Principal-Agent Relationship

Principal-agent relationship problems occur is all corners and aspects of the economic system but there are certain recent occurrences which has contributed to the current financial crisis.
        These principle agent problems affected stress testing at two prominent levels: internally and externally.  The internal problem would be a dual between risk managers and risk takers within financial firms whilst the externally consisted of a feud between financial firms and authorities.        

The internal issue appeared to be more dominant during the credit boom. Decision making within firms is usually a competition between risk and return. When returns are high the risk appear low and as a result the risk managers become overlooked and under-appreciated. As this procedure occur within individual firms, it proliferates into the system. As a result, competition among the market increases for higher returns on equity neglecting the risk management side of operations.
        The external issue may be made up of different components but is similar in nature to the internal issue. However, this problem arises due to a problem referred to as time-consistency. It is conveyed that, “If the ex-post failure of an institution risks destabilises the system, an ex-ante pre-commitment by the authorities to let it fail with will lack creditability.  This is simply stating that if the bank owes a small amount on money it is there problem but if a lot if owed it’s the authorities’ problem.
        The time consistency issue weakens incentives for to consider themselves for large-scale risk to their balance sheet due to possible opportunity of failure. As a result, the lack of desire to indulge in big-risks the greater the possibility of weaker incentives to manage these risks which may appear in the future.
        Evidence of this can be seen during a series of seminars with financial firms conducted by the Bank of England and the FSA. A Survey used to determine the sort of stress testing which these firms routinely used revealed some very ordinary stresses. This occurred as there was simply no incentives for individuals or teams to run severe stress test and express the results to management, in fear of losing bonuses and due to severe shock and the procedure the authorities would commence if the situation arose and save the bank from failure.