Study notes

Principal Agent Problem

How do the owners of a large business know that managers work to build shareholder value? This lack of information is known as the principal-agent problem or the “agency problem".

The divorce between ownership and control

Ownership and control

The owners of a private sector company normally elect a board of directors to control the business's resources for them. However, when the owner sells shares, or takes out a loan or bond to raise finance, they may sacrifice some of their control.

Other shareholders can exercise their voting rights, and providers of loans often have some control (security) over the assets of the business

This may lead to conflict between them as different stakeholders can have varying objectives. The flow chart below attempts to show the divorce between ownership and control.

The Principal Agent Problem

How do the owners of a large business know that managers work to build shareholder value? This lack of information is known as the principal-agent problem or the “agency problem".

The principal agent problem revolves around how best to get your employees to act in your interests rather than their own?

Shareholders tend to want strong returns in the form of dividend payments and a rising share price.

Managers may have objectives such as power, bonuses, large expense accounts, prestige and status. The problem is the many shareholders have no day-to-day control over managers.

Pension fund managers cannot dictate what CEOs and CFOs of businesses decide to do and senior executives may have little knowledge of what their managers are doing.

Many investors are 'passive'. The biggest investors in UK-listed companies tend to be large institutional shareholders such as pension funds and insurance companies.

Examples of the principal-agent problem that have hit the headlines include the miss-management of financial assets on behalf of investors (e.g. Equitable Life.) The classic case in the United States was the Enron fraud and debacle.

The global financial crisis focused attention on the failure of shareholders in the major banks to understand the complex and highly risky behaviour that was being undertaken by bank employees involved in the sub-prime mortgage boom and the growth of securitised lending.

In the banking crisis it became clear that senior management at many of the world's biggest banks simply did not understand the complexity of what their traders were doing. Traders stood to earn huge bonuses if their risky loans worked, but faced little sanction or loss if they went bad. This skewed their incentives and created a problem of moral hazard.

The term moral hazard originated in insurance, recognising the idea that people with insurance may be careless – for example, paying for secure off-street parking looks less attractive if your car is insured!

A separation of ownership and control in banks and insurance companies contributed to the sub-prime crisis and the result has been a collapse in shareholder value as share prices of banks and insurance companies has fallen sharply. Several banks in the UK were wholly or partially nationalised.

Employee Share Ownership Schemes

There are various strategies available for coping with the principle- agent problem. One is the expansion of employee share-ownership schemes. But the use and occasional misuse of share options schemes has been controversial for several years.

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