Agency Theory

What Is Agency Theory?

Agency theory is a principle that is utilized to make sense of and resolve issues in the relationship between business principals and their agents. Most commonly, that relationship is the one between shareholders, as principals, and company executives, as agents.

Grasping Agency Theory

An agency, in broad terms, is any relationship between two parties wherein one, the agent, addresses the other, the principal, in everyday transactions. The principal or principals have recruited the agent to perform a service for their sake.

Principals delegate dynamic authority to agents. Since numerous choices that influence the principal financially are made by the agent, differences of assessment, and even differences in needs and interests, can emerge. Agency theory expects that the interests of a principal and an agent are not generally in arrangement. This is at times alluded to as the principal-agent problem.

By definition, an agent is utilizing the resources of a principal. The principal has entrusted money however has practically no everyday information. The agent is the leader however is bringing about almost no risk in light of the fact that any losses will be borne by the principal.

Financial planners and portfolio managers are agents in the interest of their principals and are given responsibility for the principals' assets. A lessee might be in charge of protecting and defending assets that don't belong to them. Even however the lessee is entrusted with the job of dealing with the assets, the lessee has less interest in protecting the goods than the actual owners.

Areas of Dispute in Agency Theory

Agency theory addresses disputes that emerge essentially in two key areas: A difference in objectives or a difference in risk aversion.

For instance, company executives, with an eye toward short-term profitability and raised compensation, may want to extend a business into new, high-risk markets. In any case, this could represent an outlandish risk to shareholders, who are generally worried about the long-term growth of earnings and share price appreciation.

One more central issue frequently addressed by agency theory includes inconsistent levels of risk tolerance between a principal and an agent. For instance, shareholders in a bank might protest that management has set the bar too low on loan endorsements, subsequently facing too great a risk challenges defaults.

Lessening Agency Loss

Different advocates of agency theory have proposed ways of settling disputes among agents and principals. This is termed "diminishing agency loss." Agency loss is the amount that the principal fights was lost due to the agent acting in opposition to the principal's interests.

Chief among these strategies is the offering of incentives to corporate managers to boost the profits of their principals. The stock options granted to company executives have their starting point in agency theory. These incentives look for a method for streamlining the relationship among principals and agents. Different practices remember binds executive compensation for part to shareholder returns. These are instances of how agency theory is utilized in corporate governance.

These practices have prompted worries that management will imperil long-term company growth to help short-term profits and their own pay. This can frequently be seen in budget planning, where management decreases gauges in annual budgets so they are guaranteed to meet performance objectives. These worries have prompted yet another compensation scheme in which executive pay is partially deferred and to be determined by long-term objectives.

These arrangements have their equals in other agency relationships. Performance-based compensation is one model. Another is requiring that a bond is posted to guarantee delivery of the ideal outcome. And afterward there is the last resort, which is basically terminating the agent.

Features

• Common principal-agent relationships incorporate shareholders and management, financial planners and their clients, and lessees and lessors.
• Agency theory endeavors to make sense of and resolve disputes over the individual needs among principals and their agents.
• It is called "decreasing agency loss to Resolve the differences in expectations."
• Performance-based compensation is one way that is utilized to accomplish a balance among principal and agent.
• Principals depend on agents to execute certain transactions, which brings about a difference in agreement on needs and methods.
• The difference in needs and interests among agents and principals is known as the principal-agent problem.

FAQ

What Is the Principal-Agent Problem?

The principal-agent problem is a conflict in needs between a person or group and the representative authorized to act for their benefit. An agent might act in a manner that is in opposition to the best interests of the principal. The principal-agent problem is basically as shifted as the potential jobs of principal and agent. It can happen in any situation in which the ownership of an asset, or a principal, designates direct control over that asset to another party, or agent. For instance, a home buyer might think that a realtor is more interested in a commission than in the buyer's interests.

What Disputes Does Agency Theory Address?

Agency theory addresses disputes that emerge principally in two key areas: A difference in objectives or a difference in risk aversion. Management might want to grow a business into new markets, zeroing in on the prospect of short-term profitability and raised compensation. Be that as it may, this may not sit well with a more risk-unwilling group of shareholders, who are generally worried about long-term growth of earnings and share price appreciation.There could likewise be contradictory levels of risk tolerance between a principal and an agent. For instance, shareholders in a bank might protest that management has set the bar too low on loan endorsements, in this way facing too great a risk challenges defaults.

What Are Effective Methods of Reducing Agency Loss?

Agency loss is the amount that the principal battles was lost due to the agent acting in opposition to the principal's interests. Chief among the strategies to determine disputes among agents and principals is the offering of incentives to corporate managers to boost the profits of their principals. The stock options granted to company executives have their starting point in agency theory and look to enhance the relationship among principals and agents. Different practices remember binds executive compensation for part to shareholder returns.