Question

explain the agency problem about compensation during the fiancial crisis

Answer 1

rincipal-agent theory is broadly applicable in situations where multiple parties strive to maximize their utility and which have asymmetric information.

The financial crisis started after the bust of the US housing bubble, which originated as a result of irresponsible profit maximization by parties in the mortgage lending chain. Those parties couldn’t be held accountable for their actions as they were able hide information from their counterparties and government. After the bust of the housing bubble, the losses of the sub-prime mortgages greatly affected the financial system. No one could determine the financial stability of their counterparties anymore, which let to a complete stop on credit lending between the financial institutions. Many institutions had a high leverage and a high funding with short term debt, which got them into liquidity troubles and even bankruptcies.

the following principal-agent relationships present in the financial crisis:

1. Mortgage borrower and lender (two-sided problem)

2. Mortgage lender and investment bank

3. Investment bank managers and stockholders

4. Investment bank and government

5. Investment bank, rating agencies and investors

6. Investment bank and financial institutions

7. Financial institutions and creditors

8. Financial institutions and customers / investors