Agency Theory: Definition, Examples of Relationships, and Disputes
Agency theory explains and resolves corporate principal-agent difficulties. The typical relationship is shareholders as principals and executives as agents.
Knowing Agency Theory
Generally, an agency is any relationship in which the agent represents the principal in daily interactions. Principals engage agents to execute services. Principals give agents decision-making power. Differences of opinion, priorities, and interests can occur since the agent makes many financial decisions for the principal. Agency theory suggests principal and agent interests are not always aligned. Some call this the principal-agent issue.
By definition, agents use principal resources. The principal has entrusted money but has minimal daily involvement. The agent makes decisions but bears little risk because the principal will pay any losses.
Financial planners and portfolio managers manage their principals’ assets as agents. A lessee may be responsible for securing non-owned assets. Despite being responsible for protecting the assets, the lessee is less concerned than the owners. Agency theory focuses on disputes arising from differing aims or risk aversion.
For example, executives seeking short-term profitability and higher pay may want to enter high-risk areas. However, shareholders who care most about long-term earnings growth and share price appreciation may be at risk.
Incompatible principal-agent risk tolerance is another major agency theory issue. Bank shareholders may complain that management has lowered loan approval standards, increasing the likelihood of defaults.
Reduce Agency Loss
Many agency theory proponents have proposed strategies to resolve agent-principal disagreements. This is “reducing agency loss.” The principle claims agency loss when the agent acts against the principal’s interests.
Incentives for corporate managers to maximize principle profits are one of these tactics. Agency theory underpins executive stock options. Incentives aim to improve principal-agent relations. Other tactics include linking executive pay to shareholder profits. These demonstrate agency theory in corporate governance.
These methods raise fears that management will risk long-term firm growth for short-term earnings and remuneration. Management routinely cuts estimates in annual budgets to fulfill performance goals. These issues have led to another executive pay structure that partially defers and is based on long-term goals.
Similar solutions exist in other agency partnerships. Example: performance-based pay. Another is requiring a bond to guarantee results. The final option is firing the agent.
What disputes does agency theory resolve?
Differences in goals or risk aversion are the main causes of agency theory debates. Management may want to enter new markets for short-term profit and higher pay. However, risk-averse shareholders who value long-term earnings growth and share price increases may not like this.
Principals and agents may have different risk tolerances. Bank shareholders may complain that management has lowered loan approval standards, increasing the likelihood of defaults.
The Principal-Agent Problem?
The principal-agent problem occurs when a person or organization and their representation have conflicting priorities. An agent may operate against the principal’s best interests. Principal and agent roles vary, and so does the principal-agent dilemma. Any time a principal gives direct control of an asset to an agent, it can happen. A house buyer may think a realtor cares more about commission than the buyer’s needs.
Effective Agency Loss Reduction Strategies?
The principle claims agency loss when the agent acts against the principal’s interests. One way to resolve agent-principal disagreements is to incentivize company managers to maximize principle profits. Based on agency theory, executive stock options aim to maximize principal-agent relationships. Other tactics include linking executive pay to shareholder profits.
Conclusion
- Agency theory explains and resolves principal-agent priority issues.
- Principals rely on agents to perform transactions. Therefore, priorities and methods differ.
- The principal-agent dilemma is when agents and principals have different agendas and interests.
- Conciliating expectations is “reducing agency loss.”
- Performance-based remuneration helps balance principal and agent.
- Shareholders and management, financial planners and customers, and lessees and lessors are principal-agent relationships.
