The thorough overview of the issue of principal-agent

The principal-agent issue
is found in a wide variety of contexts, and we witness it in many corporate and
financial environments. Just as complex and strict it seems, the banking
industry holds unique traits and poses risks that we don’t see in other areas
of business.  As we clearly see
conflicting incentives and interests between different parties during financial
crises and corporate breakdowns, it is crucial to see how the agency issue
stands in a significant position in such financial chaos. This paper gives a
thorough overview of the issue of principal-agent problem prevalent in many industries,
and specifically investigates into the banking industry. It also shows an
analysis of the principal-agent problem playing a root role in the recent financial
crisis in 2007-2008.


Principal-agent problem

The principal agent problem
occurs when the “principal” assigns specific tasks to an “agent,” who performs
the task on the principal’s behalf. However, if the agent’s incentives are not
aligned with those of the principal, implying a conflict of interest, and the
principal is unable to monitor the agent’s actions, the agent has the
incentives and the capability to act undetected against the principal’s
interests.  The issue of principal-agent problem was first presented
in 1976 by Michael Jensen and William Meckling, who outlined a theory of
ownership & capital structure that would be designed in in such a way as to
avoid what they defined as agency costs and its relationship to the issue of
separation and control. The two key components of the agency issue are private
information and conflicting interests. Without conflicting incentives, the
principal may simply leave the agent to his own devices. Without the issue of
holding private information, the principal merely needs to organize the
contract to cover each realization of private information ex post.

Figure 1: Owner-manager’s choices and the value of the firm

1 above illustrates the agency issue, and we see that when the owner-manager
sells (1-?): investors will pay (1-?)V* if they didn’t know the manager consumers perks of F0
and the real firm value is V0 now. The manager moves along V1P1
(slope = -?) and he rises to a higher indifference curve
with equilibrium point A. If the investor expects the owner-manager’s
consumption of perks, the manager could only move along the true budget line VF,
so B is the equilibrium point. V2P2 represents the
tradeoff between the firm value and manager’s non-pecuniary benefits after
selling (1-?).

Figure 2: The principal-agent problem in the contract

Contracts are a key piece
in all industries that are used to mitigate the conflict of interest between
agents and principals. In terms of the contract theory, the optimal contract
maximizes total benefits of both parties involved. However, even with
incentive-based compensation, principal-agent problem still arises as shown on
Figure 2, where maximum points are colored in red, while the outcome in yellow
is suboptimal since the agent controls the effort. Conceptually, the process of
determining the optimal terms of contract seems relatively straightforward.

However, in practice it becomes difficult because the exact benefits gained by
the principal and the exact costs incurred by the agent are not easily
measured. Thus, the contract theory is concerned with optimizing incomplete
contracts (contracts which are formed without perfect information regarding the
costs and benefits).


Principal-agent problem in
the banking industry

issues are evident when managers pursue their own interest, not those of
providers of finance. It is clear that this principal-agent problem is
pervasive in financial institutions and the banking markets – between shareholders and bank creditors, and
between banks and their clients. The interconnectedness and the complexity of
the industry create an environment that is ripe for potential incentive
conflicts. The industry of financial services bear a myriad of agency
relationships in which monitoring is difficult, and most of these relationships
involve risk transfer or risk sharing within groups. Accordingly, ethical
standards must be high, in case the power of the players’ owns incentives
drives them to act counter to their fiduciary duty to their own clients. However,
the financial services industry’s primary function is money management. The
focus of the industry is making money, not necessarily doing the morally right
thing, and hence it’s more likely for those in this industry to take
immoral/risky actions that generate money. They are aware of the fact that they
won’t be responsible for the potential consequences, whether it’s good or bad.

Therefore, the inherent temptation, greed, and incentives in the banking
industry make it vulnerable to moral hazard, adverse selection, and the principal-agent


The financial crisis and
the principal agent problem

2007-2008 financial crisis was the collapse of trust within the financial
system, caused by the subprime mortgage crisis. The principal-agent problem was
evident in many layers and groups throughout the mortgage chain during the crisis,
which is visualized in Figure 3 below. The issue involved a number of players –
mortgage borrowers and lenders, investment bank, the government, rating
agencies, financial service institutions, and clients/investors. The complex relationships among these different parties,
combined with the density of information in each transaction, provided a breeding
ground for principal–agent issues. Furthermore, the amount of money involved significantly
amplified each individual’s incentives, making those incentives more difficult
to ignore.

      Figure 3: Principal-agent relationship chain in the
financial crisis

The agency
issues relevant to each of the corresponding numbered groups are laid out

 Mortgage borrower and lender (two-sided issue)
– The conditions for given out mortgages were flexible and the borrowers were
able to withhold/falsify information, which lacked verification and signaling
requirements. They could hide their financial status and thus get a more
favorable mortgage, and consequently commit moral hazard. Mortgages in most of
the states in US were non-recourse, implying that the borrower could default on
his mortgage and only lose the house. If the house prices fall below the
mortgage level, he will default on his mortgage to avoid loss. Mortgage lenders
could make irresponsible loans, as they only aim to maximize the amount of

 Mortgage lender and investment bank – A
mortgage lender was able to make these irresponsible and risky mortgages, and
he could simply resell them to investment banks and securitizers. The only
information he needed was the loan-to-value ratio (size of loan vs. the
assessed value of the house) and the credit score of the borrower. This
information was of low quality because they were able to force property
assessors to give higher value for the houses and maximize the credit score
right before the mortgage application. This allowed the investment banks to
overestimate the mortgage qualities.

3.     Investment bank managers and stockholders
– Investment bank managers strived to maximize their utility in bonuses by
making huge short-term profits at the expense of an extremely high medium and
long-term risk, whereas stockholders were interested in optimal strategies to
make the firm most profitable in the long-run, thereafter maximizing their
stock value and dividends. After the managers receive their bonuses they were
not accountable for their risk-seeking behaviors. The short-term strategies
that were utilized before the crisis resulted in a huge drop in the stock value
in 2008.

4.      Investment
bank and government – The US government failed to set strict regulations in
protecting domestic mortgage borrowers and restricting irresponsible mortgages,
and also didn’t enforce strong requirements on investment banks. There was an
indirect principal-agent issue in this segment as there were no contract/deals
involved. Large financial institutions committed moral hazard on the government
because they saw themselves “too big to fail” or “too entangled to fail.” They
took big risks and knew that they would not be blamed for the aftermaths (or
only to a certain extent) because they counted on the government to bail them

5.    Investment
bank, rating agencies and investors – The agency issue here was twofold, as
there was a direct link between the securitizer and the rating agency, and an
indirect connection between the investors of the rated security and the rating
agency. Instead of carrying out their responsibilities in providing investors
accurate evaluations of securities, rating agencies were heavily swayed by investment
banks and thus underestimated relevant risks. As investment banks were
negotiating ratings at different agencies, the rating agencies aligned their
interests with the banks, instead of investors.

6.      Investment
bank and financial institutions – Investment banks were also involved in
adverse selection, by hiding information regarding the actual risk of the
securities from the financial institutions that would purchase their products.

These securities were shielding the real risk of the mortgages, even disguising
as low-risk securities.

7.      Financial
institutions and creditors – Many financial institutions relied on short-term
debt to fund their assets, provided by creditors (mostly other financial
institutions). Throughout the crisis it became more difficult to figure out who
was exposed to large amounts of bad mortgages. Credits were barely extended due
to information asymmetry between financial institutions and their creditors,
and this soon evolved into a severe credit crisis. It became difficult to tell
the type of financial institutions that asked for credit, as they had no idea
how risky their assets were. The bad types couldn’t get any credit at all
because of their high chance of default.

8.      Financial
institutions and clients/investors – The government guarantees on
deposits were the only ones that prevented massive bank runs and collapse of
the financial system, as it was difficult for the financial institutions to
prove that they were in good shape. Investors did not receive such protection
and tried en masse to sell their
stocks, causing a huge drop in stock prices for all financial institutions
(including the good ones that failed to signal their type).



In the banking industry,
trust becomes the most crucial, and yet the most difficult to persist.  Once trust breaks a little in the association
among a few groups, it takes only a split second to become completely shattered
in terms of the entire financial system, evident in the crisis in 2007-2008. Thus,
information alignment and share of interest/incentives between key parties are
critical in promoting a healthier financial environment. This paper shed light
on how the principal-agent problem is prevalent in the banking industry, and
how it contributed to the recent financial crisis. Continuous research in this
field can provide insight on how such agency issues can be prevented, taking
into account of the banking industry’s unique and vulnerable nature.