Agency risk refers to the potential of conflicts of interest that may arise between the principal and the agent in a principal-agent relationship. This type of risk occurs when one party, the agent, is delegated decision-making authority and acts on behalf of another party, the principal. Agency risk arises due to the possibility that the agent may not always act in the best interests of the principal, creating a divergence between the objectives of the two parties.
This risk can stem from various factors, such as informational asymmetry, where the agent possesses more information than the principal, leading to adverse decision-making or opportunistic behavior. It can also result from misaligned incentives, as the agent may prioritize personal gains over the principal's interests.
Agency risk can manifest in several ways, including moral hazard, where the agent takes undue risks due to the lack of monitoring or accountability. It can also arise from conflicts of interest, where the agent's personal interests or relationships influence their decision-making, potentially to the detriment of the principal.
Mitigating agency risk often requires mechanisms such as contracts, monitoring, and compensation structures that align the interests of the agent with those of the principal. These mechanisms aim to reduce the likelihood of the agent engaging in behavior that is contrary to the principal's objectives.
Overall, agency risk underscores the importance of establishing effective governance, control, and monitoring systems to ensure agents act in the best interests of the principals they represent.
