Principal Agent Problem in Banking Industry example

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Principal-Agent Problem in Banking Industry



Principal-Agent Problem Description

The Impact of Principal-Agent Problem

Solutions to Avoid Principal-Agent Problem




In today’s uncertain world, the role of banks is integral for existence of any major economy. Banking system is used for financing of various commercial initiatives, maintaining payments across organizational boundaries, providing multitude of financial services in retail sector and, if required, crediting institutions under difficult market conditions (Kern, 2006). This integral role is also explained with the regulatory approaches applied towards banking industry by state authorities, and debates around the real value which these regulations carry. The regulation over banking industry is required due to the multiplier effect of bank’s activities over the economy and the amount of stakeholders involved into creating this effect. Consequently, banks operate following a set of procedures or standards which are defined based on anticipated economic and operational risks. Stakeholders are interested in appropriate functionality of these standards since their welfare as customers, employees and investors explicitly depends over the health of banking system overall (Kern, 2006).

With changes occurring in the financial world, stakeholders’ interest and associated practices and standards undergo changes and adaptations, which frequently result into conflicts of interests, where mutual benefits become predominant over the practices adopted earlier. Liu (2011) admitted that financial innovation and regulatory dialectic are the most frequent reasons for such conflicts. The more specific term applied towards such conflicts of interests is principle-agent conflict, which exists in many forms in industries other than banking, but is still considered as one of the most frequently occurring in the current. This is particularly noticeable based on the case of recent financial crises, where new emerging forms of principle-agent conflict were identified (Shah, 2014). This paper will provide more detailed description of the recently identified cases of principle-agent problems in banking industry, applying them to the existent financial problems.

Principal-Agent Problem Description

In principal-agent relationships, principal is a person which empowers another person, an agent, to perform a task on behalf of the principal. Ideally, both agent’s and principal’s incentives should be aligned, but the real world scenarios often have different set-up, where agent’s incentives are not aligned with those of a principal. Consequently, agent could act against the principal’s motivation remaining undetected, which is known as principal-agent problem (Shah, 2014). Kern (2006) identified two sources of the principal-agent problem, where the first is aforementioned misalignment of incentives, and the second is imperfect information, which occurs when principal is not successful in observing agent’s work. Divergence of interests is another reason frequently discussed in frames of principal-agent problem, which concerns over alignment of individual goals perceived by principal and agent. If …

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