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0 Introduction
The principal – agent problem is an idea derived from agency theory, formulated by
economists and political scientists, first described by S. Ross in 19731. It usually gets
analyzed and disputed in terms characteristic of those areas of science. In some
aspects, agency theory and problems arising from it may be described as having a
universal impact on social sciences as a whole, whereby just as in game theory, the
incentives attributable to the parties involved may be used to predict people’s
behaviour, design organizational systems and draw contracts between parties.
Therefore, it is not only possible but desirable to discuss agency theory and the
principal – agent problem in terms of law and legal economics, as the tools derived
from analysing the incentives ruling parties’ actions, may help shape legal
relationships2.
Below I will focus on how the principal – agent models are shaped by law and
regulation in companies and their most sophisticated form, banks. I will briefly
describe the principle – agent relationships existing within corporate organizations
first, in order to focus on describing the specific characteristics and problems of
agency based relationships in banks as a notably specific type of company. Finally I
try to suggest how bank regulation and governance may ultimately influence the
shape that these relationships take, minimising the agency risk.
1
S. Ross, “The Economic Theory of Agency; The Principal’s Problem”, American Economic Review,
G3, p 134-139
2
K. Eisenhardt, “Agency Theory: An Assessment and Review”, The Academy of Management Review,
vol. 14 no. 1(Jan 1989), p. 57-74
the principal’s side, is that the agent will be able to perform the actions handed down
to him in a more efficient way than if the principal would perform them himself.
In a perfect world, where information is spread out efficiently throughout the system,
both the agent’s and principal’s interests would be ideally in tact, so that the agent
would act in perfect accord with the interests of the principal. However, no such
system can be identified in reality. First of all, information in any principal-agent
model will not be shared symmetrically between the parties. This arises as a
consequence of the principal’s delegation of power to the agent. Secondly, however
the agent will be working on behalf of the principal, his interests may not be aligned
to those of the delegating party. Instead he may be tempted to use his powers in order
to satisfy his own interests surpassing those of the principal. There are three main
issues identifiable as risks to achieving an efficient balance in any principal - agent
relationship. These main issues are adverse selection, moral hazard and non –
verifiability. Adverse selection occurs when the agent may come into possession of
information that the principal does not know of. Moral hazard may be described as a
situation where the agent may act against the will of the principal unbeknownst to
him, possibly to the detriment of that principal’s interests. The last problem is when
both parties may own the same information but this remains unknown to any third
person3.
15
[1988] BCLC 20 at p. 40; I can only find reasons for the application of this principle to banks, as
well as other companies. It is always the ultimate issue in a bank failure, to secure the payouts of
deposits to depositors who are anything if not a banks creditors (even though the actual terms of a
deposit contract with a bank are different to those of a credit agreement).
16
See for example West Mercia Safetywear Ltd v Dodd [1988] BCLC 250
17
See, S. Griffin “Company Law…”, p. 316
18
S. Heffernan “Modern Banking”, 2008, p. 1-5
4.1. Additional Relationships
From this basic outline it becomes visible that the principal – agent framework is
more complex than that of other business enterprises. What distinguishes a bank’s
principal – agent framework is that in addition to the standard relationships between
the managers, shareholders, creditors there will be more element s active. Secondly,
because of the nature of a bank’s activity these enterprises are essentially more
sensitive to informational disparities between the parties forming principal- agent
relationships within their structure. Because of the nature of bank activities,
shareholders cannot effectively oversee every decision a bank makes, as this would
render the whole business concept functionally impossible. Depositors in a bank have
very little say as to how the bank invests their funds and find it hard to monitor these
decisions at all. Bank management, does not have the tool s necessary in turn to
influence when depositors will be able to withdraw their funds, essentially leaving
banks prone to “bank runs” and changing moods based on inadequate information.
A depositor will ultimately find himself in a position of a principal in atypical
asymmetric information sharing model where he cannot perform effective supervision
of his funds because of a number of reasons. This is de to a number of reasons, for
example a bank will pool the capital it receives from deposits and diversify it into a
large number of loans to limit losses. However losses will always exist, in order to
supervise him capital the depositor would have to monitor a very large number of
transactions performed by a bank. Also, deposit insurance schemes will further limit
the incentive depositors have for examining a bank’s activities19. Insurance schemes
are however necessary due to the fact that the incentives guiding shareholders’ actions
aren’t exactly in line with their own.
Bank shareholders’ incentives to monitor bank activities will be less limited, as they
have a legitimate expectation of the bank paying out dividends. Their incentives
suffer however from the free – rider problem. They stand a chance to move the risk of
making losses onto the shoulders of the depositors, while personally being responsible
to for any operational losses with only the capital they chose to invest in the form of
19
S. Heffernann “Modern…”, p. 6 – 8. However, most jurisdictions recognise the need for some sort of
deposit insurance. The Unites States was first to develop such legislation in 1933. Since then, in 1991
the US have developed the Federal Deposit Insurance Corporation through the Federal Deposit
Insurance Corporation and Institutions Act 1991. In the UK the deposit insurance scheme has been
instated by the Financial services and markets Act 2000, under part XV of the act.
share20s. Furthermore, shareholders mostly choose to vote with their feet and focus on
the short term percentage increase in net share worth rather than actual dividend. The
more shares are held by small individual investors the less effective the supervision
and shareholder influence over management. Furthermore, even the powerful investor
will tend to favor to put an emphasis on best possible performance by his agent,
pushing towards more outcome based contract formulation so that the agent’s
remuneration will be mostly aligned with what profits he effectively stands to make.
The shareholder will have a better informational relationship with his agent than the
depositor, also implementing better reporting measures will increase agency costs to
the shareholders, meaning they would stand to make a smaller profit than if no such
measures were implemented into the banks internal governance systems. The
depositor will only stand to make only a certain predetermined and usually low profit
on the money he invested, he stands a much bigger informational disproportion than
the shareholder. To this group, introducing more behavior - based measures into the
agency contract would be desirable21. In a company that is not a bank this problem of
two principal groups, having different incentives would not occur. In a economic
system where competition among banks is high would, in my opinion, only increase
the shareholder principal group’s incentives to further limit their scrutiny of their
agents focusing on limiting agency costs and improving the final profit outcome of
the management’s activities. This is a point well – observable when the recent bank
crisis in the United States and the UK is observed. The response in the U.S. was to
impose a 90% income tax burden on bank manager’s income paid out in bonuses.
Although this seems like a measure that could greatly limit the application of result –
based agency contracts, I find it to be a comforting half – measure, imposed solely to
console those who find bank managers morally responsible for the recent financial
crisis22. This is because, performance based manager contracts are purely a form of
aligning their interests with those of the shareholders.
20
K. Alexander “Corporate Governance and banks: The role of regulation in reducing the principal –
agent problem”, Journal of Banking Regulation, vol. 7 no. 1/2, 2006, p. 17 - 40
21
K. Eisenhardt, “Agency…” p. 57 - 74
22
See, BBC NEWS, available at: http://news.bbc.co.uk/2/hi/business/7953869.stm My opinion is
based on the fact that the legislature is clearly based on post facto conditions, being the fact that the tax
will be imposed on those managers whose institutions have received public help and the managers
already receive more than 250, 000USD remuneration already. Rather than being an attempt at
changing parties incentives, it seems like the recently passed bill is more of a legislatively designed
financial punishment to those managers.
Acting as agents in banks, managers invest both considerable amounts of time capital
and reputation, to produce results for shareholders. Although there may exist
problems in the relationship between shareholders and managers, arising from
informational asymmetry and interest issues such as enjoying job – perks or empire
building by managers, there is a basic foothold aligning the interests of both the
parties. This is because in essence managers stand to lose not only the considerable
amounts of time invested in the success of the operations of the bank, but also their
reputation and any future incomes that would come their way if they didn’t take
excessive risks. So there is a reasonable ground to believe that agents in essence may
be more risk averse than their principals in this framework and shareholders may find
it necessary to bring forward incentives for additional risk taking23.
26
K. Alexander, “Corporate…”, p. 21
27
Basel Committee on Banking Supervision, Pillar One, part 3, H, par. 5, sub. Par. 438 .Quoted in K.
Alexander, “Corporate …”, supra note 47
6.0. Developing Regulation and Reform
If I were to suggest a way of setting up a principal – agent framework for banks I
would focus reform efforts on three issues. These issues are shareholder monitoring
and influence improvement, depositor disclosure improvement and greater regulator
involvement in the daily operations of banks.
To minimize the chance of moral hazard occuring along the main principal – agent
relationship between shareholder and management, a greater degree of shareholder
activism is necessary. Institutional shareholders should be given greater powers to
monitor the actions of the management. Shareholders owning more than a specified
percentage of shares should be allowed to appoint one director to the board. A
manager appointed this way will be able to know to whom he owes his seat of power,
at the same time being limited by the fiduciary duty of owing loyalty to the
company28. This solution would limit a manager’s incentive for empire building and
the proverbial “easy life”, also aligning each particular manager’s remuneration with
his actual performance and giving the principal a greater incentive to scrutinize it.
Some authors believe that in relation to banks there should a regime limiting the
extent of limited liability of shareholders, so that to limit the extent to which they
might urge their agents to take excessive risks29. Sufficient evidence exists that banks
would perform better under a stricter shareholder liability regime, based on historical
data, but the idea itself seems too outrageous to be accepted into modern into banking
regulation.
Once shareholders’ interests have been given greater attention, the need arises to
counter possible problems that may be caused by the shareholder’s abusing their
comfortable situation and transferring risks towards the depositors. A government
could increase the trust in the system as a whole if greater measures to increase
disclosure towards depositors were to be introduced. Thaler and Sustein have
developed a theory dubbed “libertarian paternalism”. This idea, basing on empirical
28
L. Zingales, „The Future of Securities Regulation”, Center for Economic Policy Research
Discussion Papare Series, available at: www.cepr.org/pubs/dps/DP7110.asp
29
L. Evans N. Quigley “Shareholder Liability Regimes, Principal Agent Relationships and Banking
Industry Performance”,Journal of Law and Economics no.38,1995, p. 498 - 520
evidence, suggests that some rules ought to be designed so that the default option
chosen by most people will maximize social welfare30. An example of such a rule is
that whenever someone would choose to invest money in a bank through opening a
money management account or making a deposit, they should receive a pre –
established set of disclosures about the investment they are making, containing a set
of financial data, historical information, a complete set of information regarding a
bank’s operations in relation to money paid in by any depositor.
Finally, in order to ensure that regulators and regulation is even able to have an
influence on the banking sector I believe that a separation of retail banking from
investment banking from the investment banking is a necessity. Furthermore, I
believe that banking institutions should be separated from other financial institutions
and their activities should be strictly numerated, so that financial innovation could
take place in the system through financial institutions, but separately from banks,
effectively cutting these innovations from the scale effect that banks produce in their
activities. A Glass – Steagall Act type legislation would be a significant step towards
ensuring soundness within the system of bank corporate governance31. The basic
critique of such an arrangement is that this would mean that this would limit the
banking sector’s efficiency and profitability. Although this might be true, such an
arrangement would be systemically desirable, as part of a possible macro – regulation
framework that would perhaps limit some profits during “high - times” in the banking
sector, but would also prevent bubbles form occurring or regulators losing touch with
innovation.
7.0. Conclusion
In the area of corporate governance, banks seem to stand out as a subject of research.
Organizationally more complex and more important to the system as they are, they are
also more vulnerable to the imperfections that arise in relations between humans. This
particularity of the principal – agent framework existent in banks leads to a necessity
to ask some specific questions. First, what can be done to banks specifically from a
30
T. Thaler and C. Sustein, „Libertarian Paternalism”, The American Economic Review, Vol. 93:2, p.
175-179
31
Some authors suggest the return of similar legislation in different forms. See : L. Zingales ”The
Future…”p. 3
regulatory perspective to upgrade the efficiency of their operations? Secondly, do
these improvements require a new banking law with a set of hard legislative rules, or
does secondary regulation released by legislative empowered regulators suffice?
Having answered the first question in the preceding paragraphs I wish to focus on the
second issue. The extent to which banks are different from typical companies and
their importance to national and recently also to the global financial systems suggests
that banks deserve to be managed by specific legislation, that would address them
specifically. Most legal systems in the world already have such legislation, addressing
banks as a particular type of company. These legislations should evolve to address
more of the specific issues relating to corporate governance and existing principal –
agent problems experienced by banks.