Question

4) Explain how the principal-agent problem applies to both banks and borrowers and also regulators and banks. What do some of the solutions to each situation have in common?

Answer 1

Problem between a principal and an agent happens as and when a situation has been created by the principal where the incentives of the agent does not range with that of the principal. Usually, principal should make a range of incentives which should be given to the agent in order to make the agent the pet of the principal. The ultimate aim for providing such an incentive is to make the agent to work as per the wish of the principal.

If we take the case of banks and borrowers as well as regulators and banks, especially credit rating agencies, problem between principal and agent happens when the principal ( company ) hire the agent for credit rating. If the credit rating is low, borrowing cost to company will rise. Hence, the company will provide the agent an incentive package in order to maintain a high level rating to the company. Here, the company usually won't object the incentive payment to the agent as the future of the company will spoil if it can't maintain a high rating.

But, issues may occur for any simple matter, ie; if the agent deviates a little from the command given by the principal, or if the agent do anything in his own discretion on the course of his duty, the principal- agent issues will happen. Information asymmetry is a main problem. As the agency costs should be beared by the principal and if the agent performed in his interest, conflicts may occur between them.

Solutions

There are mainly two solutions for the issues between principal and agent by combining the interest of both the parties. They are :

• Contract Design

Preparation of a contract between them which include the terms and conditions of the contract. Issues such as information asymmetry, incentive of agent to act for principal, regulating monitoring etc. should be addressed.

• Performance Evaluation and compensation

Fixing the compensation of the agent solve half of the problems. Such compensation should be connected with the act of agent. Through subjective evaluation, this act should be observed as that method of evaluation is more convenient as well as accurate. Profit-sharing, deferred compensation or else stock options are the major methods of compensation to the agent.