The standard principal-agent model discussed
in class is bilateral for simplicity’s sake; in the real world the model
functions more often as a triangle with one agent and two clients. The first
example that comes to my mind is that of a stock broker. Here, the broker would
be the agent, and the buyers/sellers of stocks and the firm the broker works
for are both the principals. The agent’s job here is to match either a market
order or a limit order from the buyer to that of the seller. A market order is
the stereotypical way of stock buying. Buyers say how many shares of a stock
they want to purchase and the broker finds a seller for that amount at whatever
the current market price is. This can be risky for the buyer because the market
can fluctuate before the broker is able to find the seller. A limit order is
when the buyer sets a limit price and once the stock falls to that limit or
below the broker can find a seller. This has a lower chance of being executed,
but is safer for the buyer. The same problems can arise when selling a stock. The
more trades the broker can facilitate, the more the firm reaps the benefits.
Also, if the broker can create a trade between clients that use the same firm, the
better off the firm is. For the broker, there is very little moral hazard, they
make trades for the buyers/sellers when a match arises.
The case of a financial manager is
very different. Just like a broker they are the agent of the principal firm and
principal client. However, a financial manager has the power to invest and sell
without the permission of the client. Here is where moral hazard becomes
apparent, and the principals could not see eye to eye regarding the performance
of the agent. The financial advisor could make a lot of trades, which would
benefit the firm and hurt the investor, or the financial advisor could be very
careful with trading and most likely benefit the investor and not the firm. The
solution to resolving this tension relies heavily on the agent. The agent would
have to work very diligently in finding a relatively diverse and high trade
volume that provides good returns on investment. This way the neither principal
is disappointed. Also, if the company is in the market of a particular stock, then it is in the firm’s best interest to push that stock to its clients even if it does not better the client’s portfolio. In this case, the agent should find clients with portfolios that need that particulars stocks properties. Whether it be to further diversify or get into a new market, it should be to benefit that client.
The triangle principal agent case can be seen in any other type of broker such as that of one in real estate. More often than not, the agent has to accommodate two principals. Clearly, this can lead to conflict in which case the agent must diffuse the problem in a manner unbiased to either side.
I think you told this story mostly right, but I'd modify a few things, base on my experience as an investor (and what I know of my parent's experience). When signing on with a financial advisor - general permission is given, a discussion of risk preference happens to serve as a guideline for what type of portfolio should be constructed, but then given that you are right that on particular trades that happens without approval of the client.
ReplyDeleteThe other big deal issue is what the company is required to disclose and whether the disclosure requirements are sufficient to offset the moral hazard you describe. (In my opinion, those requirements are woefully inadequate.) If the financial house makes a market in the security, they are required to disclose that. I do think disclosure in this case works reasonably well. You would not expect the financial house to abuse clients in a particular security that they make a market in, because it would invite the regulators to investigate them.
But if the firm takes a position on a security that some other company makes a market for, then I believe there is no disclosure requirement in this case. Indeed, because the financial markets are so fluid, it is unclear of how a disclosure requirement would work, but as a consequence it gives the company power to act against the client's for its own gain, as you suggest in your penultimate paragraph.
One way some of this might be prevented is if clients could file a class action suit against the company after the fact, and if such suits allowed for punitive damages if the finding when in favor of the clients filing the suit. Absent this sort of potential punishment, I'm not sure how to prevent this sort of moral hazard. Even decent financial managers might engage in unsavory behavior when the market turns soft. Experience suggests that the market can't self-regulate well against this sort of unethical behavior.
Following investments with a class action law suit would definitely be another way to solve this problem. It would keep firms in check as well as allow clients security against any firms that are dishonest. I suppose, the easiest way to fix this problem would be to have all trades be approved by the client prior to the agent acting. The advice the firm and agent provide would still raise some moral hazard, but the necessary approval of the client would limit this.
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