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«The Principal–Agent Problem in Finance (a summary) Sunit N. Shah Published 2014 by the CFA Institute Research Foundation Summary prepared by Sunit ...»

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Through TARP and other policies, the US government also served as a major player in the financial crisis, creating principal–agent problems with its ©2014 The CFA Institute Research Foundation The Principal–Agent Problem in Finance (a summary) own actions. (Striking similarities exist between the US financial crisis and that of Japan in the late 1990s.) First, the US government needed to ensure that the structure of the Capital Purchase Program motivated the “right” banks to apply for the preferred stock capital injections offered under the program. Second, the US Treasury needed to ensure that it approved the banks whose financial distress costs were the highest. Research shows that the government succeeded in both endeavors.

Some of the government’s actions, however, have been called into question. The insertion into the banks’ capital structures of a government-owned layer just above common equity meant that only one layer of capital needed to fail before regulators would have to seize bank assets to protect the taxpayers.

The market perceived this change as an increase in risk, and banks with small common equity cushions suffered, in terms of stock market performance, relative to banks with large cushions.

The government’s behavior regarding Fannie Mae and Freddie Mac has also been questioned. In 2008, the Federal Housing Finance Authority (FHFA), acting in its authority as conservator of these entities, struck a deal with the US Treasury that stabilized Fannie and Freddie in exchange for preferred stock amounting to $1 billion. About four years later, the FHFA and the Treasury signed an amendment to that agreement providing the Treasury with a full sweep of Fannie’s and Freddie’s earnings in the future as repayment for the taxpayers’ investment in the two firms.

Consequently, several principal–agent problems have been alleged to exist.

The first involves a conflict of interest for the FHFA, which has a fiduciary duty to act on behalf of Fannie and Freddie shareholders in its role as conservator but also has a duty to act on behalf of the taxpayers in its role as part of the government. The second principal–agent issue pertains to an alleged violation of the Administrative Procedure Act and involves a conflict of interest within the government between its duty to act on behalf of the taxpayers as owners of Fannie and Freddie and its duty to administer the Housing and Economic Recovery Act by guiding Fannie and Freddie toward private ownership. The third issue alleges an improper use of the law of takings and involves a conflict between the government’s role as agent of the taxpayers and its duty to provide just compensation when it forcibly removes private property.

The research has also illuminated potential principal–agent problems in the role of rating agencies. These agencies’ revenue streams are generally a function of how many ratings they provide, and this system creates an incentive to sacrifice accuracy for speed. Furthermore, the oligopolistic nature of the ratings market enables issuers to engage in “ratings shopping”—that is, having their securities rated by the agency that will provide the highest rating. This behavior, in turn, gives the agencies an incentive to skew their 6 ©2014 The CFA Institute Research Foundation The Principal–Agent Problem in Finance (a summary) ratings upward. In addition, the repeat-customer nature of the business has resulted in many issuers’ receiving advice from the agencies on structuring the very securities that will later be rated—a practice that has been likened to an auditor auditing his or her own work.

Conclusion Organizations such as CFA Institute have developed codes of ethics to guide finance professionals and to set expectations for ethical behavior and professional conduct. Reflection upon such behavior, and on how successful the industry as a whole has been in achieving its ethical goals, has rarely been more important than it is now. Financial products and relationships have become so complex and interwoven that discerning ethical actions from irresponsible behavior is significantly more difficult than it has been in the past.

This development is demonstrated by the recent financial crisis, which threatened to bring down the entire financial system. Investors and the general public have noticed, as several recent surveys have shown, that trust both of and within the financial markets has reached frighteningly low levels.

Asset management compensation structures directly provide managers with incentives that, if misaligned with those of the investors, can lead to conflicts with the managers’ fiduciary duty to those investors. The tendency of investors to focus on short-term performance can exacerbate this problem and provide managers with additional incentives that run counter to the investors’ best interests. Consequently, many asset managers, wishing to avoid the misaligned incentives that investor short-termism can create, have sought sources of capital with long lock-up periods and launched publicly traded entities to provide stable capital bases.

The banking industry contains its own share of potential incentive conflicts, many of which were highlighted by the recent financial crisis. Research on the compensation structures of senior bank executives is mixed, whereas most research on the incentives of the traders and others more directly involved in daily decisions points to these incentives as reasons for the increased risk on bank balance sheets. Several observers have also weighed in on changes the government must make to the current market environment to keep such problems from recurring. In addition, the literature offers considerable criticism of the way rating agencies are compensated. These researchers claim that the agencies’ pay schemes motivate them to sacrifice accuracy for speed and to shade their ratings up to benefit their clients.

Who will act to solve these problems in the future? On their own, members of the financial profession are realizing that it is not enough to avoid conflicts or manage their own conflicts responsibly. A sustainable financial system requires a trustworthy reputation, not only for individuals but also ©2014 The CFA Institute Research Foundation The Principal–Agent Problem in Finance (a summary) for the industry. There has sometimes been a leadership void, but the recent financial crisis has prompted CFA Institute and other organizations to take a more active role in (1) aligning interests so that the economic benefits of finance can be realized and (2) improving corporate governance in the financial industry. By finding ways to cultivate an ethical culture in the finance industry, we can together shape a better future for finance.

****** The complete monograph can be found at http://www.cfapubs.org/doi/ abs/10.2470/rflr.v10.n1.1.

Use your smartphone to scan the QR code to go straight to the webpage.

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