Principal-Agent Problem, Free-Rider, Balance Sheets: Examining Equity Contracts - Essay Sample

Introduction

In this paper, four major concepts will be discussed. The first part will look into details the concept of the principal-agent problem and how it relates to equity contracts. In the next section of the assignment, the concept of free-rider will be discussed in details and the reasons as to why this problem occurs in the debt market. Thirdly, it will look at a case of a balance sheet and suggest a possible decision to be taken by the bank manager if there was to be an unexpected deposit outflow of $50 million.

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The Principal-Agent Problem As It Pertains To Equity Contracts

The principals are the stakeholders who own the majority of equity in a firm. They are the major shareholders in a firm, and they hire the agents whose role is to manage the firm and ensure profitability while owning only a small percentage of the firm (Kang & Liu, 2010). Equity contracts are the claims to a share in assets and profits of a firm, and they are generally subject to the principal-agent problem, which is a moral hazard. Managers who run the firms are only owners of a fraction of the shares or the firm they manage, and they are the agents of the owners who are another different people, but who own the majority shares of the fir. A moral hazard is involved due to the separation of the ownership and control of the firm since the agents who are the managers in control of the firm would act in their interest and not entirely in the interest of the owners or the principal (Kang & Liu, 2010). The incentives of the agents (managers) in the maximization of profits is less than that of the owners since they only take home a little fraction of the profits made.

The principal-agent problem occurs when the agent solely acts in his interest, ignoring the interest of the principals. The principal legally appoints the agent in any principal-agent relationship, and the agent must act fully in the interest of the principal. Principal-agent problems in equity contracts usually occur due to a varied number of reasons. The primary cause is the conflict of interests between the two parties due to the asymmetric position of information whereby the agents tend to possess more information as opposed to the principles. The problem in most cases result in agency cost, a cost incurred by the principals and which results from the principal-agent problem. As a result, this problem is referred to as a moral hazard since agents can act in their interests, but at the expense of the principals.

The Reason Why the Free-Rider Problem Occur In the Debt Market

By definition, a free-rider problem is a burden that arises when a resource is shared, and the use of the resource is by people who do not pay their fair share or do not pay anything at all for it (Tufekci, 2014). The problem is capable of occurring in any setup or community regardless of its size. In economics, the free-rider is an issue too and is considered as one of the market failure examples. In economics, the free-rider problem arises when there is an inefficient distribution of services and goods, and individuals are allowed to consume disproportionate to their fair contribution of the shared resource or pay less than they ought to do as per their fair share of the cost. Through free riding, the production and consumption of goods and services through the methods of the current free market could be limited. There is little or no incentive to the free-rider as to why they should contribute to the collective resource because they are in a position to enjoy their benefits even without contributing towards it (Tufekci, 2014). Consequentially, there cannot be sufficient compensation to the person producing the resource. If in some other way the shared resource does not get subsidized, then it might end up not getting produced.

According to Kovela & Skok (2015), businesses should not voluntarily produce goods or services under such conditions, and if the free-rider problem looms, the company should back away. There are two chances, either a public agency should provide the shared resource using taxpayer money, or resource will not be provided. In debt markets, there are restrictive covenants that may reduce moral hazard, but for them to be effective, such covenants have to be monitored and enforced. Bondholders may become free riders if they realize that other bondholders monitor and reinforce the restrictive covenants on their behalf (Tufekci, 2014). Other bondholders may copy the same and free ride, resulting in a situation where there are not enough resources dedicated to monitoring and enforcing restrictive covenants.

Your bank has the following balance sheet.

Assets

Reserves $50 million

Securities $50 million

Loans $150 million

Liabilities

Checkable deposits $200 million

Bank capital $50 million

Table SEQ Table \* ARABIC 1: Bank balance sheet

The Action to Be Taken By the Bank Manager If There Is an Unexpected Deposit Outflow of $50 Million

The bank will have a reverse shortfall of $15 million after the deposit outflow. One of the actions that could be taken by the bank manager is to try borrowing from the Federal Funds market to balance the shortfall. The other thing to do would be to take out a discount loan from the Federal Reserve, and sell 15 million dollars of the securities that are owned by the bank, and sell off 15 million dollars of the loans held by the bank. Looking at all of these actions, they would cost the bank, and the bank manager should opt for the method that is least costly to acquire funds (Kovela & Skok, 2015).

Specializing In Lending As a Means of Reducing the Adverse Selection Problem in Lending

Specializing in lending is very important, and it can, in several ways, reduce the adverse selection problem in lending. One, specializing in lending helps in pooling the resources of small savers. There usually exists a contrast between the borrowers and the lenders. Whereas many borrowers require large amounts, most of the lenders usually offer small sums. For instance, a borrower of $10,000 loan with no intermediaries would have to find ten people willing to lend $1000 (Booth & Booth, 2004). That is not efficient. Banks, on the other hand, would have to pull small deposits from its customers to use in making hefty loans. Insurance companies also need to collect many small premiums and invest them in serving a few large claims. That is the same scenario with the mutual funds that accept and pull together small investment amounts to buy a large bond and stock portfolios. In all these cases, many savers must be attracted by the intermediary, and therefore, the soundness of the institution must be believed widely. Accomplishing this requires credit ratings or federal insurance.

The other importance of specializing in lending as a means of reducing the adverse selection problem in lending is that it helps in providing liquidity. Liquidity is a term used in referring to the level of ease and the cost of converting an asset as a means of repaying a loan. Financial intermediaries make it easy, transforming various assets into loan repayment methods through checking the accounts, ATMs, and debit cards, among others (Booth & Booth, 2004). Economies of large scale enable the financial intermediaries to meet the obligations of short term outflows of such assets and profiting from the spread between long term and short term interest rates at minimum costs.

Conclusion

In conclusion, the principal-agent problem majorly occurs as a result of the conflict of interest between the two parties, where the agents tend to act in their interests and not that of the owners. For the free-rider problem, it occurs in the market if bondholders realize that other bondholders monitor and reinforce the restrictive covenants on their behalf, and hence become reluctant in monitoring and reinforcing them. Lastly specializing in lending is essential in reducing the adverse selection in lending as it helps in pooling the resources of small savers, and also helps in providing liquidity.

References

Booth, J. R., & Booth, L. C. (2004). Deposit insurance and specialization in commercial bank lending. Review of Financial Economics, 13(1-2), 165-177. https://www.sciencedirect.com/science/article/pii/S1058330003000661

Kang, Q., & Liu, Q. (2010). Information-based stock trading, executive incentives, and the principal-agent problem. Management Science, 56(4), 682-698. https://pubsonline.informs.org/doi/abs/10.1287/mnsc.1090.1128

Tufekci, Z. (2014). The medium and the movement: Digital tools, social movement politics, and the end of the free rider problem. Policy & Internet, 6(2), 202-208. https://onlinelibrary.wiley.com/doi/abs/10.1002/1944-2866.POI362

Kovela, S., & Skok, W. (2015). Mergers and acquisitions in banking: a framework for effective IT integration. International Journal of Business and Management, 10(3), 279-294. https://scholar.google.com/scholar_url?url=http://eprints.kingston.ac.uk/30553/3/Kovela-S-30553.pdf&hl=en&sa=T&oi=gsb-ggp&ct=res&cd=0&d=17338130825942550837&ei=N44HXqTmJIjDmAHWl7_gDQ&scisig=AAGBfm3X3JyPYndA8AJbNl6LKOYeAvQz2g