Question

Give an example of how the principal-agent problem might prevent you from getting financing for something you want to do. Can you think of a way of overcoming this problem?

Answer 1

The Principal Agent Problem occurs when one person (the agent) is allowed to make decisions on behalf of another person (the principal). In this situation, there are issues of moral hazard and conflicts of interest.

The agent usually has more information than the principal. The consequence is that the principal does not know how the agent will act. Also, the principal cannot always ensure that the agent acts in the principal’s best interests

In many real-world examples, the agent will not prioritize the best interest of the principal, but will instead pursue his own goals. Politicians (the agents) and voters (the principals) is an example of the Principal Agent Problem. A widespread real-life example of the principal agent problem is the way companies are owned and operated. The owners (principal) of a firm will elect a board of directors. The board of directors monitor and guide the management team like C-Level executives (the agents). More often than often, these agents will act in their own best interest. Another example is landlord and tenant. The landlord owns house and rents out to tenants. He asks tenants to take care of the property and minimise electricity bills. But, tenants may open windows rather than turn down the heating.

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.