# Principal-Agent Relationship: What It Is, How It Works, and New Developments

> **Definition**
>
> The principal-agent relationship is a legal, fiduciary relationship in which one party takes on responsibility for acting on behalf of another.

The principal-agent relationship is a formal relationship at the center of the financial world. The agent acts on behalf of the principal and should not have a conflict of interest in carrying out the act. The relationship between the principal and the agent is referred to as the "agency" and the law of agency establishes guidelines for such a relationship.

Planners giving advice, fund managers investing your capital, and exchange managers overseeing specific markets are all agents acting on your behalf. Grave problems often follow should the relationship go awry. It's thus crucial to understand when investing. Most modern political arrangements involve principals (voters) and agents (representatives), so it's also a major political concern as well.

### Key Takeaways

*   A principal appoints an agent to act on their behalf and in their best interest. Examples include an investor choosing a fund manager or someone hiring an attorney for legal work. 
*   There should be no conflict of interest between the two. It creates a principal-agent problem if there is one.
*   The principal-agent relationship is expressed clearly in a written contract or is implied through duties and actions.
*   New developments in this area include the rise of ML and AI which often mean that there aren't just differences in what agents and principals know but also between what agents know and what these systems are doing.

![Principle-Agent Relationship: An arrangement in which one entity legally appoints another to act on its behalf.](https://www.investopedia.com/thmb/glANjlXvBfYGkQyAIHnUAHeiG0Q=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/principal-agent-relationship.asp-final-90cb73bbf44d4cd6b630c126c0070dc0.png)

*— Investopedia / Joules Garcia*

## How a Principal-Agent Relationship Works

A principal-agent relationship is often described as implicitly or explicitly contractual. Investors are the principals when they buy shares of an index fund and the [fund manager](https://www.investopedia.com/terms/f/fundmanager.asp) is the agent. The index fund manager must manage the fund which consists of many principals' assets in a way that will maximize returns for a given level of risk following the fund's prospectus.

> **Important**
>
> Agents have an obligation to perform tasks with a certain level of skill and care and may not intentionally or negligently complete the task in an improper manner.

Any willing and able parties can enter into the principal-agent relationship in a legal transaction. The principal within the relationship is an individual who assigns an agent to carry out a task in simple cases. Other such relationships have principals that include corporations, nonprofits, government agencies, or partnerships.

The agent should be capable of understanding and ultimately carrying out the task assigned by the principal. Common examples include hiring a contractor to complete a repair on a home, retaining an attorney to perform legal work, or asking an investment advisor to diversify a portfolio of stocks.

Some common examples from finance and investing include:

1.  Shareholders (principals) and corporate executives (agents)
2.  Investors (principals) and fund managers (agents)
3.  Bondholders (principals) and company management (agents)
4.  Banks (agents) and depositors or regulators (principals)

## Fiduciary Relationship

It [creates a fiduciary relationship](https://www.investopedia.com/ask/answers/041315/what-are-some-famous-scandals-demonstrate-agency-problem.asp) between the parties involved whether the principal-agent relationship is expressed clearly through a written contract or implied through actions. The agent acting on behalf of the principal must carry out the assigned tasks with the principal's best interest as a priority.

The agent handles tasks the principal gives provided that the principal provides reasonable instruction. The agent also must perform tasks in a manner that won't intentionally harm the principal. A duty of loyalty is implied within the principal-agent relationship which requires that the agent refrain from putting themself in a position that creates or encourages conflict between their interest and the principal's interest, also known as the principal-agent problem.  

## The Principal-Agent Problem

The [principal-agent problem](https://www.investopedia.com/terms/p/principal-agent-problem.asp) arises when one party (the agent) acts on behalf of another (the principal) in a situation where their incentives may not be perfectly aligned and where there's asymmetric information. This concept has become central to modern economic and financial theory. It emerged from the convergence of two lines of study: the examination of how firms actually operate, not just how economics said they did, and academics exploring risk-sharing among groups.

### Origins and Development

The study of the principal-agent problem evolved significantly in the late 20th century. As Ronald Coase noted in his seminal 1937 paper "The Nature of the Firm," economists had to focus their analysis at the firm level rather than at the industry level. This shift led to a deeper examination of individual worker incentives and the conflicts that might arise within organizations.

Scholars such as Stephen Ross, Michael Jensen, and William Meckling had helped create the study of [agency theory](https://www.investopedia.com/terms/a/agencytheory.asp) by the 1970s. Jensen and Meckling published a 1976 paper that gave us the agency definition that most use.

Two ingredients are necessary for a principal-agent problem to exist, according to agency theorists:

*   **Conflicting incentives**: The interests of the principal and the agent must not be perfectly aligned.
*   **Information asymmetry**: The agent must have access to information that the principal doesn't have and the principal must be unable to thoroughly monitor the agent's actions. You hire someone and can't always tell what they're doing.

The problem is obvious when both these conditions are met: The agent has incentives and the ability to act in their interest without immediate accountability.

The financial sector is particularly susceptible to principal-agent problems because of its complex, interconnected nature and the prevalence of risk-sharing arrangements. Agents clearly often have incentives to take actions that benefit themselves at the expense of the principal in financial relationships, such as excessive risk-taking, short-term focus at the expense of long-term value, or misuse of resources.

### Can Ethics Be Taught?

A famous survey made headlines in 2013 when it found that many on Wall Street saw unethical conduct daily and that executives were the most likely to think they couldn't get ahead without it.

A 2020 follow-up study to 2010 changes in the investment adviser qualification exam which added sections on adviser ethics found that advisers who passed those sections had fewer reports of misconduct later than those who didn't have to study that area.

### Trust and Financial Advisors

This is why trust is central to investors' relationships with financial advisors, lenders, planners, and others. "There’s nothing in life we do, no decision we make, that doesn’t have to do with money in some way," said [Valerie R. Leonard](https://www.investopedia.com/inv-100-top-financial-advisors-7556227), CEO of EverThrive Financial Group in Birmingham, Alabama. "If clients don’t believe they can trust you…they will never do business with you. It’s really that simple."

So what fosters trust between a client and their financial advisor? "Throughout my career, I’ve recognized that clients must buy into our relationship before they can buy into my services. They need to know that I genuinely care about them, that they can rely on me to do what I say I’m going to do, and that I’m willing to be open and honest about who I am," Leonard said. 

### Challenges and Solutions

Addressing principal-agent problems often involves finding creative ways to align [incentives](https://www.investopedia.com/terms/i/incentive-fee.asp) and reduce information asymmetry. Standard approaches include the following:

1.  Performance-based compensation
2.  Behavioral finance training to better align incentives
3.  Increased monitoring and reporting requirements
4.  Governance structures that provide oversight
5.  Laws and regulations that enforce fiduciary duties, that is, provide grave sanctions to counteract profit-seeking incentives among agents

You'll notice that many of the above have come about in the years since agency theory was introduced. These solutions aim to do more than bolster the trust of clients. They're intended to work when there is none at all.

New challenges in managing principal-agent problems continue to emerge as financial markets and instruments become increasingly complex, requiring a rethinking of these traditional approaches.  

## New Developments in the Principal-Agent Relationship

Recent advances in AI and [ML](https://www.investopedia.com/terms/m/machine-learning.asp) are reshaping the landscape of principal-agent relationships in finance, introducing novel challenges for regulators and clients. ML-based trading systems have received significant attention and broader AI applications and regulatory shifts are also transforming how financial institutions operate and are governed.

### Machine Learning and Automated Trading

ML-based trading systems are reconfiguring traditional principal-agent relationships. These systems use complex mechanisms like [deep neural networks](https://www.investopedia.com/terms/n/neuralnetwork.asp) to develop trading rules that are internally based on data inputs. This shift introduces new forms of knowledge risk such as how much the agent knows about what the principal is doing as well and limits how the principal can change trading when directed by the agent. It obscures the decision rules used by automated systems.

Specialists have previously suggested more robust contracts to cover issues that might arise or better regulations in this area to address how incentives between principals and agents often diverge. These solutions don't apply in these new spaces.

As the [economic sociologist](https://www.investopedia.com/economic-sociology-5248697#:~:text=Economic%20sociologists%20conceive%20of%20economic,and%20markets%20as%20social%20systems.) Christian Borsch puts it, "Conventional solutions to principal-agent problems can't easily address \[the issues with ML systems\]. For example, given the opacity of these systems, better-designed contracts between the principal and agent or more deterministically construed relationships \[that is, computer programmers directing applications\] between them offer no viable solutions."

Not even computer scientists who develop AI and deep neural networks know precisely how the algorithmic processes arrive at specific decisions or results. Investors have their concerns: 74% of retail investors trust human advice over robo-led advice.

The issue is "jarring enough" regarding the issues raised in finance, as Borsch puts it, but ML systems are also being applied in medicine, where principal-agent relationship issues also arise.

### Broader AI Applications in Finance

AI has been deployed across various financial services, each with its own principal-agent implications:  

*   **Credit scoring and lending**: AI algorithms are increasingly used in credit decisions, potentially reducing human bias but also raising concerns about transparency and fairness in lending practices or giving the appearance that objectivity in the ML system was trained on structurally biased data.
*   **Fraud detection**: AI systems enhance the ability to detect financial fraud but their effectiveness relies on the quality of data and the alignment of incentives between financial institutions and their technology providers.
*   [**Robo-advisors**](https://www.investopedia.com/terms/r/roboadvisor-roboadviser.asp): AI-powered investment advisory services are changing the relationship between financial advisors and clients. These systems promise more objective, data-driven advice but they raise questions about fiduciary responsibility and the role of human judgment.

### Blockchain and Decentralized Finance (DeFi)

The rise of blockchain technology and DeFi platforms are also said to introduce new issues and potential solutions for classic principal-agent relationships:

*   **Smart contracts**: These self-executing contracts have the terms directly written into code and supposedly cut the need for intermediaries in some financial transactions, potentially minimizing certain types of agency conflicts.
*   **Decentralized autonomous organizations**: These blockchain-based entities operate through community governance, presenting a novel approach to aligning stakeholder interests.

### Regulatory Responses and "Ethical AI"

The rise of AI in finance has prompted regulators to reconsider how oversight is done.

*   **Explainable AI**: Regulators and researchers emphasize the need for "explainable AI" in financial services that would enable institutions to interpret and justify AI-driven decisions. This push addresses the "black box" problem inherent in many complex AI systems. It's one thing to understand that there's a problem, however. It's been quite another to render AI explainable, at least so far. It's a black box problem, after all, especially when financial institutions that are ill-suited to understanding such systems are involved.
*   **AI governance**: Financial institutions are developing internal governance specifically for AI deployment, aiming to align AI systems with organizational values and regulations.
*   **Ethical AI principles**: There's a growing focus on incorporating ethical considerations into AI development and deployment in finance, addressing issues like bias, fairness, and societal impact.

### Changing Compensation Structures

The financial industry is also seeing shifts in how human agents are compensated:

*   **Longer-term incentives**: Some institutions are changing how agents are compensated to better align rewards with longer-term performance metrics in response to criticisms of "short-termism" that agents are often given greater incentives to pump up short-term results.
*   **Environmental, social, and governance (ESG)-linked incentives**: [ESG](https://www.investopedia.com/terms/e/environmental-social-and-governance-esg-criteria.asp) factors are often incorporated into executive compensation packages, aligning management incentives with broader societal goals.
*   **Team-based incentives**: Recognition of the collaborative nature of modern finance is leading to more team-based compensation structures, potentially mitigating some of the individual-level agency problems.

## What Is a Principal-Agent Problem and How Can It Be Avoided?

A principal-agent problem is a conflict in priorities or goals between someone who owns an asset, the principal, and the person appointed to control the asset, the agent. Conflicts of interest can cause this problem so carefully designing contracts and setting up regular performance evaluations are key to limiting issues.

## Why Do Principals Hire Agents?

A principal may hire an agent and begin a principal-agent relationship for several reasons. One is that the principal may not have enough time to handle any tasks they've given over to the agent for handling. Another is that the agent may have specialized skills that allow them to be more effective at accomplishing a particular task.

## What Happens When an Agent Doesn't Act As a Fiduciary?

Fiduciaries accept a legal responsibility to act in the best interest of the person for whom they're working. An agent can face monetary damages if they don't fulfill their fiduciary duty to the principal and act instead in their own interest.

## The Bottom Line

The principal-agent relationship is a fundamental concept in finance and economics that occurs when one party (the agent) acts on behalf of another (the principal). This arrangement is ubiquitous in the financial world, from corporate executives managing companies for shareholders to fund managers investing on behalf of clients.

These relationships are essential for the functioning of modern finance but they have the inherent potential for conflicts of interest. The principal-agent problem arises when the agent's incentives don't perfectly align with those of the principal and when the principal can't fully monitor or understand the agent's actions.

Recent technological advances in AI and ML are reshaping these relationships in profound ways. Traditional methods of aligning incentives and ensuring accountability are being challenged as decision-making becomes increasingly automated and opaque.

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