Literature

Review

THE PRINCIPAL–AGENT
PROBLEM IN FINANCE

Sunit N. Shah

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Available online at www.cfapubs.org 9 781934 667729
Literature
Review

THE PRINCIPAL–AGENT
PROBLEM IN FINANCE

Sunit N. Shah
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The Principal–Agent Problem in Finance

Sunit N. Shah
Strategist
Pine River Capital Management

The relationship between a principal and the agent who acts on the princi-
pal’s behalf contains the potential for conflicts of interest. The principal–agent
problem arises when this relationship involves both misaligned incentives
and information asymmetry. In asset management, factors contributing
to the principal–agent problem include managers’ compensation structures
and investors’ tendency to focus on short-term performance. In the banking
industry, myriad principal–agent relationships and complex instruments
provide a fertile breeding ground for incentive conflicts, many of which were
highlighted by the recent financial crisis.

Introduction
Within economics, the study of incentives is a relatively new one. In fact,
Joseph Schumpeter’s (1954) thousand-plus-page authoritative survey, History
of Economic Analysis, contains not a single mention of the word “incentive”
(Laffont and Martimort 2002). The study of principal–agent relationships,
an even newer phenomenon, resides within this framework. The principal is
one who delegates a task to the agent, who performs the task on the principal’s
behalf. Everyday examples of this relationship include a homeowner using a
real estate agent to sell a house and a business owner hiring a manager to run a
store. Within this construct, whenever the two entities’ interests are misaligned
and monitoring is difficult, the agent could act in a way that does not reflect the
principal’s best interests. Such is the basis of the principal–agent problem.
Any system that includes such relationships is vulnerable to potential
principal–agent problems; the financial system is no exception. Individuals
in a variety of roles within this system, including investment managers, bro-
ker/dealers, rating agencies, and even the government, serve as agents in one
form or another. Within asset management, compensation structures in large
part drive managers’ interests, and if these contracts are not structured cor-
rectly, managers may have an incentive to act counter to the fiduciary duty they
have to their investors. Furthermore, investors’ tendency to focus on short-term
performance may indirectly provide managers with additional incentives that
exacerbate this problem. Similar incentive problems exist within the banking
industry, many of which were clearly illuminated by the 2008 financial crisis.
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The Principal–Agent Problem in Finance

This literature review addresses these concerns to provide a better understand-

ing of principal–agent relationships, and the associated potential problems, in
finance.
Evolution of the Principal–Agent Problem.  Initially, most econo-
mists concerned themselves principally with the mechanics of markets; guided
by Adam Smith’s “invisible hand,” these markets generally function without
a hitch (Laffont and Martimort 2002). As economics matured as a science,
this analysis grew ever more granular over time. As Ronald Coase notes in his
seminal paper “The Nature of the Firm” (1937), in the 1930s, the new trend
among economists was toward beginning their analysis at the firm level rather
than at the industry level. His work was a catalyst for much of the progress in
this transition. Coase explores the question of why firms exist in the first place,
as opposed to having every individual in an economy simply contract sepa-
rately with every other. He concludes that it is rational for firms to exist when
the costs of executing transactions on the open market exceed those of orga-
nizing the same transactions in a group setting (Coase 1937). Coase addresses
individual worker incentives, monitoring, and the use of “authority” within an
organization. The work of Coase and his contemporaries, however, maintained
a high-level view of the firm and did not delve deeply into the incentives of
individual workers or the conflicts those incentives might create.
As economic thought continued to progress, analysis shifted from firm-
level behavior to intra-firm mechanics. Initially, models assumed that the
individual members of a firm had identical utility functions, so all members
of a given team had no motivation other than to work in tandem. It was not
until the late 1950s and early 1960s that attention began to focus on the diver-
sity of incentives across members of a given team, the inability to fully moni-
tor all employees’ behavior, and the problems that this combination causes for
delegation (Laffont and Martimort 2002).
The study of these conditions initiated the subdiscipline of econom-
ics known as “optimal contract theory,” which examines the conflict that
can occur as a result of the delegation of tasks to an agent in the presence of
incomplete information. Contract theory addresses two distinct sets of ques-
tions: those that arise before a contract is struck, including optimal methods of
behavior, such as signaling and screening; and those that arise post-agreement,
including actions caused by misaligned incentives, such as shirking behavior.
Meanwhile, in the 1960s and 1970s, another set of economists, including
Kenneth Arrow and Robert Wilson, explored risk sharing among groups of
people with different attitudes toward risk (Eisenhardt 1989). Wilson (1968),
for example, examines what happens when a syndicated group of individuals
needs to make a joint decision with an uncertain outcome, such as the debt/
equity split for investing a joint $1 of capital in an uncertain venture. Spence
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 The Principal–Agent Problem in Finance

and Zeckhauser (1971) tackle a slightly different problem; they explore sev-
eral mathematical models of insurance contracts in which the insurer and the
insured have different utility functions, the insurer has various monitoring
abilities, and the insured has several choices of behavior available. Such anal-
yses bring to light a set of difficulties that can occur when parties to a contract
involving the exchange of risk alter their actions after the contract has been
struck.1 This area of investigation came to be known as “agency theory.”
These two lines of study share a common thread: Both examine how one
party to a contract must be wise to the possibility that the other party might
change his or her behavior post-agreement. Consequently, these two paths
merged over time. In this way, agency theory came to include the examina-
tion of post-contract behavior both in a cooperative framework with conflict-
ing incentives and in the context of risk sharing among groups (Eisenhardt
1989). This combination came to represent the latter half of contract theory
mentioned above and was eventually dubbed the “principal–agent model.” The
difficulty involved in structuring the optimal contract in the principal–agent
model when the principal has to worry that the agent might act in a way
that does not reflect the principal’s interests has come to be known as the
“principal–agent problem.”
In their examination of insurance contracts, Spence and Zeckhauser (1971)
find that, even with conflicting incentives, cases in which the insurer can moni-
tor the insured’s actions yield no issues because the insurer can simply structure
the contract to yield the appropriate payoffs for each action the insured might
take. Cases of incomplete monitoring, however, do create a problem:
[When] a signal . . . depends in part or completely on the insured individ-
ual’s action . . . [t]he insured will be induced to alter his natural maximiz-
ing action somewhat in order to influence this signal and thus increase his
payoff from the insurer. The insurer can be cognizant of this adverse incen-
tives problem, but he cannot overcome it. Given his limited information-
monitoring capability, his selection of the optimal insurance payoff function
is a second-best exercise. Neither complete risk spreading nor appropriate
incentives for individual action will be achieved. To find the optimal mix-
ture of these two competing objectives is a difficult problem, here as in the
real world. (p. 387)
This outcome highlights a key component of agency research. For the
principal–agent problem to be meaningful, two ingredients are needed: con-
flicting incentives and private information. Without the former, the principal
may simply leave the agent to his or her own devices; without the latter, the
principal need only structure the contract to cover each realization of the pri-
vate information ex post. Consequently, for a principal–agent relationship to
1
See Arrow (1971) for a thorough treatment of this topic.

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The Principal–Agent Problem in Finance

exhibit the principal–agent problem, both characteristics must exist (Laffont and
Martimort 2002).
Although the above conclusion arose through an examination of risk
sharing within a group, it applies to agency research in general, including
contracting within a firm. Consider a store owner who aims to hire a manager
to run her store. On the one hand, if the owner and manager have the same
incentives—say, if the manager is the owner’s husband—then the owner may
simply engage the manager without fear that he might act in a way counter to
her interests. On the other hand, if the owner can perfectly monitor the man-
ager’s effort—say, through security cameras or network logs—she can simply
structure the contract to contain a large penalty in any situation involving a
lack of effort on the manager’s part. Only if the manager has both different
incentives from the owner and the ability to shirk his responsibilities unde-
tected might principal–agent problems arise.
Several works in the 1970s brought the study of the principal–agent rela-
tionship into sharper focus. Ross (1973) examines classes of utility functions
and payoff structures in which the solution to the principal’s problem leads to
Pareto efficiency, or outcomes in which no one party can be made better off
without making another party worse off. Jensen and Meckling (1976) explore
agency costs to both the principal and the agent and examine the impact of
such costs on a number of other variables, including the ownership structure
of the firm, the fair market value of the firm’s stock, and the firm’s use of debt
and equity. Harris and Raviv (1979) demonstrate the added value of monitoring
in principal–agent relationships and explore the benefits of imperfect, or noisy,
monitoring to the outcome of such arrangements. The study of principal–agent
relationships has endured to this day, with several recent works addressing simi-
lar issues. As one example among many, Miller (2008) examines potential solu-
tions to the principal–agent problem for various management patterns within
a firm and concludes that there is no single solution to such problems. Instead,
he constructs a contingency theory in which various conditions within the firm
call for different solutions to any principal–agent problems that appear.2
Principal–agent problems arise naturally in a variety of economic rela-
tionships and contexts. Mas-Colell, Whinston, and Green (1995) provide the
following list of examples in their exposition:
[•] insurance companies and insured individuals (the insurance company
cannot observe how much care is exercised by the insured),
[•] manufacturers and their distributors (the manufacturer may not be able
to observe the market conditions faced by the distributor),
2
For a thorough review of the agency literature, see Eisenhardt (1989). For more detail on
the principal–agent problem, see Mas-Colell, Whinston, and Green (1995) or Laffont and
Martimort (2002).

4 ©2014 The CFA Institute Research Foundation

 The Principal–Agent Problem in Finance

[•] a firm and its workforce (the firm may have more information than its
workers about the true state of demand for its products and therefore about
the value of the workers’ product), and
[•] banks and borrowers (the bank may have difficulty observing whether
the borrower uses the loaned funds for the purpose for which the loan was
granted). (p. 478)
The principal–agent problem itself contains two subcategories of conflict
based on the informational asymmetry involved. The first, known as adverse
selection, involves problems arising from hidden knowledge. The second,
known as moral hazard, involves problems arising from hidden action. For
example, an owner’s incomplete knowledge of the abilities of a manager she
considers hiring could cause an adverse selection problem, whereas the inabil-
ity of that same owner to observe how hard the manager works once hired
could produce a moral hazard problem (Mas-Colell et al. 1995).3
The Principal–Agent Problem in Finance.  Any industry in which
some individuals act on behalf of others faces potential principal–agent prob-
lems, and the finance industry is no exception. On the contrary, that the
study of the principal–agent problem evolved as a merger of firm mechanics
with the exploration of risk sharing among groups demonstrates how suscep-
tible the financial system is to the consequences of this problem. Not only
do financial markets include a number of intertwined relationships in which
complete or perfect monitoring is difficult, but they also involve numerous
transactions in which risk shifts from one party to another through insurance
or insurance-like products. Therefore, those involved in financial markets
must be that much more wary of the potential problems inherent in agency
relationships. The extraordinary level of interconnectedness present in finan-
cial markets creates a fertile breeding ground for potential conflicts. Consider
the path of a mortgage through the financial system:
• The bank that makes the loan must attempt to ensure that the individual
borrowing the funds puts forth his or her best effort to guard against default.
• The packager that bundles this mortgage with others must ensure that it
receives all of the pertinent information it needs from its counterparties and
so must each of the relevant parties as the resulting mortgage-backed secu-
rities (MBS) are packaged, repackaged, tranched, and sold downstream.

3
Laffont and Martimort (2002) include a third category, non-verifiability, which exists when
the principal and the agent have the same knowledge ex post but this knowledge cannot be
verified by a third party, as in the case of a benevolent court of law attempting to make a
ruling in a case between the two. This category receives notably less coverage in the literature
than either of the two mentioned in the main text here.

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The Principal–Agent Problem in Finance

• The buyers of the various resulting securities must also ensure that they
receive all relevant information as insurance in the form of credit default
swaps (CDS) is written against the resulting payments, as those CDS
are packaged into collateralized debt obligations (CDOs), and as those
CDOs are squared, cubed, and so on.
• The investment bank that packages the loans must ensure that its long-term
interests and those of its employees executing the transactions are aligned.
• The investor whose funds are used to purchase all or part of the resulting
securities must ensure that the asset manager who executes those pur-
chases does so to benefit the investment goals of the investor rather than
the manager’s own personal fee stream.
• The taxpayer must ensure, when there is an implicit guarantee by the gov-
ernment if a given firm fails, that that institution does not accumulate
excess risk as a result of participating in upside outcomes with taxpayer
insurance in the extreme downside.
Given the misaligned incentives involved and the difficulty of monitoring
one’s counterparty, ethical standards must be high to ensure that these actors’
monetary incentives do not override their fiduciary ones.
In June 2013, a former assistant director and counsel in the US SEC
enforcement division, then a partner at Labaton Sucharow, asked his law
firm to conduct a survey on Wall Street ethics. The firm surveyed 250
insiders in the financial services industry, including traders, portfolio man-
agers, investment bankers, hedge fund professionals, financial analysts, and
stock brokers.
The survey found a number of unsettling results: 23% of respondents said
they had observed wrongdoing in the workplace (Sorkin 2013), and 24% felt
some of their colleagues likely had engaged in misconduct to get ahead (Labaton
Sucharow 2013). These actors’ incentive structures were cited as contributors to
these outcomes: 26% of survey participants “believed the compensation plans or
bonus structures in place at their companies incentivize employees to compro-
mise ethical standards or violate the law” (Sorkin 2013, p. B1).
Furthermore, 17% stated that they believed company leaders would turn
a blind eye if they suspected a top earner was engaged in insider trading, and
15% doubted that leadership would report such crimes even if they knew of
them. It is not surprising, then, that 24% said they would “engage in insider
trading to make $10 million if they could get away with it” (Sorkin 2013,
p. B1). The fact that many of these results were disproportionately skewed
toward the younger members of these organizations paints a pretty grim pic-
ture of the future of leadership in the industry. In the survey administrator’s
own words:
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 The Principal–Agent Problem in Finance

A particularly troubling and consistent finding from our survey is what the
future holds for Wall Street. Many of the young professionals who will one
day assume control of the trillions of dollars that the industry manages have
lost their moral compass, accepted corporate wrongdoing as a necessary evil
and fear reporting misconduct. This is a ticking economic time bomb that
responsible organizations must immediately defuse. (Labaton Sucharow
2013, p. 1)
Many of the respondents work at firms whose codes of ethics specifically
proscribe those behaviors. JPMorgan Chase’s code states, “Our integrity and
reputation depend on our ability to do the right thing, even when it’s not the easy
thing”; Goldman Sachs’s code states, “No financial incentive or opportunity—
regardless of the bottom line—justifies a departure from our values” (Sorkin
2013, p. B1). Wrongdoing in the financial services industry also runs counter to
the CFA Institute Code of Ethics and Standards of Professional Conduct, which
states, among other things, that members and candidates must do the following:
• Place the integrity of the investment profession and the interests of clients
above their own personal interests. . . .
• Practice and encourage others to practice in a professional and ethical
manner that will reflect credit on themselves and the profession.
• Promote the integrity of and uphold the rules governing capital markets.4
(p. 1)
Other surveys have yielded similar results. CFA Institute, in conjunction
with Edelman, conducted its own survey on trust in the industry. The study
found that only 53% of investors trust investment management firms to do
what is right. This figure varies by geographical region, dipping as low as 39%
in the United Kingdom. Similar figures hold for the financial services indus-
try, with only 52% of investors, including only 33% of those in the United
Kingdom, trusting its members (CFA Institute and Edelman 2013).
These results emerge despite the importance of trust to investors. In the
same survey, the attribute investors cited most often as the most important
when making an investment manager hiring decision was “Trusted to act
in my best interest,” a response given more than twice as often as “Ability
to achieve high returns.” The top three attributes that investors identified as
building that trust—“Has transparent and open business practices,” “Takes
responsible actions to address an issue or crisis,” and “Has ethical business
practices”—all relate to integrity rather than performance (CFA Institute
and Edelman 2013). They also directly reflect the problems inherent in the
principal–agent model: Investors want a greater ability to view and monitor
4
CFA Institute, “Code of Ethics and Standards of Professional Conduct” (1 July 2010):
http://www.cfapubs.org/toc/ccb/2010/2010/14.

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The Principal–Agent Problem in Finance

their agents’ behavior, and they want to trust their agents to act responsibly in
scenarios in which they themselves cannot participate.
In truth, the majority of actors in this space are not to be vilified. As
Sorkin (2013) states, “There are clearly good people out there doing good
work. A large majority fall in that category” (p. B1). But when 28% of indus-
try insiders think “the financial services industry does not put the interests of
clients first” (Sorkin 2013, p. B1), that is 28% too many.
Roadmap.  This literature review explores the academic research behind
the principal–agent problem in the finance industry today. The discussion
focuses on two categories within the financial system: (1) asset management
and (2) banking and related activities. It begins with an analysis of compen-
sation structures in asset management. The structure of asset management
contracts directly drives the incentives that govern how managers will invest
their clients’ money; if these incentives are not aligned with those of the inves-
tors, principal–agent problems may ensue. The discussion then moves to the
tendency of investors to focus on short-term performance, known as inves-
tor “short-termism.” This tendency on the part of investors creates short-term
incentives for managers and, consequently, may indirectly cause managers to
act in ways that do not reflect the long-term interests of those very investors.
The narrative then shifts to the banking industry, using the financial
crisis of 2008 as a backdrop. The banking industry contains many potential
principal–agent problems, including some entirely of its own, and the recent
experience provided by the crisis illuminates many of these issues within a
real-life framework. This section takes a detailed look at this important event
from recent history to demonstrate examples of these issues. It expands the
discussion on compensation structures to other entities, such as bank man-
agement, traders, and rating agencies. It also examines the role of the govern-
ment in both the crisis and its aftermath, as well as the principal–agent issues
that may have arisen as a result.

Compensation Structures in Asset Management

Although many nonpecuniary factors are often involved in an asset manage-
ment contract, the compensation structure itself commonly represents the
main determinant of the manager’s incentives. Investment managers have a
fiduciary responsibility to act in their investors’ best interests, regardless of
their own. But investors who trust their funds with asset managers gener-
ally cannot perfectly monitor the level of effort the managers put forth, and
asset-level detail on where their funds are placed is often either unavailable
or costly to acquire. Consequently, if an investor’s incentives are not aligned
with those of the manager, the manager often has both an incentive to act
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 The Principal–Agent Problem in Finance

counter to the investor’s best interests and the ability to do so undetected.

Given the magnitude of payment generally involved in asset management
contracts, misaligned incentives have significant potential to override a man-
ager’s fiduciary responsibility to his or her clients. Structuring such contracts
optimally is, therefore, of the utmost importance.
Traditional Contract Structures. As a category, asset management
contains a diverse set of investment strategies. Despite the major differences
across these investment categories, compensation terms are often similar.
Generally, investment managers receive two streams of fee revenue. The first,
called a “management fee,” is typically a percentage of the assets under man-
agement (AUM) and is often justified by overhead expenses, such as rent, tech-
nology infrastructure, and the fixed portion of payroll. The second stream of
revenue generally represents a percentage of the return created by the manager
net of the management fee. This fee stream is commonly termed the “perfor-
mance fee” or “incentive fee” and is often applied only to the return generated
above the portfolio’s previous maximum value, called the “high-water mark.”5
■■ Management fee vs. incentive fee.  Because the management fee repre-
sents a payment equal to a specific percentage of the fund’s assets, both the
management fee and the investors’ assets grow based on the return to the
fund. Consequently, along this dimension, the manager’s incentives and those
of the investors are aligned. The management fee can be viewed as essentially
a small equity stake for the manager in the fund. Investors often ask manag-
ers to coinvest with them in their funds as a way of amplifying this effect
without paying larger management fees.
The performance fee, in contrast, gives the manager a strong incentive
on the upside to provide additional effort at the margin to increase the fund’s
return. According to Goetzmann, Ingersoll, and Ross (2003), among oth-
ers, the incentive fee can be treated like a call option in the sense that the
manager participates in any upside above the high-water mark but does not
suffer from any downside below it. Essentially, the performance fee gives the
manager the option to purchase an equivalent percentage of the fund at that
same percentage of the high-water mark. That is, if a manager receives a 20%
performance fee, he or she has a fee stream equivalent to the option to pur-
chase 20% of the fund at 20% of the high-water mark.
In one sense, then, the trade-off between the management fee and the
incentive fee boils down to a question of equity compensation versus option
compensation. Management fees provide the manager with a moderate level
of direct alignment with the investor’s interests in all scenarios, whereas
5
Although different areas within asset management generally structure compensation con-
tracts similarly, some often use different terminology. For simplicity, the discussion here will
stick with the terms “management fee” and “incentive fee.”

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The Principal–Agent Problem in Finance

incentive fees provide a larger incentive on the upside to produce alpha but
also potentially provide an incentive to introduce more volatility and make
riskier investments. The optimal contract balances the trade-off between the
motivations in the equity-like compensation of the management fee and those
in the option-like compensation of the incentive fee.
■■ Optimal contract structure—static framework.  Several papers on optimal
compensation structure model these contracts in a static, one-period frame-
work. Lambert and Larcker (2004) examine the incentive provided to an
agent serving as management. Holding the cost of the contract to the prin-
cipal constant, they compare the incentives provided by stock option plans of
various strike prices with those provided by compensation in restricted stock.
They find that restricted stock provides the least cost-effective method for
properly incentivizing the agent from the principal’s point of view. Restricted
stock incentivizes the agent better when incentives are low, such as when the
stock price has dropped significantly below its starting value, whereas stock
options incentivize the agent better when incentives are high, such as when
the options are close to being at the money.
Agarwal, Daniel, and Naik (2009) examine the same question in a fund
management context by extending the analysis of Goetzmann et al. (2003) one
step further. They recognize that the various investors in a fund enter that fund
at different times and with different initial investments. Consequently, they con-
sider the manager’s overall pay as a portfolio of call options, with each call option
on a portion of a given investor’s wealth in the fund struck at the high-water mark
that prevailed when that particular investor invested. The manager’s incentives
are then driven by the increase in the value of the portfolio of options given each
relevant high-water mark and the relative size of each investment.
Agarwal et al. (2009) calculate, for each option in the portfolio, its “delta,”
or the increase in that option’s value for a one percentage point increase in
the value of the underlying fund. Then, they calculate the delta for all of the
options across the portfolio. Combining this portfolio delta with the manag-
er’s incentive based on his or her coinvestment in the fund yields the manager’s
overall incentive to increase the value of the fund by another dollar, which
they term the manager’s “total delta.” This analysis is similar to the analysis
of executive compensation in other management contexts, which often uses
deltas from the portfolio of stocks and options held by CEOs to estimate their
incentives to drive value increases in their firms (Agarwal et al. 2009).
The authors find that the performance fee percentages themselves serve
as a poor representation of the manager’s incentive to increase the value of
the fund. Funds with the same incentive fee structure exhibit notably dif-
ferent total deltas as a consequence of differences in the return histories of
individual capital flows. Within their data, they find the correlation between
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 The Principal–Agent Problem in Finance

total delta and the incentive fee to be only 0.17. Furthermore, they find that
total delta does explain future returns, even after incentive fees are controlled
for, whereas incentive fees do not explain future returns after total delta is
controlled for (Agarwal et al. 2009).
They also find that high-water marks and hurdle rates are positively related
to future returns, lending support to the use of these elements as a method
to align the managers’ incentives with those of the investors. Elements that
might suggest more managerial discretion, such as longer lockup, notice, and
redemption periods, are also positively related to investment returns. It is not
immediately clear, however, whether any of these correlations are causal in
nature. The authors also find that the manager’s coinvestment in a fund relates
positively to performance, which suggests further that the management fee
may be a valuable tool in aligning the incentives of the manager with those of
the investors (Agarwal et al. 2009).
■■ Optimal contract structure—dynamic framework.  Lan, Wang, and Yang
(2013) examine a similar question in a different, purely theoretical, context.
They seek to determine the optimal amount of leverage a manager can employ
as a function of the parameters of the contract and the fund’s current position
relative to its high-water mark (HWM). They use the option framework from
Goetzmann et al. (2003) and Agarwal et al. (2009) but in a dynamic model
in which the manager seeks to maximize the discounted present value of his
or her fees over time. Within this setting, Lan et al. calculate the optimal
amount of leverage both from the manager’s point of view and from that of
the investors.
They examine the effect of the contract structure on the manager’s desired
leverage and compare this amount of leverage with what is optimal for the
investors. As the incentive fee increases, holding the total cost of the contract
constant, the equity-like position of the management fee gets replaced with a
call-option-like position in the fund’s assets, which changes the manager’s
incentives. When the AUM is very far from the HWM, the manager has a rela-
tively low incentive to increase the AUM an additional percentage point because
the increase in the value of the manager’s option would be small. As the AUM
approaches the HWM, the delta of the manager’s position increases. This effect
increases his or her incentive to grow the AUM an additional percentage point,
providing motivation to increase the leverage employed in the fund’s strategy.
Lan et al. find that the management fee perfectly aligns the managers’ incentives
with those of the investors. When there is no incentive fee, the manager employs
the amount of leverage that is also optimal for investors as a result of the equity-
like characteristics of the management fee structure (Lan et al. 2013).
The authors then take the analysis one step further, incorporating a liqui-
dation option in the case of a large drawdown, representing a loss of investor
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The Principal–Agent Problem in Finance

confidence in the manager’s abilities and a resulting desire on the part of the
investors to cut their losses. This extension reflects the idea that a large enough
loss might trigger significant redemptions, resulting in a closing of the fund
and, therefore, a loss of all future management and incentive fee streams.
From the manager’s point of view, the liquidation is exogenously imposed
once the AUM reaches a predetermined percentage of the high-water mark.
This feature of the model essentially imposes a short put position on the man-
ager in addition to the long call position provided by the incentive fee. With
this liquidation option included, the authors rerun the analysis and examine
the results (Lan et al. 2013).
They find that as the AUM approaches the liquidation point, the dynam-
ics of this short put position cause the manager to reduce leverage rapidly,
often going so far as to employ a leverage ratio less than 1—or, in other words,
to invest part of the portfolio in the risk-free asset. This behavior, of course,
defeats the investors’ purpose in investing with the manager in the first place;
they have placed money with the manager to take advantage of the alpha
that manager generates, not to pay fees on a strategy that they could employ
themselves (Lan et al. 2013).
The results imply that in a framework in which the manager and the
investors have similar preferences for risk and the manager does not face a
significant risk of redemptions, a pure management fee structure is opti-
mal. The authors conclude, however, that the implications of the liquidation
option cast doubt on the prevailing wisdom that high-powered incentive
fees encourage excessive risk taking. They find that when facing the risk of
redemptions, managers may invest more conservatively than is optimal for
the investors. They state that this tendency could explain why investors often
require a lower bound on a fund’s leverage; otherwise, the manager might
choose too conservative a path in order to ensure survival and fee collection in
subsequent periods (Lan et al. 2013).
Lim, Sensoy, and Weisbach (2013) provide empirical support for this con-
clusion. They quantify the effect of increased performance on the future stream
of capital flows—and, consequently, the future stream of management and per-
formance fees—that a manager will receive. They find that for each dollar in
value a manager creates, 83 cents goes to the investors and 17 cents goes to the
manager, on average. The manager, however, receives an additional 58 cents in
expected future management and incentive fees, yielding a total of 75 cents in
additional income per dollar of value created. In other words, almost 80% of the
income generated from an additional dollar of investment value comes in the
form of fees on future capital flows. The authors find further that this number
is notably higher for nascent funds; brand-new funds receive 84 cents in future
income from each dollar of value created (Lim et al. 2013).
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 The Principal–Agent Problem in Finance

They also find that the effect of value creation from increasing capital
inflows decreases monotonically and significantly over the life of a fund, with
most of the additional capital entering in the first two years. Specifically, they
find that a 10 percentage point increase in return corresponds to a 22% increase
in AUM over the next two years for an existing fund and to a 41% increase in
AUM over the next two years for a new fund. The diminishing effect is so
strong that a steady decrease can be seen even at the quarterly level. They also
find that funds that execute strategies they identify as capacity constrained
receive a lower future capital incentive than those they deem unconstrained,
along the lines of 64 cents versus 50 cents. This finding suggests that investors
understand that some strategies can scale well whereas others will have trouble
generating the same alpha at higher levels of assets under management.
Lim et al. (2013) also find, curiously, that the direct and indirect incen-
tives of the agent are positively correlated in their sample. In other words,
firms that charge higher fees and, therefore, receive higher current compensa-
tion for a dollar increase in value creation also receive higher future compen-
sation from the same dollar of value created. This result contradicts optimal
contracting theory, under which equilibrium is reached only when the total
incentive to each agent in the market remains constant across agents. This
finding likely reflects the fact that some characteristics of a fund, such as hav-
ing a well-known management team or an in-vogue strategy, allow the fund
to both charge higher fees and create more buzz if the fund outperforms oth-
ers. This explanation could also lend credence to the existence of the “illusion
of validity,” or the tendency for individuals to place too much weight on new
evidence that supports a previously held conclusion (Burton and Shah 2013).
Investors might react even more strongly to above-average returns in funds
they already believe have top-flight management, as is likely the case if the
fund has above-average fees and they are already invested in it.
These results imply that if managers are at all risk averse, they may err on
the side of taking on less risky investments for fear of the effect that greater
risk could have on their future capital flows. To counteract this tendency, the
optimal contract would need to involve an even higher level of incentive fees to
persuade the manager to adopt the level of risk that is optimal for the investor.
This effect would be even stronger for nascent funds, which endure even larger
capital flow effects from gains and losses in performance (Lim et al. 2013).
Alternative Investor Criteria.  Although investors frequently use past
return history to evaluate money managers, they have other metrics that they
can use to measure potential agents. One common metric used is the Sharpe
ratio, the ratio of an investment’s expected return above a benchmark to the
standard deviation of this difference. Sharpe ratios are used in large part for
their simplicity, although much research has identified environments in which
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The Principal–Agent Problem in Finance

the Sharpe ratio does not serve as a good measure of performance as well as
ways in which the Sharpe ratio can be manipulated by money managers.6
Goetzmann, Ingersoll, Spiegel, and Welch (2004) determine the optimal
investment strategy when both a market of securities and the entire continuum
of option contracts on these securities are available for investment and the man-
ager seeks to maximize the fund’s Sharpe ratio. They find that out of the universe
of possible investment choices, the optimal strategy is two short positions—one
an out-of-the-money call and the other an out-of-the-money put—that together
generate a positive immediate payment to the manager. This strategy truncates
the right tail of the return probability distribution and fattens the left tail while
returning a positive payoff today. In other words, with large probability, the fund
generates a modestly high return, and with small probability, the fund blows up
entirely. Such an approach is certainly not in the best interests of many inves-
tors, but if investors use the Sharpe ratio as an important measure of manager
talent, these results imply that managers have an incentive to use this strategy.
Furthermore, as suggested by Lim et al. (2013), among others, the incentive
to impress investors along the dimensions they feel are important is that much
stronger because of the future capital inflows that may be gained.

Investor Short-Termism
The results of Lim et al. (2013) imply that investors tend to base their invest-
ment decisions on short-term evaluation. Investors often tend to do so even
when such actions may not be in their own best interests. This behavior,
called investor “short-termism,” is broadly accepted in the literature as sim-
ply one aspect of human nature in investing. Alfred Rappaport has written
extensively on the subject in the context of corporate management, calling
short-termism “a disease” for which “earnings and tracking error are the car-
riers” (Rappaport 2005, p. 65). Such behavior has even caused the British
royal family to weigh in, with Prince Charles stating that the “current focus
on quarterly capitalism is unfit for purpose” (Smith and Foley 2013).
In June 2011, the UK Secretary of State for Business, Innovation, and
Skills asked John Kay to review UK equity markets and the impact of short-
termism within those markets on the long-term outlook for quoted compa-
nies. Kay found that short-termism is a problem and that “the principal causes
are the decline of trust and the misalignment of incentives throughout the
equity investment chain” (Kay 2012, p. 9). He calls short-termism “myopic
behavior” that reflects “the natural human tendency to make decisions in
search of immediate gratification at the expense of future returns: decisions
which we subsequently regret” (p. 14).
6
For additional examples of how managers can manipulate their investments’ Sharpe ratios,
see Lo (2002) and Getmansky, Lo, and Makarov (2004).

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 The Principal–Agent Problem in Finance

The Generation Investment Management (2012) report titled “Sustainable

Capitalism” reaches similar conclusions, calling the market “long on short and
short on long” (p. 2). The report calls for several changes within the indus-
try, recommending that asset owners embrace “ways to reshape incentives
across the investment value chain” (p. 2) and that asset managers shift toward
“investing for the long term and adopting incentive structures that reward
such behaviour” (p. 2).
Investor short-termism is grounded in several established psychological
effects, including recency (the tendency to overly focus on recent experiences)
and saliency (the tendency to overweight a matter at hand and to underweight
those further from one’s thoughts). Lim et al. (2013) suggest further that
short-termism may have an even greater impact on start-up funds, reflect-
ing such additional effects as primacy (the tendency to overweight initial data
points) and representativeness (the tendency to force new observations into
categories reflected by previously encountered conventions or classifications).7
Smith and Foley (2013) note that quantifying the effect of short-termism can
be difficult, although they cite the average equity holding period as a proxy.
They state that this metric in US markets has dropped from about seven years
in the mid-20th century to as little as seven months in 2007 and today stands
at less than two years.
In Bogle and Sullivan (2009), John Bogle, founder and former CEO of
The Vanguard Group, provides similar statistics. According to Bogle, the old
speculative high occurred in 1928, the year before the Great Depression began.
In that year, stocks had a 140% annual turnover. As speculation decreased in
the 1950s and 1960s, annual turnover dropped to about 30%. In 2006, it rose
to 200%; in 2007, it was 280%; and at the time of the article’s publication in
2009, it was 320%. Bogle states further that in the 1950s and 1960s, the market
may have moved 2% or more in a day two to four times in a year, whereas in the
approximately two years after 2007, there were more than 50 such moves.
Bogle takes a value stance on the question of short-term focus:
So, what is driving the market now is not traditional long-term invest-
ing but untraditional and excessive short-term speculation. The market is
being driven by people who are betting on future prices rather than invest-
ing with the intent to own part of a business and enjoy the returns it earns
on its capital. Investment professionals—for example, pension trustees and
mutual fund managers—who represent their investor-principals have been
very conflicted. Many of these institutions have put their own interests—
accumulating assets and earning large fees—ahead of the interests of their
investors. Putting investor interests first is the way fiduciary standards are
supposed to work. . . . The correctness of traditional investment principles
and the legal requirement of serving principals first have not been totally
7
See Burton and Shah (2013) for a more detailed explanation of these biases.

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The Principal–Agent Problem in Finance

abandoned, but they are certainly out of the mainstream of investing today.
(Bogle and Sullivan 2009, p. 19)
To solve these problems, Bogle suggests imposing a tax on very short-term gains
to help curb speculative trading, as well as supplementing the fiduciary duty of
money managers with regulation enforced by powerful federal and state agencies.
The tendency of investors to focus on short-term results might force asset
managers to manage for the short term in response, which might cause them
to neglect the best interests of those very investors. In this circular fashion,
the actions of investors may indirectly provide managers with an incentive
structure that motivates them to act contrary to those investors’ long-term
interests. As Rappaport (2005) states:
The fascination of investment managers with quarterly earnings . . . is per-
fectly rational in a market dominated by agents responsible for other peo-
ple’s money but also looking out for their own interests. (p. 65)
The following discourse explores this issue in a variety of contexts—
corporate management, mutual funds, and hedge funds—concluding with a
discussion of the consequences of this dynamic.
Short-Termism and Corporate Management.  The examination of
the effect of investor short-termism on corporate management largely begins
with two theoretical papers by Jeremy Stein in the late 1980s. Stein (1988)
posits a model of shareholder myopia that artificially depresses stock prices
during a temporary period of low earnings and precipitates takeovers at unfa-
vorable prices. Management reacts to the anticipated myopia of the firm’s
shareholders in a myopic fashion itself, selling off the long-term value of the
firm to boost its short-term outlook.
Stein (1989) follows up that theory with a broader model of many firms
in a competitive environment in which managers can reduce future earnings
to increase current earnings at a discount and the market must decide how to
evaluate each firm’s stated earnings. This research concludes that a scenario in
which management teams do not artificially inflate earnings and the market
takes earnings announcements at face value could not persist, because each
manager would then have an incentive to start inflating earnings. The only
potential equilibrium involves managers selling the firm’s long-term value to
inflate current earnings, with the market rationally anticipating such behavior.
That result bears repeating: Even though the market rationally anticipates the
earnings inflation, managers are still better off managing earnings. This is a
prisoner’s dilemma–like situation in which the cooperative equilibrium—when
no manager massages earnings and the market expects as much—is best for all
parties but such an outcome is untenable, because each manager has a distinct
incentive to defect. Consequently, each manager mortgaging the firm’s future,
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 The Principal–Agent Problem in Finance

with the market rationally anticipating this behavior, is the only possible equi-
librium, even if the future sell-off occurs at a large discount to today’s dollars.
The academic literature abounds with examinations of investor short-
termism and its effect on corporate management. Some studies explicitly find
that management acts for the short term as a result. By using conference call
transcripts, Brochet, Loumioti, and Serafeim (2013) verify the relationship
between short-term investor biases and short-term management decisions.
The vast majority of the research in this area, however, takes as a given that
management focuses on short-term horizons, rather than explicitly verifying
this relationship. The consensus in the literature is that investor sentiment
drives management to act this way, both for the sake of the firm’s stock price
and for the sake of their own jobs.8
Decades later, investor short-termism still garners much academic atten-
tion. Alfred Rappaport, who has written extensively on the topic, provides
an example. Rappaport (2005) states that he understands the appeal of using
earnings to perform discounted cash flow analyses. But earnings have limited
informational power for two reasons—one, companies have considerable lati-
tude in managing earnings, and two, earnings in one year represent a small
fraction of a company’s overall lifetime discounted cash flow story. Rappaport
concludes that investors place too much emphasis on earnings and goes on
to state that management’s obsession with short-term metrics compromises
shareholder value. As potential solutions for these concerns, he suggests dif-
ferent compensation schemes for management, including deferred compen-
sation based on performance relative to peers, as well as new performance
reporting that separates current cash flows from forward-looking accruals
with certainty levels attached to future flows (Rappaport 2005).9
Short-Termism and Mutual Funds.  As professional money manage-
ment grew in scope, academic focus on investor short-termism expanded to
the mutual fund industry. Ippolito’s (1992) examination of this industry is the
most noted work in this area. He finds that investors react significantly to the
most recent period of performance but that older information has no effect on
fund allocation. Furthermore, he disaggregates these flows into inflows and
outflows and finds the reactions to be asymmetrical: Winning funds receive a
larger increase in capital inflows than losing funds suffer in withdrawals.
Sirri and Tufano (1998) also find an asymmetry in mutual fund investor
reaction to performance, stating that “fund consumers chase returns, flock-
ing to funds with the highest recent returns, though failing to flee from
8
See Shleifer and Vishny (1990), Bebchuk and Stole (1993), Bolton, Scheinkman, and Xiong
(2006), and Bushee (1998) for additional examples. For a general survey on the topic, see
Laverty (1996).
9
See Rappaport (2011) for a broader discussion on the topic.

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The Principal–Agent Problem in Finance

poor performers” (p. 1590). They find a similar asymmetry with respect
to fees; investors respond to fee decreases by injecting capital, whereas fee
increases cause little capital outflow. They also find that investor sensitiv-
ity to performance increases with a fund’s fees. In summary, investors tend
to inject money when the prospects of a fund improve, either with higher
performance or lower fees, but are not quick to withdraw money when pros-
pects diminish.
This behavior can be explained by a combination of several known psycho-
logical effects. When looking to place new money, an investor likely focuses on
recent performance as a result of saliency or representativeness. Once money
is placed, however, the status quo effect causes a need to feel compelled before
actually making a change (Burton and Shah 2013). Consequently, investors
react strongly to recent results when placing money but are slow to move those
funds in the face of underperformance once those funds have been placed.
Chevalier and Ellison (1997) find similar results and dissect the data even
further. They find a strong relationship between the most recent two-year returns
and capital flows in the mutual fund market. Disaggregating flows into invest-
ment and divestment, they also find that minor to moderate negative perfor-
mance relative to the market, defined as underperformance of 0 to 15 percentage
points (pps), causes little change in capitalization, whereas underperformance of
more than 15 pps causes outflows to increase dramatically. For outperformance
of 0 to 15 pps, inflows increase moderately but steadily, whereas outperformance
of more than 15 pps creates massive inflows for the fund.
From these results, Chevalier and Ellison then estimate the manager
incentive to change risk profiles in the later months of a year given the outlook
of potential inflows and outflows. Their empirical work implies, for example,
that young funds that have either underperformed the market by more than
12% or outperformed it by between 0% and 10% by September have a disin-
centive to increase risk 50%, whereas those that have underperformed by less
than 12% or outperformed by more than 10% are incentivized to increase
risk. The results for older funds are directionally similar but more muted in
magnitude (Chevalier and Ellison 1997).
The authors then examine whether fund managers alter the risk profiles
of their portfolios as a result of the differences in inflows and outflows they
expect to face. They find that, at a 1% significance level, funds alter their posi-
tions in response to the incentive to add or reduce risk implied by expected
capital inflows or outflows. Put differently, they find that managers choose
their investments at least in part based on their own incentives to maximize
capital under management and, consequently, their long-term stream of fees,
rather than following their fiduciary duty to manage the assets solely based on
what is best for their investors (Chevalier and Ellison 1997).
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 The Principal–Agent Problem in Finance

Short-Termism and Hedge Funds.  Several factors might cause capital

flows in the hedge fund industry to respond to performance differently from
how they do in the mutual fund industry, such as subscription periods limiting
inflows and lockup and redemption periods limiting outflows. Potential inves-
tors in hedge funds may have also faced higher search costs, due to the legal
advertising restrictions historically imposed on these institutions (Baquero and
Verbeek 2005). The academic focus on short-termism in hedge funds, how-
ever, has been much more limited, likely because different reporting standards
in this industry make empirical research more difficult to perform.
Agarwal, Daniel, and Naik (2004) examine the particulars of capi-
tal inflows to hedge funds, including how these flows relate to past perfor-
mance, managerial incentives, and impediments to withdrawals. They find
that money flows respond to recent performance in a convex fashion. That is,
capital inflows are more sensitive to marginal performance at higher levels of
performance relative to peers. They also calculate each manager’s delta from
a marginal dollar in investment income earned and use that as a proxy for a
manager’s incentive to increase returns. They find that investors place more
capital with managers with higher deltas, suggesting that investors consider
managerial incentives in their decisions.
Baquero and Verbeek (2005) disaggregate capital flows into investment
and divestment and compare their results with prior research on the mutual
fund industry. Strikingly, they find the opposite result for hedge funds than
previous research found for mutual funds. They find that inflows are sensitive to
long-run overperformance, whereas outflows respond immediately to underper-
formance. They also find that these relationships are linear in nature, whereas
previous research found such relationships, especially for positive performance,
to be convex. They posit the extensive up-front search cost involved in vetting
a hedge fund and its managers as an explanation for the slow reaction to recent
outperformance, whereas they reason that withdrawing money after a period of
underperformance requires much less time to comfortably execute.
Consequences of Investor Short-Termism. The research on firm
management, mutual funds, and hedge funds has shown that investors and
general stakeholders focus on short time horizons in their agent evaluation.
In a seminal paper in behavioral finance, De Long, Shleifer, Summers, and
Waldmann (1990) highlight one issue that could arise as a result of this
short-termism. Before this work, stalwarts of the efficient market hypothesis
(EMH) had long maintained that markets required only one rational actor
to maintain efficiency because any irrational actors in the market would have
their irrational trades counteracted by the rational actor, who would reap
the rewards once market prices returned to fundamental values. These pro-
ponents argued that this outcome would hold true regardless of how many
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The Principal–Agent Problem in Finance

irrational investors existed in the marketplace because the rational investor

would always just counter their positions and simply wait until the market
returned to form (Burton and Shah 2013).
De Long et al. (1990), however, show that when investors face finite time
horizons, fully countering these irrational trades may not be in the inves-
tors’ best interests. Their model involves a set of rational investors who know
the fundamental value of a given asset and another set of investors who irra-
tionally believe the asset to have a different value. All investors make their
investment decisions in one period and then liquidate their holdings in the
next in an overlapping generations framework. Consequently, rational inves-
tors can take only so large a position against irrational movements of the
market for fear that the market might move against them even further and
might not correct before they are forced to liquidate. This possibility limits
the extent to which a manager can invest to benefit his or her investors, given
the risk of further incorrect market movements against the manager’s position
in the short term and the consequent redemptions that may result.
According to Agnew (2012), the investor tendency toward short-termism
has been amplified by the experience of the financial crisis of 2008. Prior
to the crisis, capital inflows were large and hedge funds were able to dictate
favorable terms. When the crisis hit, however, liquidity dried up and many
funds imposed restrictions to keep investors from withdrawing their assets.
This strategy changed the perception of hedge funds in investors’ minds from
vehicles that provide outsized returns with high liquidity to institutions in
which one’s capital might get locked up. This shift in investor sentiment forced
hedge funds as a group to move toward more liquid terms. Less than a third
of all hedge funds offered monthly liquidity or better in 2008, compared with
58% in 2013. In 2011, fewer than 7% of funds offered liquidity less frequently
than quarterly, whereas about 25% did in 2008. Agnew finds that this shift
toward greater liquidity has cost hedge funds the ability to deliver the same
performance. Overall, she finds the current investor demands for high liquid-
ity, high returns, and low volatility to be incompatible with one another.
Frazzini, Kabiller, and Pedersen (2013) describe one possible way to
avoid the effects of investor short-termism, using Warren Buffett’s Berkshire
Hathaway as a model for discussion. They examine Berkshire’s history from
1976 to 2011 and find that it achieved a Sharpe ratio of 0.76, higher than
that of any stock or mutual fund with at least 30 years of history from 1926
to 2011. Berkshire returned an annualized 19.0% in excess of the T-bill rate
for 1976–2011, compared with an annualized excess return of 6.1% for the
general market. Berkshire’s volatility, however, was also higher, at 24.9% ver-
sus 15.8% for the overall market. This volatility led to some large drawdown
periods, including a 76% underperformance compared with the market from
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 The Principal–Agent Problem in Finance

1998 to 2000 as the tech bubble was building; during this period, Berkshire
lost 44% of its market value while the stock market gained 32%. But these
drawdowns did not bring about the demise of Berkshire Hathaway, although
similar losses have undone other large funds in the past.
Frazzini et al. (2013) attribute this outcome not only to Buffett’s stel-
lar ability as an investor but also to Berkshire’s unique corporate structure.
According to the authors:
We find that both public and private companies contribute to Buffett’s per-
formance, but the portfolio of public stocks performed better, suggesting
that Buffett’s skill is mostly in stock selection. Why then does Buffett rely
heavily on private companies as well, including insurance and reinsurance
businesses? One reason might be that this structure provides a steady source
of financing, allowing him to leverage his stock selection ability. Indeed, we
find that 36% of Buffett’s liabilities consist of insurance float with an aver-
age cost below the T-Bill rate. (p. 4)
They liken collecting insurance premiums up front and later paying out claims
to taking out and repaying a loan, and they find Berkshire’s cost of capital in
this context to be more than three percentage points lower than the average
T-bill rate (Frazzini et al. 2013).
This permanent base of capital allows Berkshire Hathaway to avoid the
whims of investor sentiment, immunizing it from the vicious cycle of redemp-
tions that has forced other large funds to unwind quickly. Since Berkshire’s
inception, several other hedge funds have followed its lead. Many have launched
reinsurance companies, including Moore Capital in 1999 (Mider 2013);
Greenlight in 2004 (Davidoff 2012); and SAC, Third Point, and Paulson—
all after 2010 (Mider 2013). Others have launched other publicly traded
vehicles, such as the two publicly traded REITs created by Pine River Capital
Management—Two Harbors, which began in 2009, and Silver Bay, which had
its IPO in 2012 (St. Anthony 2013).

The Banking Industry and the Financial Crisis of 2008

The previous two sections explored the asset management industry, including a
discussion of the direct incentives that compensation contracts provide to man-
agers, as well as one of the indirect incentives that investor short-termism pro-
vides to those same managers. This section turns the focus to another important
area of the financial system: the banking industry. It uses the financial crisis
of 2008, an important event from recent history that illuminated many of the
principal–agent problems endemic to this industry, as a case study and analyzes
the numerous instances of misaligned incentives that contributed to the crisis.
The complexity of the banking industry creates an environment that is
ripe for potential incentive conflicts. In the run-up to the financial crisis,
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The Principal–Agent Problem in Finance

bank employees, both those executing the trades to purchase securities and
those managing the traders, often faced conflicts between the incentives cre-
ated by their compensation contracts and their duty to the shareholders of
their companies. The government certainly faced tension between its duty
to represent taxpayer interests and its stance of not interfering with private
industry. And the bailouts themselves forged a new principal–agent relation-
ship between bank managers and the taxpayers whose money was used to sta-
bilize their institutions. The myriad interconnected relationships among the
various parties involved, combined with the density of relevant information
in each transaction, provided a fertile breeding ground for principal–agent
issues. Furthermore, the amount of money involved amplified each individu-
al’s incentives significantly, making them that much more difficult to ignore.
The following discussion reviews the literature on these relationship pairs and
the principal–agent problems that existed within them.
Bank Employees as Agents for Shareholders.  The classic
principal–agent relationship, that of worker or manager as agent for the firm
owner, played its part in the events of the financial crisis. Many have attrib-
uted much of the responsibility for the crisis to bank employees, stating that
compensation contracts structured incentives in such a way as to misalign
them with those of shareholders and promote actions that did not forward
the best interests of the banks themselves. Being closest to the decisions that
accumulated risk on bank balance sheets, bank traders have been chastised
for sacrificing long-term firm value to line their own pockets. Management,
meanwhile, has received similar blame for its oversight—or lack thereof.
■■ Traders as agents for shareholders. The crisis literature is nearly unani-
mous on the existence of principal–agent problems in the relationship between
bank traders and the shareholders of the banks they represented. Crotty’s
(2009) scathing piece sets the tone for the discussion. According to Crotty,
traders received incentive compensation based on profits created in a given year,
regardless of the risk these trades created for the banks in future years. Crotty
cites as evidence AIG’s Financial Products division, which lost $40.5 billion in
2008 but whose employees received a total of $220 million in bonuses for that
year, which averages to more than $500,000 per employee. Under this incen-
tive scheme, Crotty concludes, taking excessive risk during a bubble actually
represents rational behavior, even if the individual trader knows his or her
actions are likely to contribute to a crash in the intermediate future.
Kirkpatrick (2009) also posits a misalignment between trader compensa-
tion and firm incentives. He states that traders, especially senior ones, gener-
ally have unlimited upside to their bonuses, whereas the downside is floored
at zero, with any losses borne by the bank and its shareholders. He makes two
suggestions to cure this defect. The first is to defer bonus compensation subject
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 The Principal–Agent Problem in Finance

to future clawback to better align outcomes with the long-term interests of

shareholders. The second is to incorporate the amount of capital put at risk into
employee performance targets, which some banks do, although most do not.
Crotty (2009) delves further into the relationship between trader com-
pensation and firm incentives, going into detail on the subject of collateral-
ized debt obligation (CDO) sales. He states that when bank traders found
the safest tranches of mortgage-backed securities hard to sell, they kept those
tranches on their banks’ balance sheets and sold the remaining portions to
boost bonuses from additional sales. Crotty states that this behavior persisted
despite the fact that it put unhedged risk on the balance sheet, citing the fol-
lowing now-famous quote from Citigroup CEO Charles Prince:
When the music stops, in terms of liquidity, things will be complicated. But
as long as the music is playing, you’ve got to get up and dance. We’re still
dancing. (pp. 568–569)
Crotty (2009) then dives deeper into the complexity inherent in these
securities and includes a description of CDOs, CDO-squareds, and
higher-power CDOs. According to Crotty, these securities are so complex
that it can take a powerful computer several days to price a single CDO via
black box simulation models. He believes this complexity gives sellers of these
instruments an informational advantage over the buyers of these securities,
creating, in effect, a new and separate principal–agent problem. Whoever
prices the security can, in Crotty’s judgment, manipulate the statistical mod-
els to produce a price that reflects his or her interests, while the buyer sees
only the subset of information that the seller chooses to present.
Alan Blinder, a former vice chairman of the Federal Reserve, describes
in a 2009 Wall Street Journal opinion piece how traders’ compensation struc-
tures incentivize them to take big bets, with the downside being absorbed by
“other people’s money” (p. A15). According to Blinder, the same is true for
CEOs, whereas the shareholders, those whose interests they represent, want
to take many fewer of these risky bets. He attributes the evolution of these
arrangements to changes in the ownership structure of banks over the past few
decades. When banks were partnerships employing the partners’ capital, the
partners were much more averse to giving traders the liberty to take large bets
(with the partners’ money). With the shift toward stockholder-owned corpora-
tions, the management and ownership groups separated, creating a divergence
in incentives and thereby causing a change in behavior. Blinder describes
hedge funds as hybrid structures that invest partner money in addition to other
people’s money and cites this arrangement as an important reason why these
funds bet far less significantly on mortgage-related securities before the crisis.
Blinder (2009) considers it to be the role of government to abolish com-
pensation practices that misalign employee and shareholder incentives, but he
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The Principal–Agent Problem in Finance

adds that when this approach was tried two decades ago in an initiative that
he was a part of, it failed miserably. Instead, he blames boards of directors,
stating that these bodies are supposed to represent the interests of the share-
holders but instead often reflect those of management. According to Blinder:
The unhappy (but common) combination of coziness and drowsiness in cor-
porate boardrooms must end. As one concrete manifestation, boards should
abolish go-for-broke incentives and change compensation practices to align
the interests of shareholders and employees better. . . . The problems are
many and complex, and the government’s to-do list is not only long but also
a political minefield. Yet fixing compensation incentives does not require
any government action. It can be done by financial companies, tomorrow.
Too bad they didn’t do it yesterday. (p. A15)
■■ Management as agent for shareholders. Although the literature pres-
ents near unanimity on the principal–agent problems caused by the incentive
structures of bank traders, the verdict on management incentive structures
is much more mixed. Soon after the crisis, several opinion pieces came out
stating emphatically and unequivocally that compensation structures for bank
CEOs caused them to act counter to the banks’ interests. John Bogle, in his
interview with Financial Analysts Journal editor Rodney Sullivan (Bogle and
Sullivan 2009), states that the asymmetry inherent in management’s joining
in the firm’s upside during good times without forfeiting those proceeds when
downside risks are realized cannot continue to go unacknowledged as a major
issue. He calls for government regulation as the cure.
Crotty (2009) again provides a scathing viewpoint, citing such statistics
as those regarding Merrill Lynch’s chief executives, who were paid $240
million in performance-based compensation from 1997 to 2008 despite the
fact that Merrill’s losses in 2007 and 2008 wiped out all previous earnings
reported by the firm over that time frame. Crotty’s discussion of the com-
plexity of the relevant securities further implies that mark-to-model practices
afforded management an additional layer of private information that it could
use to further its own interests at the expense of shareholders.
As time passed, however, researchers performed in-depth empirical
analysis, and the results became more mixed. Kirkpatrick (2009) examines
the remuneration policies of banks to determine whether management had
incentives to take excessive risk. He finds that some bank CEOs received
most of their compensation in the form of stock or options, whereas others
received mainly short-term compensation. As of 2006, European banks paid
24% of CEO compensation in fixed salary, 36% in cash bonuses, and 40% in
long-term incentives. In contrast, a study of six US banks found that salary
made up only 4% to 6% of top executive compensation, with stock compen-
sation reaching very high levels. Kirkpatrick cites an example of one bank
24 ©2014 The CFA Institute Research Foundation
 The Principal–Agent Problem in Finance

in particular that leaned strongly toward long-term compensation, requiring

the CEO to hold shares worth five times the previous three years’ average
cash component. From these data, he concludes that management incentives
to take risks varied considerably across banks. He also cites the finding that
banks that failed tended to have CEOs with higher stock holdings, whereas
the banks that survived had higher incentives to take risks, implying that the
incentive alignment may not have mattered anyway.
Kirkpatrick (2009) also gives an overview of the contribution of corporate
governance structure to the financial crisis. For example, he says board mem-
bers faltered in their responsibility to represent shareholders, both in failing
to create systems that would cause information about risk exposure to reach
senior management and in approving strategy decisions without instituting
the appropriate systems to monitor their implementation. He finds that firms
whose management exerted more control over their balance sheet, liquidity,
and capital typically performed better during the crisis.
Chesney, Stromberg, and Wagner (2010) consider bank CEO compensation
as a derivative instrument, using the related terminology: delta, the sensitivity of
the CEO’s compensation to the value of the bank’s stock, and vega, the sensitiv-
ity of the CEO’s compensation to the volatility of the bank’s stock price. The
higher a CEO’s delta, the greater the alignment between his or her incentives
and those of the bank’s shareholders; the higher a CEO’s vega, the greater the
alignment between his or her incentives and those of the bank’s optionholders
or, equivalently, the greater his or her incentive to take risks. Chesney et al. find
that bank write-downs are positively associated with the CEO’s vega, implying
that banks whose CEOs had a higher incentive to take risks performed worse.
They also find that write-downs are negatively associated with the CEO’s delta,
implying that banks whose CEOs’ incentives had greater alignment with those
of the shareholders performed better. They find, however, that the vega effect
dominates the delta effect quantitatively. The positive relationship between bank
write-downs and vega also strengthens when alternative versions of vega are
used, such as the sensitivity of the CEO’s wealth to discrete changes or jumps in
risk—that is, to changes in the nature of the risk taken.
Fahlenbrach and Stulz (2011), in contrast, report directionally opposite
results. They find some evidence that banks whose CEOs’ interests were more
closely aligned with those of shareholders actually performed worse during
the crisis. They also find that banks whose CEO compensation packages were
more sensitive to stock volatility (or, equivalently, had a higher vega) did not
suffer worse stock returns during the crisis. Furthermore, they find that bank
returns during the crisis are negatively related to the dollar incentives repre-
sented by the CEO’s equity compensation. Lastly, they find that bank CEOs
did not liquidate their equity in advance of the crisis, causing them to lose
©2014 The CFA Institute Research Foundation  25
The Principal–Agent Problem in Finance

much of their wealth during it, in line with the fate of the shareholders they
represented. The authors conclude that these findings are inconsistent with
the view that CEOs led banks to take on excessive risk as a result of their own
incentives and in spite of those of shareholders.
Bailouts. The advent of the government bailout programs created a
separate, yet less classically obvious, principal–agent relationship. When the
Troubled Asset Relief Program (TARP) was signed into law, the government
agreed to use taxpayer dollars to prop up financial institutions to avoid the
systemic risks that would result from their collapse. As steward of the taxpay-
ers’ funds, the government implicitly took on the responsibility of using those
assets judiciously. As such, it bore the burden of funding only those institu-
tions with the greatest systemic importance so as to maximize the trade-off
between spending taxpayer dollars and reducing the negative externalities
that might be borne by the public if the financial system were to collapse.
The structure of the bailout programs itself created a second, related
principal–agent relationship. Because some banks had flexibility about whether
to apply for aid, any misalignment between the banks’ interests and those of the
taxpayers could result in a misuse of those bailout funds. Furthermore, to the
extent that it had been assumed that the government would bail out systemi-
cally important institutions if large risks turned against them, the banks were
implicitly acting as agents of the taxpayer while making those risky decisions
all along.
■■ Lessons from the Japanese crisis.  Some research has shown striking similar-
ities between the Japanese banking crisis of the late 1990s and the financial col-
lapse of 2008. Iwatsubo (2007) examines the behavior in the 1990s of Japanese
banks, which shifted lending from other sectors to real estate even in the face of
declining land prices. He cites moral hazard as the explanation, describing the
problem as “gambling for resurrection” (p. 167). Essentially, poorly capitalized
banks used the backstop of the deposit insurance system as a reason to choose a
riskier asset portfolio in an effort to become competitive again.
Iwatsubo then takes this analysis one step further, showing empiri-
cally that the decision to increase or decrease risk in response to a decline
in capital depends on the initial franchise value of the bank. High-valued
banks decrease risk to avoid falling into insolvency, whereas low-valued banks
increase risk to try to become competitive in the marketplace again. The put
option inherent in the deposit insurance system again serves as a backstop
against this increased risk (Iwatsubo 2007).
Furthermore, Iwatsubo (2007) creates a theoretical model reflecting the
banks’ incentives and analyzes how capital adequacy requirements and capital
injections by government affect the banks’ incentives to assume risk. He finds
that a prospective future capital requirement incentivizes banks to assume more
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 The Principal–Agent Problem in Finance

risk today as a result of the expectation of increased future capital costs, whereas
a prospective future capital injection program has the opposite effect because of
the expectation of reduced future capital costs. He also finds that, empirically,
as banks approached the capital adequacy requirement in the 1990s, they sim-
ply issued more subordinated debt to ease the capital restriction and bet harder
on real estate to try to become competitive again. The additional subordinated
debt issuance eased the capital crunch, but the increased leverage on the real
estate bets simply increased the problem of nonperforming loans.
Other research has directly compared the US financial crisis with that
of Japan a decade earlier. Hoshi and Kashyap (2010) develop a framework to
evaluate the US government’s role post-crisis, using the role of the Japanese
government in the Japanese banking crisis of the 1990s and the resulting
outcome for comparison. They find a number of similarities between the
two crises and identify eight lessons that the US government should have
learned from Japan’s experience. Many of these lessons involve the potential
principal–agent problem inherent in allowing banks free choice over whether
or not to receive assistance. With this autonomy, the banks essentially act as
agents for the taxpayers, deciding whether or not to accept funds to stem a
systemic collapse and avoid the resulting negative externalities that taxpayers
might face (Hoshi and Kashyap 2010).
The authors posit that a potentially failing bank may have a stronger
incentive to refuse assistance than the taxpayers would like, for two reasons.
First, accepting assistance serves as a negative signal indicating the bank’s
inability to receive additional funding in private markets. Second, exchanging
new securities that sit above common equity in the capital structure creates
a debt overhang problem for the existing shareholders. These two factors do
not affect the taxpayers’ willingness to aid the banks but do enter into a given
bank’s decision making. The lesson as stated here involves incorporating the
possibility that banks will reject assistance from the aid programs in such a
way that banks’ incentives to accept or reject assistance are aligned with those
of the taxpayers (Hoshi and Kashyap 2010).
They find further that the Japanese government program did not ade-
quately tie assistance to credible inspection programs. They posit that this
omission was intended to remove the potential negative signal associated
with accepting aid, but ironically, the banks hesitated to accept aid anyway.
Consequently, the 1998 program was too small. A similar program the fol-
lowing year did involve inspections, and the authors provide evidence that
this program was more successful in inducing lending by the recipient banks
than the predecessor program was. Regulators, however, did not force banks
to clean up their nonperforming loans, and this omission resulted in subopti-
mal outcomes (Hoshi and Kashyap 2010).
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The Principal–Agent Problem in Finance

Several of the other lessons also involve principal–agent issues inherent in

the banks’ ability to push back against the reforms. Cited failings include forc-
ing the banks to take more aid than they preferred as well as not nationalizing
the most troubled banks and forcing them to unwind. Hoshi and Kashyap
(2010) evaluate the US government’s post-crisis policies and find that, although
it is too early to assess the effect of policies addressing half of the eight lessons
they specify, only one of those lessons was heeded by the government, whereas
at least three were clearly ignored, including the two listed above.
■■ Application to the US crisis. Hoshi and Kashyap’s (2010) research raises
two key questions regarding the government’s and banks’ roles as agents for the
taxpayers: (1) Did the parameters of the Capital Purchase Program (CPP) elimi-
nate the potential adverse selection problem in which the wrong banks (from
society’s point of view) opt in, and (2) did the Treasury approve the banks whose
financial distress costs were the highest? In response to this research, Bayazitova
and Shivdasani (2012) assess the decisions of banks as a result of their incentives
in the marketplace. This study addresses the issue of the banks, as agents of soci-
ety, potentially receiving government aid not for the protection of a given bank’s
shareholders but as a result of the externalities that the bank’s failure would
cause for society because of its systemic importance in the economy.
They find the answer to both questions above to be yes. Banks that did
not apply for the CPP tended to have stronger capital ratios, more stable
funding profiles, and higher asset quality than those that did apply, whereas
those that were accepted into the program were larger and posed greater sys-
temic risk. The authors also find that banks that were approved for CPP funds
but rejected them received little boost to equity valuations. They conclude
that the adverse signaling and debt overhang concerns raised by Hoshi and
Kashyap (2010) did not prevent the weakest banks from participating in the
buyout program (Bayazitova and Shivdasani 2012).
The authors, however, do find evidence that management’s personal
incentives may have played a role in bank behavior. TARP placed compensa-
tion limits on the banks’ management, and the political climate around the
passage of TARP was such that many anticipated further political interfer-
ence in management compensation for banks that accepted TARP funds.
Management’s incentive to disassociate from TARP increased notably with
the passage of H.R. 1586, which placed a 90% tax on all employee bonuses
given by institutions that received at least $5 billion of TARP assistance.
First, Bayazitova and Shivdasani (2012) examine the banks’ decision
whether to accept or reject CPP. They find that banks with CEO compensation
over the TARP limit were more likely to reject TARP and that this likelihood
to reject increased significantly with management compensation, as did the
probability that a bank would exit TARP once in it. These findings suggest that
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 The Principal–Agent Problem in Finance

management, appointed as agent for the shareholders and acting as surrogate

agent for the taxpayers, may have instead acted in its own best interests rather
than in the best interests of the principals it was supposed to represent.
Bayazitova and Shivdasani (2012) also touch on the potential con-
flict between the two agency roles of the government as a result of TARP.
According to the authors, through the FDIC guarantee on deposits, the gov-
ernment essentially owned a claim on bank assets that was senior to several
layers of debt and all layers of equity. Consequently, much of the capital struc-
ture would have to falter before regulators forced the bank to raise additional
capital or seized bank assets. But the insertion of a government-owned layer
of preferred equity meant that only the common equity layer remained as a
buffer to protect taxpayers before regulators would have to act. If the market
had perceived this situation as an increase in risk, the market price should
have reacted, which is exactly what the authors find. Using two proxies for the
thickness of the common equity cushion—the common equity component of
the Tier 1 capital ratio and the tangible common equity ratio—they find that
both became correlated with stock returns only after the CPP infusions took
place. They conclude that this finding is consistent with the view that markets
perceived a shift in government incentives under the CPP and an associated
additional risk in having a thin layer of common equity capital. By providing
this new capital injection meant to help banks, the government shifted its
own incentives in a way that hurt banks with a small common equity layer
relative to those with a larger buffer.
In a Hoover Institution journal piece, Richard Epstein (2013) discusses a
more current consequence of the government’s entering the capital structure of
private firms as agent for the taxpayers. In 2008, the Federal Housing Finance
Agency (FHFA), acting in its authority as conservator of Fannie Mae and
Freddie Mac, struck a deal with the US Treasury that stabilized the two insti-
tutions in exchange for preferred stock amounting to $1 billion. According to
Epstein, the Housing and Economic Recovery Act (HERA) gave the Treasury
broad discretion as to the terms and conditions attached to that stock, but it also
directed the government to guide Fannie and Freddie toward becoming stable,
private, shareholder-owned companies. In August 2012, the FHFA and the
Treasury signed an amendment that provided the Treasury with a full sweep of
Fannie’s and Freddie’s earnings as interest on the taxpayers’ investment.
Several lawsuits have been filed as a result. Based on these filings, Epstein
(2013) lists three ways in which the government is alleged to have conflicts
of interest in its role as agent for the taxpayers. The first involves a conflict
of interest for the FHFA, which has a fiduciary duty to act on behalf of the
Fannie and Freddie shareholders in its role as conservator but also has a duty
to act on behalf of the taxpayers in its role as part of the government. The
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The Principal–Agent Problem in Finance

second pertains to an alleged violation of the Administrative Procedure Act

and involves a conflict of interest within the government between its duty to
act on behalf of the taxpayers as owners of Fannie and Freddie and its duty
to all parties involved to administer HERA according to its specified terms,
including guiding Fannie and Freddie toward private ownership. The third
revolves around an improper use of the law of takings and involves a conflict
between the government’s role as agent of the taxpayers and its duty to pro-
vide just compensation when it forcibly removes private property. Implicit in
the last allegation rests the idea that usurping all profits from lower levels of
the capital structure is tantamount to taking the property itself.
One question raised by a governmental policy of responding to systemic
risk is how to accurately estimate the systemic risk of a bank. One popular
proxy for systemic risk has been bank size, as evidenced by the popular slo-
gan for the government bailout programs, “too big to fail.” Zhou (2009) uses
one previously invented measure—PAO, or the probability that at least one
other bank becomes distressed upon the given bank’s failure—and invents
two other measures of the systemic risk or importance of a given bank: SII, or
the expected number of bank failures in the banking system upon the given
bank’s failure, and VI, or the probability of the given bank’s failure given
that at least one other failure in the system occurs. He finds that size does
not necessarily correlate well with systemic importance and, therefore, should
not automatically be taken as an accurate measure of systemic risk. He posits
instead using a bank’s leverage ratio as a potential tool to identify banks with
high systemic risk.
Crotty (2009) also identifies a principal–agent problem within the US gov-
ernment, specifically in former Goldman Sachs CEO Henry Paulson’s acting
as secretary of the Treasury. He highlights Paulson’s decision to let Lehman
Brothers go under and his subsequent actions to save AIG, from which
Goldman Sachs received $12.9 billion in taxpayer money as a result of its trans-
actions with the insurance giant. Crotty insinuates that Paulson’s past relation-
ship with Goldman Sachs entered into his decision making on this issue, and he
further concludes that this arrangement allowed banks to gamble with a public
money backstop, incentivizing them to take large bets as they participated in
upside outcomes while shifting the burden to taxpayers on the downside.
■■ Analysis of government policy. According to John Bogle, over time,
financial markets have reached the point of privatization of profits with public
assumption of risk, whether through government-sponsored enterprises, such
as Fannie Mae and Freddie Mac, or through bailouts of the banking system.
In a sense, when governmental policy is to bail out banks that fail during a
crisis, the banks become agents acting on behalf of the taxpayers, who are
assuming the risk of the banks’ actions. Bogle states that such a system, in
30 ©2014 The CFA Institute Research Foundation
 The Principal–Agent Problem in Finance

which government assumes the risk but does not take a strong regulatory or
ownership role, cannot persist (Bogle and Sullivan 2009).
Poole (2009) posits an interesting market-based solution. He recommends
regulation that would require every bank above a size threshold to maintain
10% of its liabilities as 10-year uncollateralized notes that are subordinated
to all other debt obligations, so the bank would have to refinance one-tenth
of this debt every year. If a particular bank could not refinance this debt in a
given year, it would have to shrink its balance sheet by 10%. This restructur-
ing would be managed by the bank itself rather than the government, miti-
gating potential principal–agent problems. Moreover, in the event of another
bailout, this layer of the capital structure would provide an additional cushion
before taxpayers suffered losses.
Rating Agencies as Agents for the Market.  Another principal–agent
problem examined in the crisis literature involves the rating agencies as agents
for the market. As independent arbiters, these agencies are tasked with rat-
ing various financial instruments as accurately and objectively as possible.
As Crotty (2009) argues, however, these parties receive fee revenue for each
instrument rated and face no recourse if the securities or loans do not perform
later. Therefore, the rating agencies’ incentive was simply to maximize deal
flow rather than optimize the quality of their output. According to Crotty,
competition among the rating agencies exacerbated this problem because
banks merely shopped around for the highest rating provider.
Kirkpatrick (2009) also analyzes the rating agencies’ role in the financial
crisis. He cites the concentration of banks that represent the rating agencies’
customer base as creating a potential conflict of interest in which the agen-
cies must appease their customers to get repeat business. Furthermore, he
addresses the fact that agencies engage in discussions with banks about how
to structure an instrument to get the desired rating, likening this scenario to
an auditor auditing his or her own work; the agencies are rating a security
that they themselves helped to design.
Kotecha, Ryan, and Weinberger (2010) make a similar argument—that
market forces place downward pressure on ratings accuracy as a result of the
“ratings shopping” behavior cited by Crotty (2009). They examine the ratings
environment closely and conclude that simply increasing ratings transparency,
as previous governmental acts have attempted to do, cannot fix the problem:
The underlying compensation model must also be changed. They propose a
new structure in which rating costs are deducted from issuance proceeds and
yearly interest payments cover annual reevaluation of the ratings.
Other Principal–Agent Relationships.  Crotty (2009) extends his argu-
ment involving fee income to other parties in the crisis, including the mortgage
©2014 The CFA Institute Research Foundation  31
The Principal–Agent Problem in Finance

brokers who sold the loans, the investment bankers who packaged them, and
the banks that serviced them. Crotty argues that all of these parties were incen-
tivized to maximize flow rather than quality. He also addresses the obscurity
involved in the CDO market, stating that this obscurity gives the banks selling
these securities another layer of private information in deals with counterparties.
Because the banks’ objective is to maximize flow, they have an incentive to not
provide counterparties with the entire truth in these transactions.
As Timiraos and Zibel (2013) point out, government regulation has
attempted to address this issue by forcing banks to keep 5% of these securities
on their balance sheets so that they have some “skin in the game,” but individ-
uals on both the bank side and the consumer advocate side oppose such rules.
Both groups agree that the new rules would be much more complex than the
old ones and would, therefore, raise costs both for lenders and for consumers.

Conclusion
As the study of market entities within economics grew ever more granular,
academic focus shifted from industries to firms and then to individual par-
ties within firms. Consequently, the issue of competing incentives within
cooperative arrangements came to the fore. Simultaneously, economists began
studying the behavior of individuals before and after entering into risk-sharing
agreements. Eventually, these two paths merged into the study of agency the-
ory, from which the concept of the principal–agent problem was born.
The principal is one who delegates work to another, known as the agent,
who performs the task on the principal’s behalf. When the agent has an ethi-
cal obligation to act in a way that reflects the principal’s incentives but the
agent’s own incentives lie on an orthogonal path, the agent is faced with a
conflict between an ethical imperative and his or her personal interests. It
is not difficult to see how the financial system could provide a fertile breed-
ing ground for principal–agent issues, given its interconnected nature and the
risk-sharing features of the products often sold within it.
Organizations such as CFA Institute have developed codes of ethics to
guide professionals in finance and to set expectations for ethical behavior in
such situations. Reflection upon such behavior and how successful the indus-
try as a whole has been in achieving its ethical goals has rarely been more
important than it is at the current time. Financial products and relationships
have become so complex and interwoven that discerning ethical actions from
irresponsible behavior is increasingly difficult, as demonstrated by the recent
financial crisis, which threatened to bring down the entire financial system.
Investors as well as the general public have noticed, as several recent surveys
have shown, that trust both of and within the financial markets has reached
frighteningly low levels.
32 ©2014 The CFA Institute Research Foundation
 The Principal–Agent Problem in Finance

This review has aimed to summarize the existing literature on topics ger-
mane to the principal–agent problem. It split the discussion into two parts,
focusing first on investment management and then shifting to the banking
industry. It began with a broad view of compensation schemes for asset man-
agers in the contexts of hedge funds and mutual funds. These compensation
structures directly provide managers with incentives that, if misaligned with
those of the investors, can lead to conflicts with those managers’ fiduciary
duty. These contracts often have a management component that provides rev-
enue in the form of a percentage of assets under management, as well as an
incentive fee equivalent to a share of the upside return. The latter component
has often been blamed for incentivizing managers to take on too much risk as
a result of its embedded call optionality. Research that examines this issue in
a static, or one-period, context has concluded as such. But work that exam-
ines this question in a dynamic context has sometimes found that incentive
fees actually cause managers to take on too little risk. From the manager’s
point of view, the downside risk of losing money and thereby not growing the
fund over time—or, worse, facing redemptions—often outweighs the upside
risk of additional incentive proceeds because of the immense stream of future
management fees on existing and additional capital that is at stake.
The discourse then moved to investor “short-termism,” or the tendency
for investors to focus on short-term performance rather than on the long-term
outlook that represents their best interests. Investor short-termism has been
well documented in its effect on corporate governance, where short-term
thinking by stockholders causes management to sacrifice the long-term
interests of the company for small short-term gains. This same phenome-
non has been observed in the much newer field of asset management. Such
behavior by investors indirectly provides managers with an incentive to man-
age for the short term, thereby misaligning the managers’ incentives with
those of the very investors whose assets they are managing. The theoretical
research suggests that the effect of such behavior can profoundly hamper
managers’ ability to achieve optimal risk and return targets for their inves-
tors. Consequently, many asset managers have sought out sources of capital
with longer lock-up periods, thus launching publicly traded entities to pro-
vide more stable capital bases and avoid the misaligned incentives that inves-
tor short-termism can create.
Finally, the discussion shifted to the banking industry, focusing on
the myriad principal–agent relationships that catalyzed the financial crisis
of 2008. Research on the compensation structures of senior executives at
banks is mixed, whereas most research on the incentives of the traders
and others more directly involved in the decision making points to these
incentives as reasons for the increased risk on bank balance sheets. The
©2014 The CFA Institute Research Foundation  33
The Principal–Agent Problem in Finance

role of the government in the crisis was also examined, with several key
financial figures weighing in on changes the government must make to
the current market environment to prevent such problems from recurring.
The literature also offers considerable criticism of the compensation meth-
ods for the rating agencies, claiming that their pay schemes incentivize
them to sacrifice accuracy for speed and to shade their ratings up to ben-
efit their clients.
The problems, as outlined in this work, are well known, but the ques-
tion that remains is who will act to solve them in the future. On their own,
members of the financial profession are realizing that it is not enough to just
avoid conflicts or manage their own conflicts responsibly. A more sustainable
financial system requires a more trustworthy reputation, not just for individu-
als but for the industry. Where there has at times been a leadership void, the
financial crisis has prompted CFA Institute and other organizations to take a
more active role to (1) better align interests so that the economic purpose of
finance can be realized and (2) speak out to discourage poor business prac-
tices. By finding ways to cultivate a more ethical culture in the finance indus-
try, we can together shape a better future of finance.
I would like to thank CFA Institute for the opportunity to write this literature review
and the members of its staff, including Rodney Sullivan, CFA, Larry Siegel, and Barbara
Petitt, CFA, for their hard work in helping get this document to completion. I am also
grateful to Vaishali Shah, Bruce MacDonald, Adam Oestreich, Colin Teichholtz, and
Maxim Engers for all of their thoughtful comments and suggestions. All remaining errors
are my own.

This qualifies for 2 CE credits, inclusive of

2 SER credits.

34 ©2014 The CFA Institute Research Foundation

 The Principal–Agent Problem in Finance
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with greater managerial incentives are associated with superior future
performance, justifying investors’ preference for funds with higher
managerial incentives.” (Abstract)
Agarwal, Vikas, Naveen Daniel, and Narayan Naik. 2009. “Role of Managerial
Incentives and Discretion in Hedge Fund Performance.” Journal of Finance, vol. 64,
no. 5 (October):2221–2256.
“Using a comprehensive hedge fund database, we examine the role
of managerial incentives and discretion in hedge fund performance.
Hedge funds with greater managerial incentives, proxied by the delta
of the option-like incentive fee contracts, higher levels of manage-
rial ownership, and the inclusion of high-water mark provisions in
the incentive contracts, are associated with superior performance.
The incentive fee percentage rate by itself does not explain perfor-
mance. We also find that funds with a higher degree of managerial
discretion, proxied by longer lockup, notice, and redemption peri-
ods, deliver superior performance. These results are robust to using
alternative performance measures and controlling for different data-
related biases.” (p. 2221)
Agnew, Harriet. 2012. “Investor Short-Termism Is the Bane of Hedge Funds.”
Financial News (1 October): http://www.efinancialnews.com/story/2012-10-01/
investor-short-termism-bane-of-hedge-funds.
Agnew examines the ways investor short-termism has changed as a
result of the financial crisis as well as the effect it has had on hedge
funds. She discusses the current investor mandate and provides her
opinion on its tendency to depress fund returns.
©2014 The CFA Institute Research Foundation  35
The Principal–Agent Problem in Finance
Bibliography

Arrow, Kenneth. 1971. Essays in the Theory of Risk-Bearing. Chicago: Markham

Publishing.
This work contains a compilation of Arrow’s contributions to the
“decision-making under uncertainty” subdiscipline of economics.
Baquero, Guillermo. and Marno Verbeek. 2005. “A Portrait of Hedge Fund
Investors: Flows, Performance, and Smart Money.” ERIM Report Series Reference
No. ERS-2005-068-F&A (November):1–53 (http://papers.ssrn.com/sol3/papers.
cfm?abstract_id=851625).
“We explore the flow-performance interrelation by explicitly separat-
ing the investment and divestment decisions of hedge fund investors.
The results show that different determinants and evaluation horizons
underlie both decisions. While money inflows are sensitive to past
long-run performance, outflows exhibit an immediate and sustained
response to past performance in the short run. As a consequence,
the shape of the flow-performance relation differs depending on the
time horizon being analyzed. We find a weaker flow-performance
relation for winning funds at quarterly horizons compared to annual
horizons, which may explain why quarterly persistence in hedge fund
performance is not competed away. Indeed, we also find evidence that
most investors are unable to exploit the persistence of the winners.
Conversely, investors are fast and successful in deallocating from the
persistent losers, ensuring a disciplining mechanism for low quality
funds. Further, our findings do not support the existence of smart
money.” (p. 2)
Bayazitova, Dinara, and Anil Shivdasani. 2012. “Assessing TARP.” Review of
Financial Studies, vol. 25, no. 2 (February):377–407.
“We study the government equity infusions into banks under the
Capital Purchase Program (CPP) of the Troubled Asset Relief Program
(TARP). Strong banks opted out of CPP, and equity infusions were pro-
vided to banks that posed systemic risk and faced high financial distress
costs but had strong asset quality. Concerns over executive compensation
led banks to reject CPP infusions and exit the program. CPP infusions
did not have meaningful certification effects, but the subsequent stress
tests conducted for the major banks had significant certification effects.
CPP equity infusions increased investor expectations regarding future
regulatory interventions in the banking sector.” (p. 377)
Bebchuk, Lucian Arye, and Lars A. Stole. 1993. “Do Short-Term Objectives Lead
to Under- or Overinvestment in Long-Term Projects?” Journal of Finance, vol. 48, no.
2 (June):719–730.
“We examine managerial investment decisions in the presence of
imperfect information and short-term managerial objectives. Prior
36 ©2014 The CFA Institute Research Foundation
 The Principal–Agent Problem in Finance
Bibliography

research has argued that such an environment induces managers to

underinvest in long-run projects. We show that short-term objectives
and imperfect information may also lead to overinvestment, and we
identify how the direction of the distortion depends upon the type of
informational imperfection present. When investors cannot observe
the level of investment in the long-run project, suboptimal investment
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Blinder, Alan S. 2009. “Crazy Compensation and the Crisis.” Wall Street Journal (28
May):A15.
Blinder’s opinion piece in the Wall Street Journal discusses the com-
pensation structure for members of banks on Wall Street and how
he thinks these structures contributed to the big bets that caused the
financial crisis.
Bogle, John C., and Rodney N. Sullivan. 2009. “Markets in Crisis.” Financial
Analysts Journal, vol. 65, no. 1 (January/February):17–24.
“In October 2008, Rodney N. Sullivan, CFA, interviewed John C.
Bogle regarding the global financial crisis and his outlook for the
future.” (Abstract)
Bolton, Patrick, José Scheinkman, and Wei Xiong. 2006. “Executive Compensation
and Short-Termist Behaviour in Speculative Markets.” Review of Economic Studies,
vol. 73, no. 3 (July):577–610.
“We present a multiperiod agency model of stock-based executive
compensation in a speculative stock market, where investors have
heterogeneous beliefs and stock prices may deviate from underly-
ing fundamentals and include a speculative option component. This
component arises from the option to sell the stock in the future to
potentially overoptimistic investors. We show that optimal compen-
sation contracts may emphasize short-term stock performance, at the
expense of long-run fundamental value, as an incentive to induce
managers to pursue actions which increase the speculative compo-
nent in the stock price. Our model provides a different perspective on
the recent corporate crisis than the ‘rent extraction view’ of executive
compensation.” (p. 577)
Brochet, Francois, Maria Loumioti, and George Serafeim. 2013. “Short-Termism,
Investor Clientele, and Corporate Performance.” Harvard Business School
Accounting & Management Unit Working Paper No. 12-072 (November):1–54
(http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1999484).
“Using conference call transcripts to measure the time horizon that
senior executives emphasize when they communicate with inves-
tors, we develop a measure of corporate short-termism. We find that
©2014 The CFA Institute Research Foundation  37
The Principal–Agent Problem in Finance
Bibliography

the measure of short-termism is associated with various proxies for

earnings management, suggesting that our proxy partially captures
opportunistic behavior. We also show that firms focusing more on the
short-term have a more short-term oriented investor base, and fewer
analysts issuing long-term forecasts, suggesting that corporate and
capital market short-termism are related. Moreover, consistent with
analytical models that emphasize the costly nature of short-termism,
we find that short-term oriented firms exhibit lower future account-
ing and stock market performance and a higher implied cost of capi-
tal.” (Abstract)
Burton, Edwin T., and Sunit N. Shah. 2013. Behavioral Finance: Understanding the
Social, Cognitive, and Economic Debates. Hoboken, NJ: John Wiley & Sons.
“Historically, economics has assumed that financial markets are
efficient, or that an asset’s market price at any given point in time
reflects its underlying value. However, there now exists a consider-
able accumulation of evidence that supports the behavioral finance
point of view that this need not be the case. Divided into five com-
prehensive parts, Behavioral Finance offers investors an in-depth guide
to the evolving science of behavioral finance. . . . The book explores
the Efficient Market Hypothesis, highlights noise trader theory and
models including the noted Shleifer model, examines research into
psychological behavior pioneered by Daniel Kahneman and Amos
Tversky, and offers an examination of serial correlation patterns in
stock price data.” (Back cover)
Bushee, Brian J. 1998. “The Influence of Institutional Investors on Myopic R&D
Investment Behavior.” Accounting Review, vol. 73, no. 3 (July):305–333.
“This paper examines whether institutional investors create or reduce
incentives for corporate managers to reduce investment in research
and development (R&D) to meet short-term earnings goals. . . . [The]
results indicate that high turnover and momentum trading by insti-
tutional investors encourages myopic investment behavior when such
institutional investors have extremely high levels of ownership in a
firm; otherwise, institutional ownership serves to reduce pressures on
managers for myopic investment behavior.” (p. 305)
CFA Institute and Edelman. 2013. Investor Trust Study: http://www.cfainstitute.org/
learning/future/about/Documents/cfa_institute_edelman_investor_trust_study.pdf.
CFA Institute and Edelman surveyed retail and institutional inves-
tors in the United States, the United Kingdom, Hong Kong, Canada,
and Australia to “better understand the dimensions that shape inves-
tor perceptions of trust in investment managers, as well as the actions
that help to build trust.” (p. 2)
38 ©2014 The CFA Institute Research Foundation
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Chesney, Marc, Jacob Stromberg, and Alexander F. Wagner. 2010. “Risk-Taking

Incentives, Governance, and Losses in the Financial Crisis.” Swiss Finance Institute
Research Paper Series No. 10–18 (July):1–48 (http://ideas.repec.org/p/chf/rpseri/
rp1018.html).
“This paper studies the extent to which risk-taking incentives of
CEOs and other governance features in a range of years prior to the
recent financial crisis were related to the write-downs of U.S. financial
institutions during the crisis. We document that institutions whose
CEOs had particularly strong risk-taking incentives, weak owner-
ship incentives, and independent boards had the highest write-downs,
both in absolute terms and relative to total assets. Furthermore,
financial institutions with lower Tier-1 ratios and those with CEOs
who earned less than their colleagues at comparable firms had larger
write-downs.” (Abstract)
Chevalier, Judith, and Glenn Ellison. 1997. “Risk Taking by Mutual Funds
as a Response to Incentives.” Journal of Political Economy, vol. 105, no. 6
(December):1167–1200.
“This paper examines a potential agency conflict between mutual
fund investors and mutual fund companies. Investors would like
the fund company to use its judgment to maximize risk-adjusted
fund returns. A fund company, however, in its desire to maximize
its value as a concern, has an incentive to take actions that increase
the inflow of investments. We use a semiparametric model to esti-
mate the shape of the flow-performance relationship for a sample of
growth and growth and income funds observed over the 1982–92
period. The shape of the flow-performance relationship creates
incentives for fund managers to increase or decrease the riskiness
of the fund that are dependent on the fund’s year-to-date return.
We examine portfolio holdings of mutual funds in September and
December and show that mutual funds do alter the riskiness of their
portfolios at the end of the year in a manner consistent with these
incentives.” (p. 1167)
Coase, R.H. 1937. “The Nature of the Firm.” Economica, vol. 4, no. 16
(November):386–405.
In Coase’s seminal work, he explores the question of why firms exist.
He compares the costs of contracting within the firm construct with
the costs of using the market pricing mechanism and draws conclu-
sions regarding these costs implied by the fact that firms exist in the
marketplace.
©2014 The CFA Institute Research Foundation  39
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Bibliography

Crotty, James. 2009. “Structural Causes of the Global Financial Crisis: A Critical
Assessment of the ‘New Financial Architecture.’” Cambridge Journal of Economics,
vol. 33, no. 4 (July):563–580.
“We are in the midst of the worst financial crisis since the Great
Depression. This crisis is the latest phase of the evolution of finan-
cial markets under the radical financial deregulation process that
began in the late 1970s. This evolution has taken the form of cycles
in which deregulation accompanied by rapid financial innovation
stimulates powerful financial booms that end in crises. Governments
respond to crises with bailouts that allow new expansions to begin.
As a result, financial markets have become ever larger and financial
crises have become more threatening to society, which forces govern-
ments to enact ever larger bailouts. This process culminated in the
current global financial crisis, which is so deeply rooted that even
unprecedented interventions by affected governments have, thus far,
failed to contain it. In this paper we analyse the structural flaws in the
financial system that helped bring on the current crisis and discuss
prospects for financial reform.” (p. 563)
Davidoff, Steven M. 2012. “With Lax Regulation, a Risky Industry Flourishes
Offshore.” New York Times Dealbook (4 September): http://dealbook.nytimes.
com/2012/09/04/with-lax-regulation-a-risky-industry-flourishes-offshore/.
Davidoff examines the entrance of hedge funds into the reinsurance
business. He posits that funds are entering the business in response to
the fickle desires of investors, who often pull their capital out of funds
quickly after poor results. These vehicles provide permanent capital
for hedge funds to invest.
De Long, J. Bradford, Andrei Shleifer, Lawrence H. Summers, and Robert J.
Waldmann. 1990. “Noise Trader Risk in Financial Markets.” Journal of Political
Economy, vol. 98, no. 4 (August):703–738.
“We present a simple overlapping generations model of an asset mar-
ket in which irrational noise traders with erroneous stochastic beliefs
both affect prices and earn higher expected returns. The unpredict-
ability of noise traders’ beliefs creates a risk in the price of the asset
that deters rational arbitrageurs from aggressively betting against
them. As a result, prices can diverge significantly from fundamental
values even in the absence of fundamental risk. Moreover, bearing a
disproportionate amount of risk that they themselves create enables
noise traders to earn a higher expected return than rational inves-
tors do. The model sheds light on a number of financial anomalies,
including the excess volatility of asset prices, the mean reversion of
stock returns, the underpricing of closed-end mutual funds, and the
Mehra-Prescott equity premium puzzle.” (p. 703)
40 ©2014 The CFA Institute Research Foundation
 The Principal–Agent Problem in Finance
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Eisenhardt, Kathleen M. 1989. “Agency Theory: An Assessment and Review.”

Academy of Management Review, vol. 14, no. 1:57–74.
“Agency theory is an important, yet controversial, theory. This paper
reviews agency theory, its contributions to organization theory, and
the extant empirical work and develops testable propositions. The
conclusions are that agency theory (a) offers unique insight into infor-
mation systems, outcome uncertainty, incentives, and risk and (b) is
an empirically valid perspective, particularly when coupled with com-
plementary perspectives. The principal recommendation is to incor-
porate an agency perspective in studies of the many problems having a
cooperative structure.” (p. 57)
Epstein, Richard A. 2013. “Grand Theft Treasury.” Defining Ideas (16 July): http://
www.hoover.org/publications/defining-ideas/article/151966.
Epstein examines the role of the government as conservator of Fannie
and Freddie. He argues that the government’s move to sweep profits
from the two firms’ shareholders is illegal and explains the rationale
behind several lawsuits that have been brought against the govern-
ment as a result.
Fahlenbrach, Rüdiger, and René M. Stulz. 2011. “Bank CEO Incentives and the
Credit Crisis.” Journal of Financial Economics, vol. 99, no. 1 (January):11–26.
“We investigate whether bank performance during the recent credit
crisis is related to chief executive officer (CEO) incentives before the
crisis. We find some evidence that banks with CEOs whose incen-
tives were better aligned with the interests of shareholders performed
worse and no evidence that they performed better. Banks with higher
option compensation and a larger fraction of compensation in cash
bonuses for their CEOs did not perform worse during the crisis. Bank
CEOs did not reduce their holdings of shares in anticipation of the
crisis or during the crisis. Consequently, they suffered extremely large
wealth losses in the wake of the crisis.” (p. 11)
Frazzini, Andrea, David Kabiller, and Lasse H. Pedersen. 2013. “Buffett’s
Alpha.” Working paper (November):1–45 (http://www.econ.yale.edu/~af227/pdf/
Buffett%27s%20Alpha%20-%20Frazzini,%20Kabiller%20and%20Pedersen.pdf).
“Berkshire Hathaway has realized a Sharpe ratio of 0.76, higher
than any other stock or mutual fund with a history of more than 30
years, and Berkshire has a significant alpha to traditional risk factors.
However, we find that the alpha becomes insignificant when control-
ling for exposures to Betting-Against Beta and Quality-Minus-Junk
factors. Further, we estimate that Buffett’s leverage is about 1.6-to-1
on average. Buffett’s returns appear to be neither luck nor magic, but,
rather, reward for the use of leverage combined with a focus on cheap,
©2014 The CFA Institute Research Foundation  41
The Principal–Agent Problem in Finance
Bibliography

safe, quality stocks. Decomposing Berkshires’ portfolio into owner-

ship in publicly traded stocks versus wholly-owned private companies,
we find that the former performs the best, suggesting that Buffett’s
returns are more due to stock selection than to his effect on manage-
ment. These results have broad implications for market efficiency and
the implementability of academic factors.” (p. 1)
Generation Investment Management. 2012. “Sustainable Capitalism” (15 February):
http://www.generationim.com/media/pdf-generation-sustainable-capitalism-v1.pdf.
“The objective of this paper is twofold. First, we make the economic
case for mainstreaming Sustainable Capitalism by highlighting the
fact that it does not represent a trade-off with profit maximization but
instead actually fosters superior long-term value creation. Second, we
recommend five key actions for immediate adoption that will acceler-
ate the mainstreaming of Sustainable Capitalism by 2020.” (p. 1)
Getmansky, Mila, Andrew W. Lo, and Igor Makarov. 2004. “An Econometric
Model of Serial Correlation and Illiquidity in Hedge Fund Returns.” Journal of
Financial Economics, vol. 74, no. 3 (December):529–609.
“The returns to hedge funds and other alternative investments are
often highly serially correlated. In this paper, we explore several
sources of such serial correlation and show that the most likely expla-
nation is illiquidity exposure and smoothed returns. We propose an
econometric model of return smoothing and develop estimators for
the smoothing profile as well as a smoothing-adjusted Sharpe ratio.
For a sample of 908 hedge funds drawn from the TASS database,
we show that our estimated smoothing coefficients vary consider-
ably across hedge-fund style categories and may be a useful proxy for
quantifying illiquidity exposure.” (p. 529)
Goetzmann, William N., Jonathan E. Ingersoll, and Stephen A. Ross. 2003.
“High-Water Marks and Hedge Fund Management Contracts.” Journal of Finance,
vol. 58, no. 4 (August):1685–1717.
“Incentive fees for money managers are frequently accompanied by
high-water mark provisions that condition the payment of the perfor-
mance fee upon exceeding the previously achieved maximum share
value. In this paper, we show that hedge fund performance fees are
valuable to money managers, and conversely, represent a claim on a
significant proportion of investor wealth. The high-water mark provi-
sions in these contracts limit the value of the performance fees. We
provide a closed-form solution to the cost of the high-water mark
contract under certain conditions. Our results provide a framework
for valuation of a hedge fund management company.” (p. 1685)
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Bibliography

Goetzmann, William N., Jonathan Ingersoll, Matthew Spiegel, and Ivo Welch.
2004. “Sharpening Sharpe Ratios.” Yale School of Management Working Paper
(November):1–44 (http://viking.som.yale.edu/will/hedge/Sharpe.PDF).
“It is now well known that the Sharpe ratio and other related
reward-to-risk measures may be manipulated with option-like strat-
egies. This paper derives the general conditions for achieving the
maximum expected Sharpe ratio. Also derived are static rules for
achieving the maximum Sharpe ratio with two or more options, as
well as a continuum of derivative contracts. The optimal strategy has
a truncated right tail and fat left tail. Additionally, the paper provides
dynamic rules for increasing the Sharpe ratio.
“In order to address the sensitivity of the Sharpe ratio to information-
less, option-like strategies, the paper proposes an alternative measure
that is less susceptible to such manipulations. The case for using this
alternative ranking metric is particularly compelling in the hedge
fund industry where the use of derivatives is unconstrained and man-
ager compensation itself induces a non-linear payoff.” (Abstract)
Harris, Milton, and Artur Raviv. 1979. “Optimal Incentive Contracts with Imperfect
Information.” Journal of Economic Theory, vol. 20, no. 2 (April):231–259.
“It is well known that in situations involving uncertainty, the exis-
tence of a complete set of contingent claims is sufficient to assure a
Pareto-efficient allocation of resources. . . . The purpose of this paper
is to develop a theory of contracts in situations characterized by a
divergence of incentives between the two parties and asymmetric
information (i.e., moral hazard) with special emphasis on how the
possibilities for acquiring information affect the structure of the con-
tract. In particular, we seek to explain the widespread use in areas
such as employment and insurance of contracts in which the result
of an imperfect (noisy) monitoring process is used to determine the
schedule according to which one agent is compensated by another.”
(p. 231)
Hoshi, Takeo. and Anil K. Kashyap. 2010. “Will the U.S. Bank Recapitalization
Succeed? Eight Lessons from Japan.” Journal of Financial Economics, vol. 97, no. 3
(September):398–417.
“During the financial crisis that started in 2007, the U.S. govern-
ment has used a variety of tools to try to rehabilitate the U.S. banking
industry. Many of those strategies were also used in Japan to combat
its banking problems in the 1990s. There are also a surprising number
of other similarities between the current U.S. crisis and the recent
Japanese crisis. The Japanese policies were only partially successful in
recapitalizing the banks until the economy finally started to recover
in 2003. From these unsuccessful attempts, we derive eight lessons.
©2014 The CFA Institute Research Foundation  43
The Principal–Agent Problem in Finance
Bibliography

In light of these eight lessons, we assess the policies the U.S. has pur-
sued. The U.S. has ignored three of the lessons and it is too early to
evaluate the U.S. policies with respect to four of the others. So far, the
U.S. has avoided Japan’s problem of having impaired banks prop up
zombie firms.” (p. 398)
Ippolito, Richard A. 1992. “Consumer Reaction to Measures of Poor Quality:
Evidence from the Mutual Fund Industry.” Journal of Law & Economics, vol. 35, no.
1 (April):45–70.
“Unless quality is apparent at the point of sale, the market must find
ways to ensure the delivery of high-quality products; otherwise, pro-
ducers have incentives to sell low-quality goods at high-quality prices,
thereby assuring a degenerate equilibrium. . . . Despite its prominence
in the theoretical literature, direct evidence of consumer response to
less-than-promised quality is rarely measured. This market seem-
ingly is ripe for a degenerate equilibrium. There is much noise in
performance data across mutual funds and over time, requiring many
periods to judge the ability of an investment manager with statistical
confidence. . . . I explore the hypothesis that vigilance among mutual
fund investors plays an important role in generating an efficient equi-
librium in this market. I show that, as long as poor-quality funds
exist, an investment algorithm that allocates monies to the latest best
performer is rational investor behavior (taking into account transac-
tion costs). This investment algorithm conveys an externality to the
market by denying poor-quality funds the opportunity to capture an
important market share. I examine empirically whether investors fol-
low these investment rules. I find strong evidence that investors react
to new information about product quality in the mutual fund indus-
try, that they react disproportionately where the expected payoffs are
higher, and that returns within mutual funds are serially correlated.”
(pp. 45–47)
Iwatsubo, Kentaro. 2007. “Bank Capital Shocks and Portfolio Risk: Evidence from
Japan.” Japan and the World Economy, vol. 19, no. 2 (March):166–186.
“Despite the downward trend of land prices and the ex post low
return on real estate loans, Japanese banks increased their lending to
the real estate sector during the 1990s. We argue that this phenom-
enon can be explained by the risk-shifting incentives of banks and
discover that banks with low capital-to-asset ratios and low franchise
value chose high-risk assets such as real estate loans. Unlike previ-
ous studies, we show that the capital–risk relationship is non-linear
and changes from positive to negative as franchise value falls. We also
find that a capital adequacy requirement did not prevent risk-taking
behavior of under-capitalized banks since they then just issued more
subordinated debts to meet this requirement. In contrast, government
44 ©2014 The CFA Institute Research Foundation
 The Principal–Agent Problem in Finance
Bibliography

capital injections led banks to reduce risky loans at the margin.

Recapitalization by issuing subordinated debts helped banks recover
their capital losses and mitigated the credit crunch, but consequently
allowed them to increase their exposure to the real estate sector and
worsened the bad loan problems.” (p. 166)
Jensen, Michael C., and William H. Meckling. 1976. “Theory of the Firm:
Managerial Behavior, Agency Costs, and Ownership Structure.” Journal of Financial
Economics, vol. 3, no. 4 (October):305–360.
“This paper integrates elements from the theory of agency, the theory
of property rights, and the theory of finance to develop a theory of
the ownership structure of the firm. We define the concept of agency
costs, show its relationship to the ‘separation and control’ issue, inves-
tigate the nature of the agency costs generated by the existence of
debt and outside equity, demonstrate who bears costs and why, and
investigate the Pareto optimality of their existence. We also provide
a new definition of the firm and show how our analysis of the factors
influencing the creation and issuance of debt and equity claims is a
special case of the supply side of the completeness of markets prob-
lem.” (p. 305)
Kay, John. 2012. “The Kay Review of UK Equity Markets and Long-Term Decision
Making: Final Report” (July): http://bis.gov.uk/assets/biscore/business-law/docs/
k/12-917-kay-review-of-equity-markets-final-report.pdf.
“In June 2011, the Secretary of State for Business, Innovation and
Skills asked [John Kay] to review activity in UK equity markets
and its impact on the long-term performance and governance of UK
quoted companies. The Review’s principal concern has been to ask
how well equity markets are achieving their core purposes: to enhance
the performance of UK companies and to enable savers to benefit
from the activity of these businesses through returns to direct and
indirect ownership of shares in UK companies.” (p. 9)
Kirkpatrick, Grant. 2009. “The Corporate Governance Lessons from the Financial
Crisis.” Financial Market Trends, vol. 2009, no. 1:1–30 (http://www.oecd.org/finance/
financial-markets/42229620.pdf).
“This report analyses the impact of failures and weaknesses in cor-
porate governance on the financial crisis, including risk management
systems and executive salaries. It concludes that the financial crisis
can be to an important extent attributed to failures and weaknesses in
corporate governance arrangements which did not serve their purpose
to safeguard against excessive risk taking in a number of financial ser-
vices companies. Accounting standards and regulatory requirements
have also proved insufficient in some areas. Last but not least, remu-
neration systems have in a number of cases not been closely related
©2014 The CFA Institute Research Foundation  45
The Principal–Agent Problem in Finance
Bibliography

to the strategy and risk appetite of the company and its longer term
interests. The article also suggests that the importance of qualified
board oversight and robust risk management is not limited to finan-
cial institutions. The remuneration of boards and senior management
also remains a highly controversial issue in many OECD countries.
The current turmoil suggests a need for the OECD to re-examine the
adequacy of its corporate governance principles in these key areas.”
(p. 1)
Kotecha, Mahesh, Sharon Ryan, and Roy Weinberger. 2010. “The Future of
Structured Finance Ratings after the Financial Crisis.” Journal of Structured Finance,
vol. 15, no. 4 (Winter):67–74.
“The authors believe that the rating agency reforms underway in
Europe and the United States, as well as at the agencies themselves,
are steps in the right direction but do not go far enough to ensure
accuracy and timeliness of ratings. Most importantly, they fail to
address the conflict-ridden rating agency compensation system. The
authors believe that credibility of ratings cannot be restored until
rating agencies are paid not by the sell side or the buy side, but by
both the buy side and the sell side, via a transaction charge on new
issues and secondary market trades. Their proposal is to pay for ratings
via an industry fund such as has been operated for over two decades
by the U.S. Municipal Securities Rulemaking Board (MSRB), albeit
on a smaller scale and for a more limited purpose, for the benefit
of the municipal securities markets. Carefully structured, such a
compensation system would give rating agencies more appropriate
incentives to produce more accurate and timely ratings that can
hold up through both up and down markets.” (Summary: http://
www.iijournals.com/doi/abs/10.3905/JSF.2010.15.4.067#sthash.
iLpdBp3N.dpbs)
Labaton Sucharow. 2013. “Wall Street in Crisis: A Perfect Storm Looming.” U.S.
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The law firm of Labaton Sucharow conducted a survey on the state of
ethics on Wall Street and found some alarming and troubling results.
Laffont, Jean-Jacques, and David Martimort. 2002. The Theory of Incentives: The
Principal-Agent Model. Princeton, NJ: Princeton University Press.
“This book focuses on the principal-agent model, the ‘simple’ situa-
tion where a principal, or company, delegates a task to a single agent
through a contract—the essence of management and contract theory.
How does the owner or manager of a firm align the objectives of its
various members to maximize profits? Following a brief historical
overview showing how the problem of incentives has come to the fore
in the past two centuries, the authors devote the bulk of their work
46 ©2014 The CFA Institute Research Foundation
 The Principal–Agent Problem in Finance
Bibliography

to exploring principal-agent models and various extensions thereof in

light of three types of information problems: adverse selection, moral
hazard, and non-verifiability. Offering an unprecedented look at a
subject vital to industrial organization, labor economics, and behav-
ioral economics, this book is set to become the definitive resource for
students, researchers, and others who might find themselves pon-
dering what contracts, and the incentives they embody, are really all
about.” (Summary: http://www.amazon.com/books/dp/0691091846)
Lambert, Richard A. and David F Larcker. 2004. “Stock Options, Restricted Stock,
and Incentives.” Working paper, University of Pennsylvania (April):1–46 (http://
papers.ssrn.com/sol3/papers.cfm?abstract_id=527822).
“Prior work has suggested that options represent an inefficient form of
compensation because the value placed on an option by a risk-averse
employee is much less than the cost of the option from the perspective
of the firm. However, much of this work fails to properly incorporate
the incentive effect of option-based contracts into their analysis. We
use agency theory to model the optimal mix of options and stock in the
compensation contract. In contrast to prior work, we show that restricted
stock is generally not the optimal contract form, and that option-based
contracts have both efficiency and incentive advantages.” (p. 2)
Lan, Yingcong, Neng Wang, and Jinqiang Yang. 2013. “The Economics of Hedge
Funds.” Journal of Financial Economics, vol. 110, no. 2 (November):300–323.
“Hedge fund managers trade off the benefits of leveraging on the
alpha-generating strategy against the costs of inefficient fund liq-
uidation. In contrast to the standard risk-seeking intuition, even
with a constant-return-to-scale alpha-generating strategy, a risk-
neutral manager becomes endogenously risk-averse and decreases
leverage following poor performance to increase the fund’s survival
likelihood. Our calibration suggests that management fees are the
majority of the total compensation. Money flows, managerial restart
options, and management ownership increase the importance of
high-water-mark-based incentive fees, but management fees remain
the majority. Investors’ valuation[s] of fees are highly sensitive to their
assessments of the manager’s skill.” (p. 300)
Laverty, Kevin J. 1996. “Economic ‘Short-Termism’: The Debate, the Unresolved
Issues, and the Implications for Management Practice and Research.” Academy of
Management Review, vol. 21, no. 3 (July):825–860.
“In many crucial decisions, the course of action that is most desirable
over the long run is not the best course of action in the short term.
This is the dilemma addressed by the ongoing debate over economic
‘short-termism,’ sparked by contentions that U.S. firms are losing to
overseas competitors because U.S. management is unwilling or unable
©2014 The CFA Institute Research Foundation  47
The Principal–Agent Problem in Finance
Bibliography

to invest in the long run. I argue that the debate has suffered from
a limited focus; to address this problem, I present a framework that
addresses organizational and individual as well as economic per-
spectives. I offer a review of concepts, analysis, and evidence, and I
suggest a cross-discipline, multilevel research agenda for advancing
understanding of this vital topic.” (p. 825)
Lim, Jongha, Berk A. Sensoy, and Michael S. Weisbach. 2013. “Indirect Incentives
of Hedge Fund Managers.” NBER Working Paper No. 18903 (March):1–45.
“Indirect incentives exist in the money management industry when
good current performance increases future inflows of new capital,
leading to higher future fees. We quantify the magnitude of indi-
rect performance incentives for hedge fund managers. Flows respond
quickly and strongly to performance; lagged performance has a
monotonically decreasing impact on flows as lags increase up to two
years. Conservative estimates indicate that indirect incentives for the
average fund are four times as large as direct incentives from incentive
fees and returns to managers’ own investment in the fund. For new
funds, indirect incentives are seven times as large as direct incentives.
Combining direct and indirect incentives, for each dollar generated
for their investors in a given year, managers receive close to another
dollar in direct performance fees plus the present value of future fees
over the expected life of the fund. Older and capacity constrained
funds have considerably weaker relations between future flows and
performance, leading to weaker indirect incentives. There is no evi-
dence that direct contractual incentives are stronger when market-
based indirect incentives are weaker.” (Abstract)
Lo, Andrew W. 2002. “The Statistics of Sharpe Ratios.” Financial Analysts Journal,
vol. 58, no. 4 (July/August):36–52.
“The building blocks of the Sharpe ratio—expected returns and
volatilities—are unknown quantities that must be estimated statis-
tically and are, therefore, subject to estimation error. This raises the
natural question: How accurately are Sharpe ratios measured? To
address this question, I derive explicit expressions for the statistical
distribution of the Sharpe ratio using standard asymptotic theory
under several sets of assumptions for the return-generating process—
independently and identically distributed returns, stationary returns,
and with time aggregation. I show that monthly Sharpe ratios can-
not be annualized by multiplying by √12 except under very special
circumstances, and I derive the correct method of conversion in the
general case of stationary returns. In an illustrative empirical example
of mutual funds and hedge funds, I find that the annual Sharpe ratio
for a hedge fund can be overstated by as much as 65 percent because
of the presence of serial correlation in monthly returns, and once this
48 ©2014 The CFA Institute Research Foundation
 The Principal–Agent Problem in Finance
Bibliography

serial correlation is properly taken into account, the rankings of hedge

funds based on Sharpe ratios can change dramatically.” (p. 36)
Lynch, Anthony W., and David K. Musto. 2003. “How Investors Interpret Past
Fund Returns.” Journal of Finance, vol. 58, no. 5 (October):2033–2058.
“The literature documents a convex relation between past returns
and fund flows of mutual funds. We show this to be consistent with
fund incentives, because funds discard exactly those strategies which
underperform. Past returns tell less about the future performance of
funds which discard, so flows are less sensitive to them when they
are poor. Our model predicts that strategy changes only occur after
bad performance, and that bad performers who change strategy have
dollar flow and future performance that are less sensitive to current
performance than those that do not. Empirical tests support both pre-
dictions.” (p. 2033)
Mas-Colell, Andreu, Michael D. Whinston, and Jerry R. Green. 1995. Microeconomic
Theory. New York: Oxford University Press.
“The authors set out to create a solid organizational foundation upon
which to build the effective teaching tool for microeconomic theory.
The result presents unprecedented depth of coverage in all the essen-
tial topics, while allowing professors to ‘tailor-make’ their course to
suit personal priorities and style. Topics such as noncooperative game
theory, information economics, mechanism design, and general equi-
librium under uncertainty receive the attention that reflects their
stature within the discipline. The authors devote an entire section
to game theory alone, making it ‘free-standing’ to allow instructors
to return to it throughout the course when convenient. Discussion
is clear, accessible, and engaging, enabling the student to gradually
acquire confidence as well as proficiency. Extensive exercises within
each chapter help students to hone their skills, while the text’s appen-
dix of terms, fully cross-referenced throughout the previous five sec-
tions, offers an accessible guide to the subject matter’s terminology.
Teachers of microeconomics need no longer rely upon scattered lec-
ture notes to supplement their textbooks. Deftly written by three of
the field’s most influential scholars, Microeconomic Theory brings the
readability, comprehensiveness, and versatility to the first-year gradu-
ate classroom that has long been missing.” (Online Summary)
Meulbroek, Lisa K., and Mark L. Mitchell. J. Harold Mulherin, Jeffry M. Netter, and
Annette B. Poulsen. 1990. “Shark Repellents and Managerial Myopia: An Empirical
Test.” Journal of Political Economy, vol. 98, no. 5, part 1 (October):1108–1117.
“While the evidence supporting takeover-induced shortsightedness is
largely anecdotal, a recent paper by Stein (1988) develops a formal
model in which the threat of takeovers encourages myopic behavior
©2014 The CFA Institute Research Foundation  49
The Principal–Agent Problem in Finance
Bibliography

on the part of managers. A central prediction of Stein’s model is that

firms that construct barriers to takeover are able to increase profitable
long-term investments such as research and development (R & D).
This paper provides empirical evidence that firms actually decrease
R & D intensity after the introduction of shark repellents, thus fail-
ing to support Stein’s prediction. The findings suggest that takeover
impediments may reduce incentives to engage in long-term invest-
ments.” (pp. 1108–1109)
Mider, Zachary R. 2013. “A Hedge Fund Tax Dodge Uses Bermuda Reinsurers.”
Bloomberg Businessweek (21 February): http://www.businessweek.com/printer/articles/
98250-a-hedge-fund-tax-dodge-uses-bermuda-reinsurers.
Mider discusses the reinsurance company set up by the hedge fund
Paulson. He describes the vehicle as a method for hedge fund man-
ager John Paulson and others to avoid paying taxes. He also briefly
discusses other hedge funds that set up similar vehicles.
Miller, Gary J. 2008. “Solutions to Principal–Agent Problems in Firms.” In
Handbook of New Institutional Economics. Edited by Claude Ménard and Mary M.
Shirley. Berlin: Springer-Verlag:349–370.
Miller reflects on Coase’s idea that the costs of the price mecha-
nism drive the existence of firms. He explores several solutions to the
principal–agent problem in various contexts within the firm and con-
cludes that there is no catch-all solution. Instead, the solution varies
depending on the characteristics of the firm that give rise to the specific
instance of the problem.
Poole, William. 2009. “Moral Hazard: The Long-Lasting Legacy of Bailouts.”
Financial Analysts Journal, vol. 65, no. 6 (November/December):17–23.
“The U.S. government appears to be committed to supporting any
large bank that gets into trouble. A bailout environment distorts risk
assessments. Debt capital flows more readily to large institutions, even
inefficient ones, than to small ones. This article proposes reforms to
the U.S. financial system. A change in incentives is needed. Phasing
out the deductibility of interest on all business tax returns would
reduce the incentive for leverage. Another reform would require all
banks to issue 10-year subordinated notes, which would provide a
large capital cushion. Banks would have to go to market every year
to replace maturing subordinated debt, which would greatly enhance
market discipline.” (Abstract)
Poole, William. 2010. “Ending Moral Hazard.” Financial Analysts Journal, vol. 66,
no. 3 (May/June):17–24.
“FAJ editor Rodney Sullivan, CFA, recently sat down with former
Federal Reserve Bank president William Poole for an interview about
50 ©2014 The CFA Institute Research Foundation
 The Principal–Agent Problem in Finance
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the fallout from the global market crisis and how to end the moral
hazard arising from government bailouts.” (Abstract)
Rappaport, Alfred. 2005. “The Economics of Short-Term Performance Obsession.”
Financial Analysts Journal, vol. 61, no. 3 (May/June):65–79.
“In theory, discounted cash flows (DCFs) set prices in
well-functioning capital markets. In practice, investment managers
attach substantial weight in stock selection to short-term perfor-
mance, particularly earnings and tracking error. Corporate executives
blame this behavior for their own obsession with short-term earnings.
Are stock prices likely to allocate financial resources efficiently when
short-term earnings dominate investment decisions? Can investment
managers who identify stocks as mispriced on a DCF basis earn
excess returns? This article explains why maximizing long-term cash
flow is the most effective way to create value for shareholders and
charts a course for alleviating the obsession with short-term perfor-
mance.” (Abstract)
Rappaport, Alfred. 2011. Saving Capitalism from Short-Termism: How to Build
Long-Term Value and Take Back Our Financial Future. New York: McGraw-Hill.
“[Rappaport] delivers a clarion call for conquering this addiction to
short-term profit and getting on the path to building long-term value.
His solution to short-termism is simple but profound: Business leaders
must align the interests of corporate and investment managers with
those of their shareholders and beneficiaries. Part 1 of the book exam-
ines short‐termism in publicly traded companies and the investment
management community. Part 2 presents an action plan for raising
profit horizons by aligning the interests of corporate and investment
managers with those of their shareholders and beneficiaries.” (Press
Release Summary)
Ross, Stephen A. 1973. “The Economic Theory of Agency: The Principal’s Problem.”
American Economic Review, vol. 63, no. 2 (May):134–139.
Ross explores the principal–agent problem and defines classes of utility
functions and payoff structures that give rise to Pareto-optimal outcomes.
Schumpeter, Joseph. 1954. History of Economic Analysis. New York: Oxford University
Press.
“At the time of his death in 1950, Joseph Schumpeter—one of the
great economists of the first half of the 20th century—was working
on his monumental History of Economic Analysis. A complete history
of efforts to understand the subject of economics from ancient Greece
to the present, this book is an important contribution to the history
of ideas as well as to economics. Although never fully completed,
it has gained recognition as a modern classic due to its broad scope
©2014 The CFA Institute Research Foundation  51
The Principal–Agent Problem in Finance
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and original examination of significant historical events. . . . Major

topics include the techniques of economic analysis, contemporane-
ous developments in other sciences, and the sociology of economics;
economic writings from Plato and Aristotle up through the time of
Adam Smith, including the medieval scholastics and natural-law
philosophers; the work of Malthus, Mill, Ricardo, Marx, and the
important European economists; the history, sociology, psychol-
ogy, and economics of the period 1879–1914; and modern economic
developments. Schumpeter perceived economics as a human science,
and this lucid and insightful volume reflects that perception, creat-
ing a work that is of major importance to the history of economics.”
(Online Summary)
Shleifer, Andrei, and Robert W. Vishny. 1990. “Equilibrium Short Horizons of
Investors and Firms.” American Economic Review, vol. 80, no. 2 (May):148–153.
“This paper attempts to explain the often lamented pursuit by inves-
tors of short-term capital gains and the selection by firms of short-
term investment projects. Our starting point is the observation that,
in practice, arbitrage (trading based on knowledge that the price of an
asset is different from its fundamental value) is cheaper for assets that
cannot stay mispriced for long (short-term assets) than for assets that
can (long-term assets). (p. 148)
“Arbitrage generally serves the useful social function of bringing
asset prices closer to fundamental values. Arbitrage itself, however, is
guided by maximization of arbitrage profits. We [show] that the pri-
vate costs and benefits of arbitrage lead to its clustering on the trad-
ing of short-term assets. This clustering in turn leads to systematically
more accurate pricing of short-term assets than of long-term assets,
even though efficient capital allocation and managerial evaluation
might be better served by the opposite bias.” (p. 153)
Sirri, Erik R., and Peter Tufano. 1998. “Costly Search and Mutual Fund Flows.”
Journal of Finance, vol. 53, no. 5 (October):1589–1622.
“This paper studies the flows of funds into and out of equity mutual
funds. Consumers base their fund purchase decisions on prior per-
formance information, but do so asymmetrically, investing dis-
proportionately more in funds that performed very well the prior
period. Search costs seem to be an important determinant of fund
flows. High performance appears to be most salient for funds that
exert higher marketing effort, as measured by higher fees. Flows are
directly related to the size of the fund's complex as well as the current
media attention received by the fund, which lower consumers' search
costs.” (p. 1589)
52 ©2014 The CFA Institute Research Foundation
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Smith, Alison, and Stephen Foley. 2013. “Criticism of Short-Term Investing Grows
after Woodford Departure.” Financial Times (18 October): http://www.ft.com/cms/
s/0/34a2abba-37e7-11e3-8668-00144feab7de.html#axzz2qtdHBQFB.
Smith and Foley springboard from Neil Woodford’s decision to leave
Invesco Perpetual to a general discussion of investor short-termism in
UK markets.
Sorkin, Andrew Ross. 2013. “On Wall Street, a Culture of Greed Won’t Let Go.”
New York Times (16 July):B1.
Sorkin discusses a survey produced by Labaton Sucharow on the state
of ethics on Wall Street. The survey’s results show that employees at
banks do not believe that their colleagues act ethically and often do
not believe that they themselves act ethically either.
Spence, Michael, and Richard Zeckhauser. 1971. “Insurance, Information, and
Individual Action.” American Economic Review, vol. 61, no. 2 (May):380–387.
“This paper looks at some intricacies and difficulties that arise in the
real world operation of contingent claims markets. Insurance con-
tracts, the most readily observable and perhaps most important exam-
ple of contingent claims markets in action, provide the focus for our
discussion.” (p. 380)
The authors find that in cases in which the insurer can monitor the
insured, no adverse incentive problem occurs. When monitoring is
impossible or incomplete, however, appropriate incentives for action
by the insured will not be achieved.
St. Anthony, Neal. 2013. “St. Anthony: Pine River Takes on Housing Bust as
Investor and Landlord.” Star Tribune (26 May): http://www.startribune.com/
business/208912211.html.
St. Anthony discusses Pine River’s publicly traded firms: Two
Harbors, a real estate investment trust, and Silver Bay, which spe-
cializes in buying distressed property. He goes through the evolution
of these firms and discusses why Pine River thought they were good
investments to make given current market conditions.
Stein, Jeremy. 1988. “Takeover Threats and Managerial Myopia.” Journal of Political
Economy, vol. 96, no. 1 (February):61–80.
“This paper examines the familiar argument that takeover pressure can
be damaging because it leads managers to sacrifice long-term inter-
ests in order to boost current profits. If stockholders are imperfectly
informed, temporarily low earnings may cause the stock to become
undervalued, increasing the likelihood of a takeover at an unfavorable
price; hence the managerial concern with current bottom line. The
magnitude of the problem depends on a variety of factors, including
©2014 The CFA Institute Research Foundation  53
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the attitudes and beliefs of shareholders, the extent to which corporate

raiders have inside information, and the degree to which managers are
concerned with retaining control of their firms.” (p. 61)
Stein, Jeremy. 1989. “Efficient Capital Markets, Inefficient Firms: A Model
of Myopic Corporate Behavior.” Quarterly Journal of Economics, vol. 104, no. 4
(November):655–669.
“This paper develops a model of inefficient managerial behavior in the
face of a rational stock market. In an effort to mislead the market
about their firms’ worth, managers forsake good investments so as to
boost current earnings. In equilibrium the market is efficient and is
not fooled: It correctly conjectures that there will be earnings infla-
tion, and adjusts for this in making inferences. Nonetheless, manag-
ers, who take the market’s conjectures as fixed, continue to behave
myopically. The model is useful in assessing evidence that has been
presented in the ‘myopia’ debate. It also yields some novel implica-
tions regarding firm structure and the limits of [integration].” (p. 655)
Sullivan, Rodney N. 2009. “Governance: Travel and Destinations.” Financial
Analysts Journal, vol. 65, no. 4 (July/August):6–10.
“A global crisis of confidence should never be driven by poor vigilance
over governance. Sadly, however, that is our story. A serious breakdown
in trust between society at large and capital market agents is upon us.
Out of the morass, however, arises an opportunity for our profession to
deal effectively with the challenge. Now is our moment to demonstrate
true governance leadership—something so important that it should be
hard to think about anything else. To seize this moment requires that
we go beyond the well-worn crisis travelogue and suggest an itinerary
that will bring us to a sustainable governance destination.” (p. 6)
Timiraos, Nick, and Alan Zibel. 2013. “Easing of Mortgage Curb Weighed.” Wall
Street Journal (24 July):C1.
Timiraos and Zibel discuss proposed changes to the laws that require
banks to keep a portion of the mortgage securities they sell to inves-
tors. The authors discuss the pros and cons of changing the require-
ments for qualified residential mortgages and explain which entities
are in favor of such changes.
Wilson, Robert. 1968. “On the Theory of Syndicates.” Econometrica, vol. 36, no. 1
(January):119–132.
“A syndicate is defined to be a group of individuals who must make
a common decision under uncertainty that will result in a payoff to
be shared jointly among them. In this paper, the normative criterion
of Pareto optimality is employed to determine the construction, and

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conditions for existence, of a group utility function and a consensus of

the members’ probability assessments.” (p. 119)
Zhou, Chen. 2009. “Are Banks Too Big to Fail? Measuring Systemic Importance
of Financial Institutions.” Working paper (1 December):1–40 (http://ssrn.com/
abstract=1546384).
“We consider three measures on the systemic importance of a finan-
cial institution within a[n] interconnected financial system. Based on
the measures, we study the relation between the size of a financial
institution and its systemic importance. From both theoretical model
and empirical analysis, we find that in analyzing the systemic risk
posed by one financial institution to the system, size should not be
considered as a proxy of systemic importance. In other words, the ‘too
big to fail’ argument is not always valid, and alternative measures on
systemic importance should be considered. We provide the estimation
methodology of systemic importance measures under the multivariate
Extreme Value Theory (EVT) framework.” (p. 1)

©2014 The CFA Institute Research Foundation  55

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