What Is Agency Theory?
Let me explain agency theory to you directly: it's all about the relationship between principals and agents. As a principal, you rely on an agent to handle specific business or financial transactions for you, expecting them to represent your interests without letting their own self-interest get in the way.
You'll see these principal-agent relationships in everyday scenarios, like between shareholders and company management, financial planners and their clients, financial advisors and clients, or even lessees and lessors.
Key Takeaways
Agency theory is designed to explain and sort out disputes that come up between you as a principal and your agents. You depend on agents to carry out financial transactions without putting their own interests first. The core issue here is the principal-agent problem, which stems from differences in priorities and interests. Conflicts of interest can easily emerge in these setups. Again, think of common examples like shareholders and management, or clients with financial planners and advisors, and lessees with lessors.
The Principal-Agent Problem
When you as a principal delegate decision-making authority to an agent, the financial choices that agent makes directly impact you. But differences in opinions, priorities, and interests often crop up.
Agency theory operates on the assumption that your interests as principal and those of the agent won't always line up—this is what we call the principal-agent problem.
Take financial planners and portfolio managers: they act as agents for principals, managing the principals' assets. Or consider a lessee who's responsible for protecting assets that aren't theirs; they might not care as much about safeguarding those goods as the actual owner does.
Companies try to cut down on these disputes through corporate policies, but these situations can tempt even ethical people into moral hazard.
Areas of Dispute
Agency theory tackles disputes that stem from differing goals or levels of risk aversion between you and your agent.
For instance, company executives might push to expand into risky new markets, but that could unnecessarily jeopardize shareholders who are focused on steady earnings growth and share price increases. You might have incompatible risk tolerances as principal and agent.
Shareholders in a bank could argue that management is approving loans too leniently, taking on excessive default risk.
Important Note on Trust and Governance
As a principal, you often don't have full information on how your agent is performing, so you have to trust they're acting ethically. Through corporate governance, agents can be motivated to align with your interests as principal.
Agency Loss
To check if an agent is truly acting in your best interest as principal, we use the metric of agency loss. This is the gap between the best possible results for you and what actually happens due to the agent's actions.
Companies might offer incentives to managers to boost profits for principals. Stock options for executives come straight from agency theory principles. These incentives aim to tighten the bond between principals and agents. Other approaches include linking executive pay to shareholder returns.
That said, these methods can sometimes harm long-term growth by prioritizing short-term gains. You see this in budget planning where managers lowball estimates to ensure they hit performance targets.
What Reduces Agency Loss?
Agency loss decreases when you and your agent share similar interests, aim for the same outcomes, and you as principal can monitor the service level from the agent.
What Is an Example of a Principal-Agent Problem?
The principal-agent problem kicks in when an agent acts against your best interests as principal. It shows up anytime you delegate control of an asset to someone else. For example, if you're buying a house, you might worry that your realtor is chasing their commission more than addressing your needs.
How Does Risk Differ Between a Principal and an Agent?
By nature, an agent uses your resources as principal. Say you're a client at an investment firm; you hire a financial advisor to invest your money. You've entrusted them with your funds, but you have minimal daily input. Here, the advisor makes the calls but bears little risk—any losses fall on you.
The Bottom Line
Agency theory breaks down the agent-principal relationship for you. Agents need to put the principal's interests first, but differences in views can lead to issues. A typical example is the dynamic between a client and their financial advisor.
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