Agency Theory

In an agency relationship, one party, called the agent, makes decisions and acts on behalf of another, called the principal. The agency theory attempts to summarize and solve problems arising from the relationship between a principal and an agent. Agency relationships are common in financial management, due to the nature of the industry. When one person manages another person’s financial affairs, an agency relationship exists by default. Understanding the agency theory’s application in financial management can give you greater insight as an investor, stockholder or aspiring financial professional.

Principals and Agents in Finance

A number of specific agency relationships can exist in the world of financial management. Corporate executives and company shareholders serve as a prime example. CFOs and other financial executives make decisions on behalf of the interests of shareholders, the principals in the relationship. As another example, financial planners and mutual fund managers act as agents on behalf of individual clients and fund participants.

Goals and Information

The problem around which the agency theory revolves describes the main challenge of agency relationships: reconciling two distinct sets of personal goals. In an agency relationship, agents are required to work toward meeting principals’ goals, yet it is the agents’ own goals that drive them to succeed on behalf of their principals. In order for an agency relationship to be mutually beneficial, both parties’ goals must be addressed within a climate of compromise, but with the understanding that meeting the principal’s goals is the primary function of the relationship. To this end, it is vital that information be shared freely and openly between the two parties so agents are always clear on their principals’ priorities and principals are always aware of their agents’ decisions and actions.

Differences in Risk Tolerance

Financial management is all about risk, and each investor comes to the table with a different tolerance for risk. In an agency relationship, chances are high that principals and agents have different risk tolerances, which can lead to misunderstandings and a failure to agree on investing decisions. Even when agents act toward principals’ goals, their means of doing so may conflict with principals’ risk tolerances. For example, in a shareholder-executive relationship, an executive may wish to acquire struggling companies to achieve the shared goal of increasing market share at a discount, but this plan may be deemed too risky by a majority of shareholders.

Legal Fiduciary Responsibilities

In the world of finance, some agency relationships are fiduciary, meaning that agents are legally required to act in the interest of their principals. Fiduciary responsibilities formalize an agency relationship and provide greater security for principals. In the case of a financial planner who holds power of attorney for an individual client, for example, that planner has the right to conduct financial transactions on behalf of the individual without his consent or awareness. In this example, the financial planner is legally required to make decisions solely in the best interest of his client, rather than doing things with his clients’ money simply for his own personal gain.

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