Understanding the Agency Problem Minimizing the agency problem

1. Name: Fahmida Haque Shorna
ID: 4104051
Major: Finance
Level: 4, Term: 1
Assignment Topic: Agency problem & how it can be minimized?
Agency problem:
The agency problem is a conflict of interest inherent in any relationship where one party is
expected to act in another's best interests. In corporate finance, the agency problem usually
refers to a conflict of interest between a company's management and the company's
stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed
to make decisions that will maximize shareholder wealth even though it is in the manager’s
best interest to maximize his own wealth.
Understanding the Agency Problem:
The agency problem does not exist without a relationship between a principal and an agent.
In this situation, the agent performs a task on behalf of the principal. Agents are commonly
engaged by principals due to different skill levels, different employment positions or
restrictions on time and access. For example, a principal will hire a plumber the agent to fix
plumbing issues. Although the plumber‘s best interest is to collect as much income as
possible, he is given the responsibility to perform in whatever situation results in the most
benefit to the principal.
The agency problem arises due to an issue with incentives and the presence of discretion in
task completion. An agent may be motivated to act in a manner that is not favorable for the
principal if the agent is presented with an incentive to act in this way.
Minimizing the agency problem:
Agency costs are a type of internal cost that a principal may incur as a result of the agency
problem. They include the costs of any inefficiency that may arise from employing an agent
to take on a task, along with the costs associated with managing the principal-agent
relationship and resolving differing priorities. While it is not possible to eliminate the agency
problem, principals can take steps to minimize the risk of agency costs.

2. Regulations
Principle-agent relationships can be regulated, and often are, by contracts, or laws in the case
of fiduciary settings. The Fiduciary Rule is an example of an attempt to regulate the arising
agency problem in the relationship between financial advisors and their clients. The term
fiduciary in the investment advisory world means that financial and retirement advisors are to
act in the best interests of their clients. In other words, advisors are to put their clients'
interests above their own. The goal is to protect investors from advisors who are concealing
any potential conflict of interest.
Incentives
The agency problem may also be minimized by incentivizing an agent to act in better
accordance with the principal's best interests. For example, a manager can be motivated to act
in the shareholders' best interests through incentives such as performance-based
compensation, direct influence by shareholders, the threat of firing or the threat of takeovers.