resilience, not stability

Information Asymmetry and the Principal-Agent Problem

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Information Asymmetry is often held as the cause of many agency problems. The most famous such study is Akerlof’s “Market for Lemons”. Many recent studies have pinned the blame for aspects of the recent financial crisis on information asymmetry between various market participants. On the face of it, this view is hard to dispute. The principal-agent problem is pervasive in financial institutions and markets – between shareholders and CEOs, CEOs and traders, shareholders and bank creditors, and between banks and their clients.

Monitoring and Incentive Contracts

In most circumstances, market participants find ways to mitigate this principal-agent problem. In the case of simple tasks, monitoring by the principal may be enough. Unfortunately, many tasks are too complex to be monitored effectively by the principal. Comprehensive monitoring can also be too expensive.

Another option is to amend the contract between the principal and the agent so as to align their interests. Examples of this are second-hand car dealers offering warranties, bonds carrying covenants, bank bonuses being paid in deferred equity rather than cash etc. This approach is not perfect either. There are limits to how perfectly a contract can align interests and agents will arbitrage imperfect contracts to maximise their own interests – again Goodhart’s Law in operation. In fact, firms frequently discover that contracts that seem to align principal and agent interests have exactly the opposite effect. As a seminal paper in management theory puts it, “the folly of rewarding A, while hoping for B” . In the absence of a “perfectly aligned” contract, a close proxy (A) of the real objective (B) may make things worse.

At this point, it is worth noting that the imperfect nature of contracting and monitoring does not necessarily mean that the principal-agent relationship will break down. In many contracts, a small amount of moral hazard may not significantly reduce the economic benefit derived by the principal .

The Option To Walk Away

If the loss due to information asymmetry is too large despite all available contractual arrangement, then the principal always retains the option to walk away. This is of course Akerlof’s conclusion as well. In his example on health insurance for people over the age of 65, he notes that “no insurance sales may take place at any price.”

In the context of a repeated game where the principal and agent transact regularly, merely the existence of the option to walk away can mitigate the principal-agent problem. For example, let’s replace the used-car seller in Akerlof’s analysis with a fruit-seller. Even if a buyer of fruits has no knowledge of fruit quality, the seller will not sell him “lemons” as the buyer can always walk away. The seller is incentivised to maximise profits over the series of sales rather than one sale.

It is puzzling that many recent studies of the crisis neglect this option to walk away. For example,

  • For example, Richard Squire analyses the asymmetric risk incentive facing shareholders in AIG and concludes that it is not cost-effective for creditors to monitor shareholders and therefore, the problem persists. But if this is indeed the case, the optimal course of action for creditors is to simply walk away.
  • Arora, Borak et al conclude that banks that structure and sell CDOs can cherry-pick portfolios to include lemons in a manner undetectable by the buyer of the CDO.

I must stress that I am not disputing the arguments presented in either paper. But the information asymmetry problem cannot be the basis of a persistent, repeated principal-agent problem. Market mechanisms do not guarantee that no mistakes are made. However, they do ensure that repeated mistakes are unlikely. As the saying goes, “Fool me once, shame on you; fool me twice, shame on me.”

Indeed the break-down in the CDO market may simply be a case of the buyer having walked away. In the case of AIG, creditors have not walked away primarily due to the near-explicit guarantee accorded to them by the United States government.

Creditors have not walked away because of the guarantee of the state. Clients have walked away from complex products in many cases. But what about bank shareholders who have suffered so much in the crisis? Why have they not walked away from the sector? The answer lies in the implicit/explicit guarantee provided to bank creditors that is essentially a free lunch courtesy of the taxpayer. As I discussed in the conclusion to an earlier note:

“Principal-agent problems and conflicts between the interests of shareholders, managers and creditors are inherent in each organisation to some degree but usually, the stakeholders develop ways to mitigate such problems. If no such avenues for mitigation are feasible, they always retain the option to walk away from the relationship.

This dynamic changes significantly in the presence of a “free lunch” such as the one provided by creditor protection. In such a case, not walking away even after suffering losses is an entirely rational strategy. Each stakeholder has a positive probability of capturing part of the free lunch in the future even if he has not been able to do so in the past. In fact, shareholder optimism may well be proven correct if significant compensation restrictions are imposed on the entire industry and this increases the share of the “free lunch” flowing to them.”

The free lunch subsidy of “Too Big to Fail” and deposit insurance takes away the option to walk away, not only in the context of bank creditors but also in the context of other principal-agent problems within the industry. The problems of asymmetric information are thus allowed to persist at all levels in the industry for far longer periods than would be the case otherwise.

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Written by Ashwin Parameswaran

December 28th, 2009 at 6:21 am

2 Responses to 'Information Asymmetry and the Principal-Agent Problem'

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  1. […] Apart from not being applicable to investors who are not agents, it neglects the principal’s option to walk away. A much better explanation that I mentioned here and here is the role of extended periods of […]

  2. […] an earlier note, I discussed how monitoring and incentive contracts can alleviate the asymmetric information […]

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