What is agency theory?
Agency theory is a principle used to explain and solve problems in the relationship between business principals and their agents. Most commonly, the relationship is between a shareholder as a principal and an executive of the company as an agent.
- Agency theory seeks to explain and resolve disputes about their respective priorities between principals and their agents.
- Principals rely on agents to carry out specific transactions. As a result, there are differences in priorities and method agreements.
- The difference in priority and interests between agents and principals is known as the principal agent problem.
- Eliminating the difference in expectations is called “reducing agency loss.”
- Performance-based rewards are one method used to balance principals and agents.
- Typical principal-agent relationships include shareholders and management, financial planners and their clients, and borrowers and lenders.
Understand agency theory
An agency is, in a broad sense, a relationship between two parties, where one agent represents the other principal in everyday transactions. The principal or principal hires an agent to perform services on behalf of the agent.
The principal delegates decision-making authority to the agent. Many decisions that financially affect principals are made by agents, which can lead to disagreements, as well as differences in priorities and interests. Agency theory assumes that the interests of principals and agents are not always in line. This is sometimes referred to as the principal agent problem.
By definition, the agent is using the principal’s resources. The principal deposits money, but has little or no daily input. The agent is the decision maker, but the loss is borne by him, so there is little or no risk.
Financial planners and portfolio managers are agents on behalf of the principal and are responsible for the principal’s assets. The lessee may be responsible for protecting and protecting assets that do not belong to him. The lessee is in charge of managing the property, but the lessee is less interested in protecting the goods than the actual owner.
Areas of controversy in agency theory
Agency theory deals with conflicts that occur in two main areas. Differences in goals or risk aversion.
For example, corporate executives may want to expand their business into new, high-risk markets with a view to short-term profitability and high compensation. However, this can pose an unreasonable risk to shareholders who are most interested in long-term earnings growth and rising stock prices.
Another central issue often addressed by agency theory involves an incompatible level of risk tolerance between principals and agents. For example, bank shareholders may object to management setting too low a loan approval standard and the risk of default being too high.
Reduce agency losses
Various supporters of agency theory have suggested ways to resolve disputes between agents and principals. This is called “reducing agency losses.” Agency loss is the amount of money that an agent claims to have lost because he or she acted against his or her interests.
The most important of these strategies is to provide incentives to business owners to maximize the profits of their principals. Stock options awarded to company executives have their roots in agency theory. These incentives are looking for ways to optimize the relationship between principals and agents. Other practices include partially linking executive compensation to shareholder interests. These are examples of how agency theory is used in corporate governance.
These practices have led to concerns that management endangers long-term company growth in order to boost short-term profits and their own wages. This is common in budget planning. Budget planning helps management reduce annual budget estimates to ensure that performance goals are met. These concerns have partially deferred executive compensation, creating yet another compensation scheme that is determined according to long-term goals.
These solutions are similar to relationships with other agencies. Performance-based rewards are one example. The other is to require the deposit to be posted to ensure that the desired result is provided. And there is a last resort. It’s just dismissing the agent.
What controversy does agency theory deal with?
Agency theory deals with conflicts that occur in two main areas. Differences in goals or risk aversion. Management may want to expand their business into new markets, focusing on short-term profitability and high-paying prospects. However, this may not work for more risk-averse shareholder groups who are most interested in long-term earnings growth and rising stock prices. Also, there can be incompatible levels of risk tolerance between the principal and the agent. For example, bank shareholders may object to management setting too low a loan approval standard and the risk of default being too high.
What is the Principal Agent Problem?
The principal-agent problem is a priority conflict between individuals or groups and representatives empowered to act on their behalf. Agents may act in ways that are contrary to their best interests. Principal-agent problems are as diverse as the possible roles of principals and agents. This can happen in any situation where ownership of an asset or principal delegates direct control of that asset to another party or agent. For example, homebuyers may suspect that realtors are more interested in fees than buyers’ concerns.
What are the effective ways to reduce agency losses?
Agency loss is the amount of money that an agent claims to have lost because he or she acted against his or her interests. The most important strategy for resolving disputes between agents and principals is to provide incentives to business owners to maximize the interests of principals. The stock options awarded to company executives have their roots in agency theory and seek to optimize the relationship between principals and agents. Other practices include partially linking executive compensation to shareholder interests.