Principal-Agent Problem in Banking Industry - Essay Example

Principle Agent Problem in Banking Industry Name Institution Principle Agent Problem in Banking Industry Abstract The effect of principle – Agent relationship breakdown in the banking sector cannot be overlooked. This industry requires loyalty between the principle and the agent in charge of deciding on the financial principal investment in the money-oriented business setting on behalf of the principal. The paper looks at the possible causes of principal – agent problem and the possible ways to solve this problem in the banking industry: the banks and the regulator has principal-agent relationship whereby the regulators unable to discern the quality of the bank’s assets. In this way, banks may have a motivator to go for broke accordingly moving danger to investors. This foremost operator’s relationship is set up between the controller and the citizens. In any case, it is essential for the examination of the citizen’s controller relationship to think about the motivators of the banks, and the data streams between the saving money industry, the citizens, and the controllers, individually (Schüler 2003). Keywords: Principle – Agent Theory, Principle – Agent Problem, Agent’s Interest, Agent’s Performance, Agent Monitoring, Banking Industry, Risk - Taking Behaviour, Information Asymmetries, Government Policy and Regulation; Table of content References 11 Principle Agent Problem in Banking Industry Introduction Principal – Agent Theory is a situation whereby one party calls the law that has the authority/power decides to hire some of his authority onto another party known as the Agent. The agent receives the task and acts upon it on behalf of the Principle or in the interest of the principle. Similarly, it is a situation where the principal pays the agent in monetary terms to execute a particular task(s) on the behalf of the principal for a given period. It happens in any social, political, economic or legal situation. Principal–Agent Problem, on the other hand, is when the agent’s interest and objectives are not corresponding or not in line with those of the principal. There is no way the principal can monitor the performance of the agent because the agent has more knowledge/information than the principle. Thus causes the agent to act against the principal’s interests given that the principle cannot tell whether the agent is acting as per his interest or not. Analysis The principal-agent problem or rather agency problem is the issue that arise when one party which is the agent is motivated to perform on the principal’s behalf Such a problem do come about in diverse contexts. For instance employees work for their employers, managers on behalf of shareholders and lawyers in the clients’ best interest. Agency problems come up in the event that the motivations between the agent and the principal are imperfectly aligned thereby conflicts of interest arising. Eventually, the agent might be attracted to act in his or her own interest at the expense of the principal’s. In finance as well, conflicts of interest are virtually inescapable. For instance, the agent bears the full cost of placing exertion into the assignment assigned by the principal, yet normally does not get the full advantage that outcomes from these endeavours. This may make a motivation for the operators to invest less exertion into the undertaking than he or she would do if following up on his or her own particular benefit. managers also may assume unreasonable danger on the off chance that they appreciate the advantages of doing as such a high reward if there should arise an occurrence of achievement), yet not the expenses (shareholders and loan agents losing a considerable measure of cash in the event of failure. This sort of 'good peril' is especially applicable to finance and banking industry, and emerges on the grounds that the agents' activities that prompt the increment in danger are not openly discernible. In the banking industry, the Principle - Agency Problem majorly between the (agent) as in management and the (principle) - the shareholder. This Principle – Agent Problem is caused mainly by the principle’s inability to observe and monitor the agent’s work and performance that in turn leads to miscommunication between these two parties. The shareholders/principles hiring these managers/agents to act on their behalf have a significant dare in receiving the managers/agents to act in their best interests. It is because of the likelihood of the manager/agents acting in their interest given that the principle cannot closely monitor them and their performance. However, the principles also sometimes change the "rules" to favour specific actions of their choices neglecting the agent’s interest. This unfair and or insensitive treatment of the agent’s interest and at the same time not monitoring them closely makes them decide to pursue their interest instead of the principle’s interest. There are legitimate reasons in the matter of why the agent can escape without acting to the greatest interest of the principal. Firstly, the expense to the primary of getting rid or rebuffing the agent may be generally too high with respect to the formal. An also, all the more generally relevant, clarification is the vicinity of data asymmetry. Data asymmetry emerges when one party that is the agent is preferable educated over the other (the central). Data asymmetry makes it troublesome or even unthinkable for principals to know whether the agent demonstrations to their greatest interest, particularly if critical variables, (for example, the agents' exertion or capability) are undetectable. The banking and finance industry contains its own particular share of principal–agent problems, a large portion of which were highlighted by the Qatar's financial crisis of 2008. The multifaceted nature of the banking industry makes a situation that is ready for potential incentive clashes. In the keep running up to the financial crisis, bank employees frequently confronted conflicts between the motivating forces made by their pay contracts and their obligation to the shareholders of their organizations. Governments faced strain between its obligation to speak to citizen intrigues and its position of not meddling with private industry. Also, the bailouts themselves produced another important agent’s relationship between bank managers and the citizens whose cash was utilized to balance out their establishments. The unpredictable connections among the different gatherings, consolidated with the thickness of applicable data in every exchange, gave a fruitful rearing ground to principal–agent problems. Moreover, the measure of cash included opened up every individual's motivating forces essentially, making those incentives harder to overlook. Several bank employees were caught up in conflicts between their own motivations and their obligation to their banks' shareholders. Brokers, who assume chance in the interest of bank shareholders, regularly have boundless upside to their rewards, though the shareholders take part similarly in upside and drawback results. This circumstance inspires brokers to assume significantly more hazard than is ideal for the traders. In the course of financial crisis, this misalignment got to be evident, with numerous shareholders getting colossal rewards, despite the fact that their exchanges cut down the very banks for which they met expectations. Just like traders, some bank executives got extensive rewards over the long run outlines that included times of misfortune that wiped out 10 years of former profit. On the other hand, the examination that looks at the relationship between the banks' misfortunes and the basic arrangement of their directors' incentives is blended. A portion of the proof states that the banks that improved in the crisis had management remuneration structures that were better adjusted to the premiums of shareholders. Other examination shows that banks whose executives had motivators firmly adjusted to shareholder premiums really performed more awful. A third stream of exploration has demonstrated that bank CEOs did not move to sell their own property before the emergency, which exhibits that they did not foresee the losses For instance, a Principal-Agent Problem can occur between agencies for rating and the principal-company hiring them to setting a credit for rating. Therefore, since any rating that is low increases the borrowing cost for the company, it has all the reason to rearrange its agency rating in compensation. The agency compensation has to give a higher rating than the one deserved. However, in case the company does not do that, then the rating agency is unlikely to be objective due to the concern of losing prospective business by being strict. However, solutions to this Principle - Agency Problem should exist in bureaucratic rules and incentive pacts or through banking regulations in the form of outer backing. In addition, the nature of the contractual form of banking should call for shared mechanisms of governance in the banks so as investors and the stockholders are included. The primary concern of corporation governance is ensuring managers or rather agents make good use of the resources of the company in order to suit the shareholders (principle) interest. Transparency is predominantly obligatory in the banking industry since the information variances between the foreigners and in-siders are more evident when it is relating to the risks features and the assets ‘quality. Banks owned by more than one shareholder (firms) or federal state authorities (the government) face more Principal-Agent Problems as compared to other banking sectors due to their reluctance in monitoring the bank managers (agents). Naturally, when a group of people are managing a certain activity, each person tends to rely on the other person to do the work unlike when an individual is solely operating that same work. In a group of shareholders/ownership, losses are shared equally thus it is less painful to an individual’s pocket as compared to sole ownership where the shareholder has to shoulder all the expenses “alone”. Accordingly, managers (agents) do show reluctance in risk - taking behaviour as compared to firms’ owners because the managers are not able to diversify their unemployment risk. However, dispersed shareholders have more reasons to behave risk – neutral since they have the ability to diversify their risk by engaging in a large number of projects and by doing that they can easily recover the loss they make in one project from the other projects. The Banking Industry has its share of Principal–Agent Problems. The complexity of the banking industry has created an environment for potential conflicts of interest and moral hazards. Normally, bank employees experience conflicts by the incentives by the compensation agreements and their obligation to the company. Furthermore, the amount of money an individual receives as payment for the services they offer and their loyalty to the bank has a significant influence on that individual’s incentives, making those incentives very hard to ignore. The role of the Banking Industry in funds mobilization, allocation of credit to the relevant economy departments, the settlement and system of payment. Monetary policy implementation, public confidence through respectable business governance remains enthronement of greatest importance in the financial industry. The importance of financial institutions in banking nature and economic system business make their corporate governance issues very specific and so are the possible available measures to curb such problems (Andres and Vallelado (2008). The banking business complexity increases the information CA asymmetry and reduces/minimises on the stakeholders’ ability to monitor bank managers’ decision and performances. It may be in the action form or data. The correlation between agency model and asymmetric information is under default probability conditions. Asymmetric data is likely to affect the investment returns. The main issue here is the insufficient information because owners/stakeholders cannot access all corporate performance information. Therefore, control and the ownership separation brings about, the agency problem. Such problem could be the expectation of managers to represent the external owners' interests. In particular, agency problems may be evaluated by application of the techniques established for financial alternatives, as applied through a real choices context, which can include an incentive to take more risk projects to pay more out in dividends. Recommendations Various systems may be applicable in aligning the agents' interests with the ones of the principal. For instance: commissions, profit sharing, bonuses or salary increments. The government should also take a more active role in 1. Bring into line the interests so that the economic benefits of finance can be realized 2. Refining 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 investment. Most systems concentrate on adjusting the incentives between the principal and the agent. A few systems are focused on lessening the level of data asymmetry. example of adjusting the motivating forces incorporate representative possession plans, official investment opportunities and benefit sharing plans - all carrots - and release, or criminal indictment of extortion sticks. Samples of lessening data asymmetry incorporate the necessary procurement of records; reviewing and observing; and legitimate revelation prerequisites. Also this agency cost can be reduced by capitalising in observing and organising of networks in that agents are obliged to act in the best interest of the principal without requiring further supervision, this can be done by bonuses offering, inducing them to observe each other and the manager bonding or the agent to certain positive results. Also, the payment of stock preferences bring into line more watchfully with the concern of the agents To add to the above, enlightening revelation of data by the banking industry is critical with reverence to risk taking methods, risk management and risk exposure tackles, therefore, is should be significantly considered. Likewise combination the disciplinary part of the business would diminish this motivation issue in two routes: Directly, since regulatory agents would be mindful so as to enhance their hierarchical execution to stay away from the requirement for unwelcome exposure. Moreover, indirectly way given that market teach in managing an account organizations fortifies the general supervisory framework by enhancing bank directors' motivators for careful danger taking. It is a vital condition for enhancing responsibility and accordingly taking care of the motivating force issue. Nonetheless, it is not adequate. Finance industry should likewise be willing to screen administrative execution, and there must be systems set up to teach controllers in the event of poor supervisory execution. Not overlooking that the Principal - Agent Problem is reflected in administration seeking after exercises that are disadvantageous to the enthusiasm of the shareholders of the firm, the office issue in this way must be minimized and could be executed through the assurances got from great corporate administration. At last, yet essentially, an agreement between the foremost and the operators ought to be the sign. The best conceivable understanding would give administrative directors a reasonable and straightforward stake in the advantages and expenses, which their undertaking, i.e. the supervisory organization, creates for citizens. Conclusion In conclusion, financial products and relationships have become so complex and entangled to the extent that people (Agents) tend to use every opportunity they get to enrich and or smoothen their lives at the expense of the principle. Investors and the general public have also noticed that trust both of and within the financial markets have reached very low levels that are has been brought about by the agents putting their interest before the principle’s interest. Asset management compensation structures directly provide managers with incentives that, if not well aligned with those of the stakeholders, can lead to conflicts of interest between the manager and the stakeholder. Additionally, it is almost impossible to evade such conflicts in the financial industry because of acting as an intermediate for customers' other monetary actions and being their financial assets custodian, the agents always have to choose between the challenging interests of others and evaluate them against themselves. This interest conflicts brought about because of the agents trying to provide many services as they can to various parties simultaneously. One should not forget that a sustainable financial system requires a trustworthy reputation, not only for individuals but also for the industry at large. References Andres, P., & Vallelado, E. (2008). Corporate Governance in Banking; The Role of the Board of Directors. Journal of Banking and Finance, 32, 2570 – 2580. Kasum, Abubakar Sadiq, Etudaiye Muthar, Fatima Oyebola and Abdulraheem, Abdulrasheed. Agency problem in corporate governance in the Nigerian banking industry. Kern, A. (June 2004) Cambridge Endowment for Research in Finance University of Cambridge Martin Schüler (2003) Incentive Problems in Banking Supervision Centre for European Economic Research (ZEW), Mannheim, November 2003– The European Case. Okeahalam, C. C., & Akinboade, O. A. (2003). A Review of Corporate Governance in Africa: Litrature, Issues and Challenges. Global Coporate Governance Forum. Rebecca S. Demsetz, Marc R. Saidenberg and Philip E. Strahan (1997). Agency Problems and Risk Taking at Banks. Banking Studies Department, Federal Reserve Bank of New York,September 1997. Sunit N. Shah (2014) The Principal–Agent Problem in Finance (a summary), The CFA Institute Research Foundation. Wilson, I. (2006). Regulatory and Institutional Challenges of Corporate Governance in Nigeria, Post Banking Consolidation. Nigeria Economic Summit Group (NESG) Economic Indicator, 12(2). Read More