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What is the 'Agency Theory'

The agency theory is a supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving problems that can exist in agency relationships due to unaligned goals or different aversion levels to risk. The most common agency relationship in finance occurs between shareholders (principal) and company executives (agents).

BREAKING DOWN 'Agency Theory'

Agency theory addresses problems that arise due to differences between the goals or desires between the principal and agent. This situation may occur because the principal isn’t aware of the actions of the agent or is prohibited by resources from acquiring the information. For example, company executives may have a desire to expand a business into other markets. This will sacrifice the short-term profitability of the company for prospective growth and higher earnings in the future. However, shareholders that desire high current capital growth may be unaware of these plans.

Contrasting Risk Appetites

Another central issue dealt with by agency theory handles the various levels of risk between a principal and an agent. In some situations, an agent is utilizing resources of a principal. Therefore, although the agent is the decision-maker, they are incurring little to no risk because all losses will be the burden of the principal. This is most commonly seen when shareholders contribute financial support to an entity that corporate executives use at their discretion. The agent may have a different risk tolerance than the principal because of the uneven distribution of risk.

Third Party Relationships

An agency, in general terms, is the relationship between two parties, where one is a principal and the other is an agent who represents the principal in transactions with a third party. Agency relationships occur when the principals hire the agent to perform a service on the principals' behalf. Principals commonly delegate decision-making authority to the agents. Because contracts and decisions are made with third parties by the agent that affect the principal, agency problems can arise.

Other Examples of Principal-Agent Relationships

Agency theory handles numerous situations in which one party acts on the behalf of the other. Financial institutions are given the responsibility of generating shareholder wealth. However, its business practice forces it to incur risk by issuing loans – some of which are outside the comfort level of shareholders. Financial planners and portfolio managers are agents on behalf of their clients and the client’s investments. Finally, a lessee may be in charge of protecting and safeguarding assets that do not belong to themselves. Even though the lessee is tasked with the job of taking care of the assets, the lessee has less interest in protecting the goods than the actual owners.

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