatively new one. In fact,

 

Joseph Schumpeter’s (1954) thousand-plus-page authoritative survey, History of Economic Analysis, contains not a single mention of the word “incentive”(Laffont and Martimort 2002). The study of principal–agent relationships, an even newer phenomenon, resides within this framework. The principal is one who delegates a task to the agent, who performs the task on the principal’s behalf. Everyday examples of this relationship include a homeowner using a real estate agent to sell a house and a business owner hiring a manager to run a store. Within this construct, whenever the two entities’ interests are misaligned and monitoring is difficult, the agent could act in a way that does not reflect the principal’s best interests. Such is the basis of the principal–agent problem.

Any system that includes such relationships is vulnerable to potential principal–agent problems; the financial system is no exception. Individuals in a variety of roles within this system, including investment managers, bro-ker/dealers, rating agencies, and even the government, serve as agents in one form or another. Within asset management, compensation structures in large part drive managers’ interests, and if these contracts are not structured cor-rectly, managers may have an incentive to act counter to the fiduciary duty they have to their investors. Furthermore, investors’ tendency to focus on short-term performance may indirectly provide managers with additional incentives that exacerbate this problem. Similar incentive problems exist within the banking industry, many of which were clearly illuminated by the 2008 financial crisis.

 

This literature review addresses these concerns to provide a better understand-ing of principal–agent relationships, and the associated potential problems, in finance.

Evolution of the Principal–Agent Problem.  Initially, most econo-mists 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 sepa-rately 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 orga-nizing 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.

 

Full article here CFA http://www.cfapubs.org/doi/pdf/10.2470/rflr.v10.n1.1