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Principal agent risk needs to be in your risk management model

The courts will eventually determine whether the profiteers at Goldman Sachs who spun toxic securities into gold were extremely skilled players in the legal gambling dens of Wall Street, or whether they rigged the house (mortgages). Meantime, even companies that are not being sued for fraud by the U.S. Securities and Exchange Commission might want to bone up on principal agent risk — and waste no time in making it part of their risk management models.

I got a primer on principal agent risk a couple months ago from risk expert Ali Samad-Khan, the CEO of Stamford Risk Analytics and a keynote speaker at the Risk Management Association’s GCOR IV operational risk seminar in Boston. Principal agent risk speaks to the reality that employees of a company are sometimes in the position to do things that are not in the best interest of the organization. Managers who are agents don’t always do things that are in the best interest of the stakeholders or the principals.

For example, if an employee’s bonus is based on the amount of money he makes, as opposed to the amount of money to be made on a risk-adjusted basis, Samad-Kahn explained, that employee can end up making a huge amount of money by taking a huge of amount of risk. When thinking about principal agent risk in terms of payout metrics, he advised his audience of risk managers to ask two questions: Who is the intended beneficiary, and who is the intended loss sufferer? In a criminal event, where the perpetrator is intent on benefitting himself, there is a clear intended loser. It’s a zero-sum game. So, how is that situation different from principal agent risk? When an employee of a firm takes excessive risk, the intent is not to harm the firm, usually, he said. The intent is not to harm anyone but to benefit the firm and himself.

“But if you look at the distribution of all potential outcomes of this excessive risk-taking, the expected value of all the outcomes is negative. What does this mean? It means that you know full well that what you are doing is not in the best interest of the firm on a risk-adjusted basis. It means this transaction you are engaging in destroys value, and yet you go ahead and do it because it benefits you,” Samad-Kahn said.

In an environment where compensation is frequently on a “heads-I-win-tails-somebody-else-loses” basis, you wind up with an environment where there is a lot of principal agent risk,” Samad-Kahn said. Principal agent risk — now not even part of the risk taxonomy — must be factored into risk management models.

Making piles of money on a risk-adjusted basis is fine, provided the risk model is not intent on doing harm. Making piles of money by taking excessive risk that could harm the principals and the shareholders is not okay.

Of course, when the agents are the principals, and the shareholder being harmed is the American taxpayer, that’s a matter for the courts.

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