Emre Erkut, M.Phil., Pardee RAND Graduate School, 1776 Main Street, Santa Monica, CA 90401
Financial institutions are trusted with the money of their clients and manage the largest portion of investable assets. This fiduciary responsibility creates an agency between clients and financial-firm managers, in addition to that between shareholders of the firm itself and its managers (the standard agency problem). While the standard agency problem exists in all firms with a dispersed shareholder base, the additional agency problem exists in financial institutions only – only such firms have a fiduciary responsibility to their clients. The rich literature in corporate governance has paid a lot of attention to how governance mechanisms might address the standard agency problem between shareholders and managers, but not in the particular context of a financial firm. Research has also elaborated how contracts should be structured to best align management interests with client interests in financial firms, but in complete isolation of the standard agency problem. The first literature by and large ignores the distinctive nature of the financial firm, and the latter provides only a partial picture of the financial-services firm. This paper develops a set of economic models incorporating the additional agency problem, in order to formally illustrate divergences from non-financial firms in terms of the expected behavior of a firm and its executive management. More specifically, the paper demonstrates the implications of the co-existence of two principal-agent problems: one between shareholders and management and another between clients and management. Initial results indicate that under this more realistic modeling of the financial institution, financial-firm managers have different incentives than what is implied by traditional single-agency models. In this new light, extant corporate-governance structures, designed for the protection of shareholders, but with only the standard agency problem in mind, might not be optimal in addressing the incentives of financial firm managers.