For whose benefit? – When trust collides with mission
- Edward Perry
The thorny issue of trust in banking is a path well-trodden throughout the ages. But while consumers may be coming around to the idea that some areas are improving, the “agency theory problem” remains a stubborn issue.
For bankers, asset managers, and private financial advisers alike, reputation hangs on making smart and profitable decisions on behalf of their clients. But because the science of investments is imperfect at best, the agent needs to walk a strategic tightrope that both reaps rewards for the customer and becomes a profitable enterprise for the business at the same time.
Step forward the agency theory problem – a staple ingredient of business and finance academics worldwide that demonstrates the contradiction between a service provider (or “agent”) and their client (or “principal”). How can the agent, it states, square the circle of providing the best value to their principal, when they also have a vested interest in maximising revenue for their company?
For the agent, their job success may rely on logging strong financial performance targets; for the principal receiving the product or service, they may feel compromised or undervalued, even in the knowledge that full regulatory transparency is being practiced.
It’s this dilemma that can eat away at trust if not dealt with head-on. In asset management, for example, the portfolio manager is directly responsible for making strategic decisions that frequently try to outperform the market – all while taking a risk-related management fee from their client for their efforts.
As gambles go, it’s either a potential career-boosting victory for the manager if it pays off or an expensive lesson for the client if it doesn’t. It’s also worth remembering that a safe, defensive investment strategy can also undermine customer trust if their expectations for returns are not met. Either way, the client’s risk appetite needs to be in close sync with the manager for trust to be maintained.
The banking industry needs a little reminder of the erosion of trust that quickly followed the 2007-8 financial crash. For the sector, agency theory was played out across some uncomfortable examples of high-stakes debt leveraging where the customer - most typically a struggling mortgage-holder - paid the price with their home.
Professor Christopher Hennessy of London Business School suggests that, although we might have a greater awareness and better tools to mitigate risk in banking and financial services since the crash, “this has actually exacerbated the challenges of the principal-agent problem. It has become quite multi-faceted over time”.
He compares it to boxing – the idea that, if one of your opponent’s hands are covered, you only need to worry about the other. Fending off both hands, however, is exponentially more complicated.
Therefore the solution, as much as there is one, needs to focus less on trust between provider and customer, and more on the dual responsibility to work together for the common objective. As long as regulators require a certain set of documentation to be made available to customers to help them make informed decisions, says Professor Hennessy, that may be right and necessary – but it shouldn’t be considered sufficient in itself to assure full transparency.
“If we took a simple task like how to tie shoelaces,” he says, “we have to assume that written details might still be inadequate for the learner. They may need to request a conversation or visual guide before completing the task.”
So, the customer has a responsibility as well to ask the right questions, hold their ‘agent’ to account “and even hold themselves to account on the way into the decision”.