Big Banks: the Principal-Agent problem which isn't discussed

  Alan Kohler has written an interesting article about the illusions of bank capital.

This brings to mind the basic Principal-Agent problem of Banks that are 'Too Big To Fail'. The average main board director of a Big 4-5 Bank in Australia is paid at least $5m to run a very highly leveraged business with insufficient capital to deal with a significant but not unprecedented bad debt problem. Westpac in 1991 quickly became insolvent due to its exposure to property developers and there was no clawback of board remuneration. Losing your job doesn't seem to be enough of a penalty.

The Principal-Agent problem is a serious one for our banking system and rarely discussed.

From Wikipedia:

The principal–agent problem (also known as agency dilemma or theory of agency) occurs when one person or entity (the "agent") is able to make decisions on behalf of, or that impact, another person or entity: the "principal". The dilemma exists because sometimes the agent is motivated to act in his own best interests rather than those of the principal. The agent-principal relationship is a useful analytic tool in political science and economics, but may also apply to other areas.

Common examples of this relationship include corporate management (agent) and shareholders (principal), or politicians (agent) and voters (principal).[1] For another example, consider a dental patient (the principal) wondering whether his dentist (the agent) is recommending expensive treatment because it is truly necessary for the patient's dental health, or because it will generate income for the dentist. In fact the problem potentially arises in almost any context where one party is being paid by another to do something, whether in formal employment or a negotiated deal such as paying for household jobs or car repairs.

The problem arises where the two parties have different interests and asymmetric information (the agent having more information), such that the principal cannot directly ensure that the agent is always acting in its (the principal's) best interests,[2] particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are costly for the principal to observe. Moral hazard and conflict of interest may arise. Indeed, the principal may be sufficiently concerned at the possibility of being exploited by the agent that he chooses not to enter into a transaction at all, when that deal would have actually been in both parties' best interests: a suboptimal outcome that lowers welfare overall. The deviation from the principal's interest by the agent is called "agency costs".[2]