1.0 IntroductionThe principal – agent problem is an idea derived from agency theory, formulated by

economists and political scientists, first described by S. Ross in 19731. It usually gets

analyzed and disputed in terms characteristic of those areas of science. In some

aspects, agency theory and problems arising from it may be described as having a

universal impact on social sciences as a whole, whereby just as in game theory, the

incentives attributable to the parties involved may be used to predict people’s

behaviour, design organizational systems and draw contracts between parties.

Therefore, it is not only possible but desirable to discuss agency theory and the

principal – agent problem in terms of law and legal economics, as the tools derived

from analysing the incentives ruling parties’ actions, may help shape legal

relationships2.

Below I will focus on how the principal – agent models are shaped by law and

regulation in companies and their most sophisticated form, banks. I will briefly

describe the principle – agent relationships existing within corporate organizations

first, in order to focus on describing the specific characteristics and problems of

agency based relationships in banks as a notably specific type of company. Finally I

try to suggest how bank regulation and governance may ultimately influence the

shape that these relationships take, minimising the agency risk.

2.0. The Principal – Agent TheoryTo briefly describe what is understood as a principal-agent model, I find it necessary

to state that the framework occurs in any social, political, or legal situation where two

parties align themselves to fit a situation where one party, or the “principal”, with

which authority to act originally lies “hires” or diffuses some of this authority onto

another party, know as the agent. The agent is the party receiving the authority to act

on behalf or in the interest of the originating party. The reason for this alignment from

1 S. Ross, “The Economic Theory of Agency; The Principal’s Problem”, American Economic Review, G3, p 134-1392 K. Eisenhardt, “Agency Theory: An Assessment and Review”, The Academy of Management Review, vol. 14 no. 1(Jan 1989), p. 57-74

the principal’s side, is that the agent will be able to perform the actions handed down

to him in a more efficient way than if the principal would perform them himself.

In a perfect world, where information is spread out efficiently throughout the system,

both the agent’s and principal’s interests would be ideally in tact, so that the agent

would act in perfect accord with the interests of the principal. However, no such

system can be identified in reality. First of all, information in any principal-agent

model will not be shared symmetrically between the parties. This arises as a

consequence of the principal’s delegation of power to the agent. Secondly, however

the agent will be working on behalf of the principal, his interests may not be aligned

to those of the delegating party. Instead he may be tempted to use his powers in order

to satisfy his own interests surpassing those of the principal. There are three main

issues identifiable as risks to achieving an efficient balance in any principal - agent

relationship. These main issues are adverse selection, moral hazard and non –

verifiability. Adverse selection occurs when the agent may come into possession of

information that the principal does not know of. Moral hazard may be described as a

situation where the agent may act against the will of the principal unbeknownst to

him, possibly to the detriment of that principal’s interests. The last problem is when

both parties may own the same information but this remains unknown to any third

person3.

1.2. The Principal – Agent ProblemThe problems mentioned above all may have an influence on how an agency contract

will be performed. A “lemons argument” may be used to describe the possible

dangers implied in agency relationships. According to this idea, when the agent has an

informational advantage over the principal for whom he’s working, he will be

tempted to do two things, first of all hide this advantage so that it wouldn’t get

discovered by the principal and secondly to maximise the profits he makes out of the

relationship. This may be described on the example of a car dealer who trades in

proverbial “lemons” and “peaches”, knowing which car is which this dealer, without

adequate supervision or disclosure duties will not disclose this information to his

customers who are, in this relationship , the principal. Furthermore, this car dealer 3 G. Wood, “Governance or Regulation? Efficiency, Stability and Integrity in the Financial Sector”, Journal of Banking Regulation, vol. 7, no. 1/2 2006, p. 1 - 17

will also try to price all his cars at a relatively similar, but usually artificially high

level in order to further obscure his client’s ability to navigate his way through the

situation. To an economist, this situation is undesirable due to the fact that it creates

inefficiency in the market. To a lawyer, the dealer is committing an act not different

to fraud, by choosing to omit significant information about the service he is

performing to his principal4. Whatever the approach might be this inefficiency will

lead to an unbalanced market. G. Akerlof in his paper suggests that when such an

inefficient market with principal – agent problems is identified, the government as a

party ruling objectively, as if from behind a veil, may introduce regulation that will

effectively “benefit the welfare of both parties”5. The government may introduce

uniform regulation that will systemically adjust the incentives of parties, for example

increasing the effective costs of withdrawing information by the management of a

company from its shareholders, through introducing civil and criminal penalties and

prescribing compulsory disclosure of information to a third party auditor6.

3.0. The principal – Agent Framework in CompaniesWhat gives the above informational asymmetry problem further significance is its

application to relationships within structured organizations and the risks specific to

the relationship that eventually have an influence on the governance of these7. Not all

corporations may be influenced and suffer from the principal – agent problem in the

same way. For example, SMEs8 in general are owner – managed, which makes the

principal agent problem irrelevant. The true significance of the problem becomes

most clear in companies where ownership structure is less concentrated and the

performance of the agent’s duties will regularly mean his privy to specialist and

confidential information. This description suits banks perfectly, as most large banks

are public companies and the management of a bank will constitute daily contact with

specialist information possibly incomprehensible to the principal, but ultimately

desirable by him. What adds significance to the problem is the systemic importance of

banks and their ability to “make or break” a healthy economy. Through their activity

4 G. Akerlof, “The Market for “Lemons” Quality Uncertainty and The Market Mechanism”, The Quarterly Journal of Economics, vol 84, no 3 (August 1970), p. 488 - 5005 G. Akerlof, “The Market…”, p. 4886 See for example S. 489 of Companies Act 2006, relating to the compulsory appointment of third party auditors in public companies.7 E. Douglas, “The Simple Analytics of the Principal – Agent Incentive Contract”, 8 Small and Medium Enterprises, mostly being private companies.

of lending money both on a micro an a large scale they are able to facilitate large

scale corporate investment and support growing consumption by allowing easy access

to credit by retail clients9. Information abuse of agents working within these

organisations on a systemic scale will upset the whole banking system, creating

inefficiencies on an economy – wide scale. If persistent, and unmanaged, it could

possibly lead to banks failing abruptly, in a short period of time that would create

further disturbance to the system10. Authors agree that market exit in itself is does not

constitute a danger to a financial system and in economic terms may even be

identified as healthy as it gives the incentive of introducing market discipline to the

banking system. Most states choose to provide their banking sectors with additional

regulations, and special regimes that enforce stricter rules on these entities, in order to

ensure they are well managed and transparent, not in the aim that market failure as a

whole could be avoided. The goal of regulation rather is to limit the inefficiency of

the market as a whole as identified by the moral hazard in the “lemons” argument11.

3.1. Shareholder – Manager RelationshipThe most commonly recognised principal –agent relationship found in enterprises in

general is the relationship between the shareholders and the management of the

company. This relationship is the most obvious one as it resembles the classic agency

agreement under which the principal gives the authority to act to a party that can

perform the necessary task more efficiently. Residual evidence of these ancient roots

of company law remains to this day in the structural provisions of company law

constituting the members of a company to be the sole organ responsible for

appointment of directors. This basic relationship is clearly visible from an

economist’s perspective. However, when we look at it from a legal point of view it is

no longer this clear, as company directors, once appointed, legally are bound to the

company as a fictional legal person than to the interests of particular shareholders or

as a collective, with a stronger bond. This means that directors’ duties in English law

have a certain duality. Despite the fact that a director’s performance will be assessed

9 K Alexander, R. Dhumale, J. Eatwell, “Global Governance of Financial Systems; The International Regulation of Systemic Risk”, 2006, p. 242 10 G. Wood, ”Governance…” p. 15 – 16 IT should be noted that the failure of a bank that is extended over a long period of time, basically amounting to a slow degradation and eventual disappearance will not create negative effects on the system, in fact may be regarded as strengthening the rest of the economy. Overnight failures, as noted by the author are what creates a negative impact.11 T. Padoa – Schioppa “Regulating Finance”,2006, p. 1 - 2

from a purely principal – agent relationship perspective when his mandate expires and

he will stand for reelection, for the duration of his term, he is bound to follow the

interests of the company first. This is the directors’ fiduciary duty to act in the benefit

of the company12. As observed by some authors this duty should be observed that in

the first order, the company’s profit making needs must be observed. Shareholders

may be thought of only in the second order, even though ultimately it is their profit

the director is working to achieve as the company is only but a commercial entity.

Although directors have a number of other general duties, the one mentioned above is

treated as overarching as it sets a direction in which all other duties ought to be

executed13. To reassume, this basic principal - agent relationship applicable to all

companies will be a simple contract between the directors of a company and its’

shareholders, that once entered into transforms into a relationship where the company

serves as a medium for the performance of the task of shareholder wealth

maximization.

3.2. Other Principal – Agent Relationships in CompaniesHowever, it can’t go unnoticed that a company is much more complicated than just

one principal – agent relationship. By any means, in order to get a glimpse at the true

nature of any company it must be realized that they are in their purest essence a

complex nexus of contracts, with much more than just one agency relationship built

into them. This is because any given company although not a real person will form an

organism performing more than one function, influenced and influencing other actors

in the environment it is set to act14. These obligations will arise out of a number of

principal – agent agreements entered into by the management. First, they will carry

the responsibility towards their company’s creditors. Even though their responsibility

towards the creditors will only become a practical issue, as companies approach

insolvency, the directors will in reality be responsible to perform a task for the

creditors as their principals, this task being to ensure their obligations are performed

to the fullest. In Brady v Brady Nourse LJ expressed the opinion that when a company

12 This rule was expressed for example in Percival v Wright [1902] 2 Ch 421 and incorporated into legislation under Section 172 of Companies Act 2006 as the duty to promote the success of the company. It must be accented that the duty is to promote the company’s success, not that of its’ shareholders.13 S. Griffin, “Company Law; Fundamental Principles”, 2005, p. 313 14 For theories of the firm see O. Hart, “An Economist’s Perspective on the Theory of the Firm”, Columbia Law Review no. 89, p. 1757-1774

arrives at the threshold of insolvency, the interest of the company becomes that of

their creditors15. The management of a company, being in this case the agents of

creditors, may be held personally responsible if an abuse of their informational

advantage is discovered16. The same bond, but with the opposite balance will exist

where a company is itself a debtor. Here it will be the principal in relation to a

different company or person being its creditor, and ultimately agent. It may also be

said that there is a bond between the management of a company and its employees.

Although this view is disputed and employees are generally treated as outsiders under

English law, I can understand that in some way the managers may be understood to

perform tasks on behalf of employees. In this case it would only be appropriate that

the management while performing these tasks avoid abusing their informational

advantage. However the ruling approach to this issue will be that a company’s

employees are always only auxiliary to the company and therefore should not be

treated as principal in a relationship with the management17.

4.0. The Particularity of BanksBanks are essentially intermediaries in the area of finance. They gather capital from

depositors who locate it into their accounts. This capital will constitute for a banks

liabilities. Allowing clients to locate capital in their accounts, banks provide liquidity

to them, simultaneously allowing depositors to pay out their money from accounts

usually whenever they want. A bank’s assets will be the investments a bank makes in

the form of loans and other contractual agreements that put a bank basically in the

position of a provider of capital18.

4.1. Additional Relationships From this basic outline it becomes visible that the principal – agent framework is

more complex than that of other business enterprises. What distinguishes a bank’s

principal – agent framework is that in addition to the standard relationships between

15 [1988] BCLC 20 at p. 40; I can only find reasons for the application of this principle to banks, as well as other companies. It is always the ultimate issue in a bank failure, to secure the payouts of deposits to depositors who are anything if not a banks creditors (even though the actual terms of a deposit contract with a bank are different to those of a credit agreement).16 See for example West Mercia Safetywear Ltd v Dodd [1988] BCLC 25017 See, S. Griffin “Company Law…”, p. 31618 S. Heffernan “Modern Banking”, 2008, p. 1-5

the managers, shareholders, creditors there will be more element s active. Secondly,

because of the nature of a bank’s activity these enterprises are essentially more

sensitive to informational disparities between the parties forming principal- agent

relationships within their structure. Because of the nature of bank activities,

shareholders cannot effectively oversee every decision a bank makes, as this would

render the whole business concept functionally impossible. Depositors in a bank have

very little say as to how the bank invests their funds and find it hard to monitor these

decisions at all. Bank management, does not have the tool s necessary in turn to

influence when depositors will be able to withdraw their funds, essentially leaving

banks prone to “bank runs” and changing moods based on inadequate information.

A depositor will ultimately find himself in a position of a principal in atypical

asymmetric information sharing model where he cannot perform effective supervision

of his funds because of a number of reasons. This is de to a number of reasons, for

example a bank will pool the capital it receives from deposits and diversify it into a

large number of loans to limit losses. However losses will always exist, in order to

supervise him capital the depositor would have to monitor a very large number of

transactions performed by a bank. Also, deposit insurance schemes will further limit

the incentive depositors have for examining a bank’s activities19. Insurance schemes

are however necessary due to the fact that the incentives guiding shareholders’ actions

aren’t exactly in line with their own.

Bank shareholders’ incentives to monitor bank activities will be less limited, as they

have a legitimate expectation of the bank paying out dividends. Their incentives

suffer however from the free – rider problem. They stand a chance to move the risk of

making losses onto the shoulders of the depositors, while personally being responsible

to for any operational losses with only the capital they chose to invest in the form of

share20s. Furthermore, shareholders mostly choose to vote with their feet and focus on

the short term percentage increase in net share worth rather than actual dividend. The

more shares are held by small individual investors the less effective the supervision

19 S. Heffernann “Modern…”, p. 6 – 8. However, most jurisdictions recognise the need for some sort of deposit insurance. The Unites States was first to develop such legislation in 1933. Since then, in 1991 the US have developed the Federal Deposit Insurance Corporation through the Federal Deposit Insurance Corporation and Institutions Act 1991. In the UK the deposit insurance scheme has been instated by the Financial services and markets Act 2000, under part XV of the act.20 K. Alexander “Corporate Governance and banks: The role of regulation in reducing the principal – agent problem”, Journal of Banking Regulation, vol. 7 no. 1/2, 2006, p. 17 - 40

and shareholder influence over management. Furthermore, even the powerful investor

will tend to favor to put an emphasis on best possible performance by his agent,

pushing towards more outcome based contract formulation so that the agent’s

remuneration will be mostly aligned with what profits he effectively stands to make.

The shareholder will have a better informational relationship with his agent than the

depositor, also implementing better reporting measures will increase agency costs to

the shareholders, meaning they would stand to make a smaller profit than if no such

measures were implemented into the banks internal governance systems. The

depositor will only stand to make only a certain predetermined and usually low profit

on the money he invested, he stands a much bigger informational disproportion than

the shareholder. To this group, introducing more behavior - based measures into the

agency contract would be desirable21. In a company that is not a bank this problem of

two principal groups, having different incentives would not occur. In a economic

system where competition among banks is high would, in my opinion, only increase

the shareholder principal group’s incentives to further limit their scrutiny of their

agents focusing on limiting agency costs and improving the final profit outcome of

the management’s activities. This is a point well – observable when the recent bank

crisis in the United States and the UK is observed. The response in the U.S. was to

impose a 90% income tax burden on bank manager’s income paid out in bonuses.

Although this seems like a measure that could greatly limit the application of result –

based agency contracts, I find it to be a comforting half – measure, imposed solely to

console those who find bank managers morally responsible for the recent financial

crisis22. This is because, performance based manager contracts are purely a form of

aligning their interests with those of the shareholders.

Acting as agents in banks, managers invest both considerable amounts of time capital

and reputation, to produce results for shareholders. Although there may exist

problems in the relationship between shareholders and managers, arising from

informational asymmetry and interest issues such as enjoying job – perks or empire

21 ? K. Eisenhardt, “Agency…” p. 57 - 7422 See, BBC NEWS, available at: http://news.bbc.co.uk/2/hi/business/7953869.stm My opinion is based on the fact that the legislature is clearly based on post facto conditions, being the fact that the tax will be imposed on those managers whose institutions have received public help and the managers already receive more than 250, 000USD remuneration already. Rather than being an attempt at changing parties incentives, it seems like the recently passed bill is more of a legislatively designed financial punishment to those managers.

building by managers, there is a basic foothold aligning the interests of both the

parties. This is because in essence managers stand to lose not only the considerable

amounts of time invested in the success of the operations of the bank, but also their

reputation and any future incomes that would come their way if they didn’t take

excessive risks. So there is a reasonable ground to believe that agents in essence may

be more risk averse than their principals in this framework and shareholders may find

it necessary to bring forward incentives for additional risk taking23.

5.0. Governments and the role of regulatorsAs I mentioned before, there is a legitimate and empirically proven need for

government involvement in minimizing the impact of agency problems in some

markets that would otherwise be inefficient and create social costs. In the case of

banks this need for involvement through regulation is evident on due to the role that a

crisis in one bank may spread to other institutions through contagion and onto the rest

of the economy. Bank runs may cause a dramatic loss of confidence in the market by

investors and consumers, causing them to limit their spending, changing habits etc.

leading to a slow down in growth or even an economic recession24. It may therefore

be said that to some extent, the weight of responsibility for the well being of the

whole economy is placed on banks and their management sharing a balanced principal

– agent relationship allowing regulators to spot red flags before an upcoming

meltdown. In the case of privately owned banks, it remains fairly clear that however

the role banks play may be important to the system and therefore to the general

public’s well being and economic success, the general public’s interest in the

performance of banks is identifiable solely as those between institutions and

stakeholders25. However, there are undisputable grounds to assume that there may be

informational disparity leading to moral hazard between regulators and bank owners.

While the regulator will assume a position to instate best practice procedures and

governance rules to limit the possible social costs of risks in bank activity, bank

owners will be prone to designing their principal – agent contracts in ways prompting

23 J. Macey, M. O’Hara, “The Corporate Governance of Banks”, FRBNY Economic Policy Review, April 2003, p. 91 - 10724 S. Heffernan “Modern…”, p. 351- 35825 R. Levine, “Bank Regulation and Supervision”, paper for the National Bureau of Economic Research,2005, available at: http://www.nber.org/reporter/fall05/levine.html

bank managers to take excessive risks. This issue is even more underlined by the

existence of bail – out program procedures and lender of last resort schemes, which

effectively move the most of the risk onto the regulator and effectively the general

public. Systemically important banks will be most prone to this problem26.

5.1. Deposit Insurance and Lender of Last ResortHaving generally outlined the framework of principal – agent relationships that

function in the system of bank corporate governance, I find it necessary to point out to

a some issues. Steps undertaken by governments such as lender of last resort

programs, deposit insurance schemes, seem to perform the function of protecting the

party most at risk from suffering from principal – agent problems. However, these

steps may be criticized as alleviating from suffering any of the consequences of

undertaking excessive risk altogether. Although capital adequacy schemes have

multiple requirements, for example the requirement for the bank’s senior management

to have adequate knowledge of a banks procedures, or the Pillar One requirement for

banks senior management to oversee and approving the risk assessment processes,

they seem to be purely check – boxes for regulators to tick instead of having any

actual binding power27. There seems to be no empirical measure of what constitutes

adequate information of a bank’s operations on behalf of senior management. There is

also no test of what constitutes adequate involvement and understanding of a bank’s

capital rating system. Based on the above, I do not find it out of line to state that

where bank regulation and governance fail, is where it is made to rely too firmly to

rely on its self – fulfilling power.

6.0. Developing Regulation and ReformIf I were to suggest a way of setting up a principal – agent framework for banks I

would focus reform efforts on three issues. These issues are shareholder monitoring

and influence improvement, depositor disclosure improvement and greater regulator

involvement in the daily operations of banks.

26 K. Alexander, “Corporate…”, p. 2127 Basel Committee on Banking Supervision, Pillar One, part 3, H, par. 5, sub. Par. 438 .Quoted in K. Alexander, “Corporate …”, supra note 47

To minimize the chance of moral hazard occuring along the main principal – agent

relationship between shareholder and management, a greater degree of shareholder

activism is necessary. Institutional shareholders should be given greater powers to

monitor the actions of the management. Shareholders owning more than a specified

percentage of shares should be allowed to appoint one director to the board. A

manager appointed this way will be able to know to whom he owes his seat of power,

at the same time being limited by the fiduciary duty of owing loyalty to the

company28. This solution would limit a manager’s incentive for empire building and

the proverbial “easy life”, also aligning each particular manager’s remuneration with

his actual performance and giving the principal a greater incentive to scrutinize it.

Some authors believe that in relation to banks there should a regime limiting the

extent of limited liability of shareholders, so that to limit the extent to which they

might urge their agents to take excessive risks29. Sufficient evidence exists that banks

would perform better under a stricter shareholder liability regime, based on historical

data, but the idea itself seems too outrageous to be accepted into modern into banking

regulation.

Once shareholders’ interests have been given greater attention, the need arises to

counter possible problems that may be caused by the shareholder’s abusing their

comfortable situation and transferring risks towards the depositors. A government

could increase the trust in the system as a whole if greater measures to increase

disclosure towards depositors were to be introduced. Thaler and Sustein have

developed a theory dubbed “libertarian paternalism”. This idea, basing on empirical

evidence, suggests that some rules ought to be designed so that the default option

chosen by most people will maximize social welfare30. An example of such a rule is

that whenever someone would choose to invest money in a bank through opening a

money management account or making a deposit, they should receive a pre –

established set of disclosures about the investment they are making, containing a set

of financial data, historical information, a complete set of information regarding a

bank’s operations in relation to money paid in by any depositor.

28 L. Zingales, „The Future of Securities Regulation”, Center for Economic Policy Research Discussion Papare Series, available at: www.cepr.org/pubs/dps/DP7110.asp29 L. Evans N. Quigley “Shareholder Liability Regimes, Principal Agent Relationships and Banking Industry Performance”,Journal of Law and Economics no.38,1995, p. 498 - 520 30 T. Thaler and C. Sustein, „Libertarian Paternalism”, The American Economic Review, Vol. 93:2, p. 175-179

Finally, in order to ensure that regulators and regulation is even able to have an

influence on the banking sector I believe that a separation of retail banking from

investment banking from the investment banking is a necessity. Furthermore, I

believe that banking institutions should be separated from other financial institutions

and their activities should be strictly numerated, so that financial innovation could

take place in the system through financial institutions, but separately from banks,

effectively cutting these innovations from the scale effect that banks produce in their

activities. A Glass – Steagall Act type legislation would be a significant step towards

ensuring soundness within the system of bank corporate governance31. The basic

critique of such an arrangement is that this would mean that this would limit the

banking sector’s efficiency and profitability. Although this might be true, such an

arrangement would be systemically desirable, as part of a possible macro – regulation

framework that would perhaps limit some profits during “high - times” in the banking

sector, but would also prevent bubbles form occurring or regulators losing touch with

innovation.

7.0. ConclusionIn the area of corporate governance, banks seem to stand out as a subject of research.

Organizationally more complex and more important to the system as they are, they are

also more vulnerable to the imperfections that arise in relations between humans. This

particularity of the principal – agent framework existent in banks leads to a necessity

to ask some specific questions. First, what can be done to banks specifically from a

regulatory perspective to upgrade the efficiency of their operations? Secondly, do

these improvements require a new banking law with a set of hard legislative rules, or

does secondary regulation released by legislative empowered regulators suffice?

Having answered the first question in the preceding paragraphs I wish to focus on the

second issue. The extent to which banks are different from typical companies and

their importance to national and recently also to the global financial systems suggests

that banks deserve to be managed by specific legislation, that would address them

specifically. Most legal systems in the world already have such legislation, addressing

banks as a particular type of company. These legislations should evolve to address 31 Some authors suggest the return of similar legislation in different forms. See : L. Zingales ”The Future…”p. 3

more of the specific issues relating to corporate governance and existing principal –

agent problems experienced by banks.