The Principal - Agent Problem in Finance

Abstract

The relationship between a principal and the agent who acts on the principal’s behalf contains the potential for conflicts of interest. The principal–agent problem arises when this relationship involves both misaligned incentives and information asymmetry. In asset management, factors contributing to the principal–agent problem include managers’ compensation structures and investors’ tendency to focus on short-term performance. In the banking industry, myriad principal–agent relationships and complex instruments provide a fertile breeding ground for incentive conflicts, many of which were highlighted by the recent financial crisis.

Keywords: Principal, agent, conflicts of interest, misaligned incentives, information asymmetry

JEL Classification: G10