What Is an Agency Problem?
An agency problem can occur in a variety of business relationships where one party trusts the other to act on their behalf. However, there are ways you can reduce the risk of an agency problem occurring and knowing how to mitigate a conflict of interest may help. Understanding what an agency problem is can help you get a better idea of what can arise when making investments or acting as a financial agent. In this article, we review what an agency problem is, what its causes can be and how to mitigate it if it occurs.
What is an agency problem?
An agency problem is a conflict of interest between an agent and a principal, where an agent is a person or group of people who performs a task on behalf of someone else, the principal. A conflict of interest occurs when one party doesn't fulfill contractual obligations in favor of their own personal or professional interests. It's best practice for the agent to make decisions that will yield the best outcome for the principal, even if an alternative decision may positively benefit them instead.
When the agent acts in their own best interest, rather than the interest of the principal, this can create a problem between the two. For example, corporate finance managers may act as the agent for stockholders where their job is to use the money and invest it in stocks that will be in the best interest of the client. However, if the stockholder notices unapproved stock purchases, they may speak with the agent about the discrepancy and consider hiring a new finance manager.
What causes an agency problem?
There are many causes of agency problems, such as unwarranted improvements and services, which can increase the cost for the principal. One example would be if you hire an electrician to install a specific version of a light control system for your home, but they inform you they installed a newer, more advanced version that took twice as much time and money to install because it works best with your home's style. Since you expected a certain product at a specific rate, the agent may have acted in their own self-interest to profit more from the installation.
As agency problems aren't exclusive to a particular industry, company or group of people, it's important to note that causes can occur wherever agents and principals are likely to interact. Here's a non-exhaustive list of agent and principal pairs that agency problems can occur:
Executive officers (agent) and shareholders (principal)
Rating agencies (agent) and financial institutions (principal)
Politicians (agent) and voters (principal)
Fund managers (agent) and investors (principal)
Contractor (agent) and individual (principal)
Employee (agent) and employers (principal)
How can you mitigate an agency problem?
There are several ways that you can mitigate an agency problem and try to prevent them from occurring in the future. Some of these strategies include:
Practicing transparency in an agent-principal relationship can help eliminate agency problems by allowing both parties access to information regarding decision-making. Consider asking the agent to educate you, the principal, on the steps of the decision-making process and all available options when they decide on your behalf. For example, a realtor is selling a house and has three buyers, but one buyer is offering to pay in cash. The realtor and client can work out an agreement that allows the seller of the house to review cash offers before the realtor agrees to the sale on behalf of the seller.
Use concise contract language
Try to keep the language intentional and straightforward in contracts. Consider listing the agent's duties and responsibilities, avoiding vague and unrelated tasks and confirming agreement of list items. Some agent duties may include care and competence, compliance with lawful instructions and agreement to regular check-ins. While it's the agent's job to act on behalf of the principal, the principal can also help motivate the agent along the way.
Introduce corporate governance
Introducing corporate governance, such as a board of directors, is another way to mitigate agency problems. This technique results from standard principal-agent models. Economists, financial theorists and corporate analysts use standard principal-agent models to study and solve problems that arise from incidents of conflict of interest in business relationships.
Principal-agent models are the basis of agency theory. Agency theory claims that knowledge and labor are asymmetrical or unevenly distributed, so they require additional measures to correct the distributional incoherencies. A board of directors or another form of corporate governance may account for this asymmetrical distribution by monitoring the activities and decisions of the agents so that the principals don't feel required to monitor them themselves.
Seek intervention by institutional investors
Intervention from an influential external source, such as institutional investors, may encourage the resolution of an agency problem by offering financial guidance and solutions. Institutional investors include mutual funds, pension funds and insurance companies, and based on their size and influence, may be able to guide and alter a firm's decisions. They can often meet with a firm's management team and offer suggestions regarding the firm's operations.
Restrict agent capabilities
When creating a relationship with an agent, consider the amount of freedom to give them regarding making choices and acting on your behalf. Consider what agent capabilities are necessary for them to do the job efficiently and effectively and discuss them. An agent capability restriction may include asking them to provide a detailed list of their choices before making changes.
Reevaluate commission and bonus structures
A simple approach to mitigating agency problems is to limit the likelihood of financial incentives that encourage conflicts of interest. When the agent's financial gain relates to the product or service they offer you, there's an increased likelihood that they may not act in your own best interest in order to make more money. Instead, administer performance-related pay to the agent, as this can motivate them to maximize your investments because they know it will increase their monetary gain as well.
By reevaluating the commission and bonus structure in the agent-principal relationship, there's no financial incentive for the agent to act against your best interests because they are not making more money because of selling you an unnecessary service or product. Instead, they may expect an increase in their pay by representing you and your assets according to your contract.
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