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Potential Problems with an Agency Relationship

The recent experience of the U.S. financial sector with the so called subprime crisis and the attendant attempts at financial market reform have centered to some large extent on the behavior of executives in those firms who have had alleged conflict of interest relationships. In financial theory we call this "the agency problem" and have an extensive body of literature and research on the topic.

What precisely is an agency relationship, what potential problems do these relationships cause, what are their costs, and what can firms do to either eliminate or reduce these potential problems and costs?

Please explain in detail.
Please support your response with a minimum of three quality academic and/or industry references.

Examples of acceptable references include:

The Financial Times
The Economist
The Wall Street Journal
The Journal of Finance
Harvard Business Review

Examples of unacceptable references include:
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? eHow
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The Agency Problem

Agency Relationship:

An Agency relationship is one in which an agent is hired by the principle to carry out some duty on their behalf. In this sense, the stockholders in a company may hire a management team to ensure that shareholders wealth in the company is optimized. A financial manager in a company would therefore need to make decisions that are in the best interest of the shareholders of a company, those which will increase the value of the stockholders (Lui, 2011). Within a business organization the agency relationships that exist are those between stockholders and managers and that between the stockholders and the creditors of the organization.

Potential problems agency relationships cause:

In an agency relation often the agent is supposed to act in the best interest of the stockholders, whereby the management of a company which is supposed to represent the interest of the company takes actions to maximize the value of company stock. In this kind of relationship though, there are possibilities of a conflict occurring between the interests of the principal and the agent often referred to as agency problem (Lui, 2011; Westerfield, & Jordan, 2011). This is especially so in large corporations where the ownership the company is dispersed among numerous stockholders implying that the management of the company have a strong control on the running and decision making in firms. This results to a conflict as to whether the management would act in the best interest of the shareholders or they will pursue their own interests at the expense of the shareholders since they had stronger control as noted in most companies in the recent turmoil in the financial markets.

The financial market reforms after the crisis have mainly centered on the conflict of interest that exist between the management of most companies and the shareholders. This is because the crisis which originated from the sup prime mortgage crisis was mainly as a result of most managers irresponsibly pursuing to maximize profits in the mortgage lending market. The managements of most of these investment banks and mortgage lenders could not be held accountable for their methods and decisions of maximizing profits ...

Solution Summary

The solution discusses the potential problems of an agency relationship.