Course: Financial

Institutions and Markets

Submitted to:
Prof. Yasushi Suzuki

The Role of Principal-Agent Structure and

Other Factors in the Credit Market in
Making Monitoring Activities Difficult

Students Name: ABBADI Heba

Students ID#:

52115607

AY 2016 Spring Semester

Date of submission: May 19th 2016

Introduction:
Banking regulation originates from microeconomic concerns over the ability
of bank creditors (depositors) to monitor the risks originating on the lending
side. 1The management of credit risk according to Suzuki (2011) must involve
effective screening and monitoring to ensure a properly functioning financial
market. Successfully monitored and regulated markets encourage individuals
to invest; due to the disclosure of information. Therefore, theres a need to
ensure the monitoring and screening of a market. The shapes of monitoring
activities take the forms of ex ante monitoring: selects projects to be funded
and evaluate the credibility of particular borrowers, on-going monitoring:
tracks how the allocated funds are used, and ex post monitoring: ensures
that the allocated funds are used for the purposes allocated, verifies financial
outcome, and checks the necessity of action needed to protect the interests
of the lenders by judging the actions taken by borrowers. 2 The framework of
monitoring activities, include: (1) the mechanisms through which credit risk is
monitored by banks as lenders (and by investors in general) by collecting
information about borrowers and screening firms that are potential borrowers;
(2) the mechanisms through which financial authorities, as regulators,
monitor and supervise financial institutions by collecting information about
the

activities

of

banks

and

investors,

setting

regulatory

rules,

and

1 Bi ggar, D., & Heimler, A. (2005). AN INCREASING ROLE FOR COMPETITION

IN THE REGULATION OF BANKS. Retrieved May 13, 2016, from
http://www.internationalcompetitionnetwork.org/uploads/library/doc382.pdf
2 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring System
under Institutional and Transition Failures, Palgrave Macmillan. P18

implementing these rules together with associated sanctions. The following

flowchart, demonstrated by (Suzuki 2011), represents the framework of
monitoring activities:

Monitoring Activities: Framework and Analysis

Source: Japans financial slump 2011- Author: Yasushi Suzuki

Despite the significance of these institutional specificities on the banking

system, the reform of their monitoring activities results in poor outcomes for
the financial system. The limitation these institutional have; due to some
factors, such as principal-agent structure, made it role ineffective to some
extent. However, There is widespread agreement in the literature that
effective screening and monitoring by lenders and investors are critical for
the proper functioning of a financial market. 4 Thus, this paper will discuss
how the credit markets factors make monitoring activities (monitoring
borrowers by banks as well as monitoring banks by regulators) extremely
difficult. In its discussion, this paper will demonstrate the factors with
supporting examples regarding the ineffectiveness of each factor and the

3 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring System

under Institutional and Transition Failures, Palgrave Macmillan. P18
4 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring System
under Institutional and Transition Failures, Palgrave Macmillan. P18

impacts that result from such a shortage. In its conclusion, the paper will
provide recommendations in an aim to overcome the ineffectiveness imposed
on todays credit markets monitoring activities.
The factors affecting the monitoring are as follows:
1. ArrowDebreu general equilibrium model:5
In this model, the ultimate provider of financial resources is the Individual
investors (household) sector. This model suggests that under certain
economic assumptions (convex preferences, perfect competition, and
demand independence) there must be a set of prices such that aggregate
supplies will equal aggregate demands for every commodity in the economy. 6
In other words, firms and households have unrestricted access to perfect
financial markets, and have the responsibility to monitor and evaluate the
credit risk; making it an extremely difficult and costly process for
unprofessional household. Moreover, it makes it unrealistic model for banks,
those under it have no need exist; as they make a zero profit emerged from
the lack of monitoring activities delegation.
2. The incentive approach (principalagent problem):
(Aoki 1994, p. 109) has stated that transactions between investors (including
banks) might sometime enclose a level of information asymmetry and
5 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring System
under Institutional and Transition Failures, Palgrave Macmillan. P21
6 Arrow, K. J.; Debreu, G. (1954). "Existence of an equilibrium for a competitive
economy", The Econometric Society p 265

imperfection. Aoki (1994) summarizes three situations where this problem

occurs: first, an adverse selection problem: investors are provided with
minimum amount of information that dont cover the technological and
marketing opportunities, and the defined outcome of a project resulting from
management capabilities. Second, the coordination problem: this problem
occurs when the financial return of the project depends on complementary
projects by other firms, thus, managers may not necessarily be confident with
their information. Third, the moral hazard problem; where a manager fails
to accomplish his promise of profitable usage of funds; due to his unidentified
incompetence.

The model hazard problem is referred to as (Multiple

Principle-Agent Problem). A perfect multiple principle-agent problem occurs

when the agent is a risk averse; due to allocating unwanted risk on the agent
by providing him with effective work incentives. 8 Finally, Suzuki (211) has
defined the principalagent problem as a problem that arises when those who
own physical assets must rely on others to make use of them. Shareholders
can only exercise limited control over managers; due to the costly
information, hence, managers are provided with incentives to perform well
(Stiglitz 1994, pp. 98, 177).9
7 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring System
under Institutional and Transition Failures, Palgrave Macmillan. P22
8 Holmstrom, B., & Milgrom, P. (1991). Multitask Principal-Agent Analyses:
Incentive Contracts, Asset Ownership, and Job Design. Journal of Law,
Economics, & Organization, 7, 24-52. Retrieved May 13, 2016, from
https://faculty.fuqua.duke.edu/~qc2/BA532/1991 JLEO Holmstrom
Milgrom.pdf.
9 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring System
under Institutional and Transition Failures, Palgrave Macmillan. P23

3. Bounded Rationality (Rule of Thumb):

Herbert Simon developed the thesis that economic actors are intendedly
rational but only limitedly, partly because of information problems.
Williamson (1985) and Hargreaves Heap (1992, p. 17) stated that when the
cost of monitoring increase, people uses rules of thumb to save the cost of
acquiring the information which makes monitoring more complex. 10

10 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring

System under Institutional and Transition Failures, Palgrave Macmillan. P26

4. Uncertainty:
In the real world, most choices take place under conditions of uncertainty.
Knight described decision-making under uncertainty as the formulation of
subjective probability judgements. The world is faced with uncertainty when
a stochastic variation is not governed by stable probability distributions,
agents lack costless information, when agents cannot determine the extent
to which their own actions are responsible for the outcomes they experience,
and when it is impossible to preclude the possibility of systemic risk, because
the economy has no parameters (see Dymski 1993). 11 Uncertainty makes
decision processes both complex and volatile. In terms of subjective
probability in credit risk management, Volatility stemming from lenders
uncertainty is a crucial factor in the systemic fragility of financial markets and
one of the most crucial factors making their monitoring activities difficult and
ineffective (Meltzer 1982; Davis 1995). The socialization of credit risks and of
uncertainty depends upon the formal and informal institutional settings and
the associated background of each country. This means that a system that
works in one country will not necessarily have universal applicability.
Reflection:
The relationship between monitoring activities by both banks and households
(individuals) and the financial regulation in the credit market is significantly
apparent. Effective and active monitoring activities by both banks and
investors have a critical role in ensuring the proper functioning of a financial
11 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring
System under Institutional and Transition Failures, Palgrave Macmillan. P28

market as well as the efficient running of the market. Moreover, monitoring

activities role is recognizable in ensuring a well emphasized regulation in a
credit market. Credit markets deal build relationships with investor; as their
role isnt limited on daily transactions but also on long-term future trade.
What is exchanged is money today for a (often vague) promise of money in
the future, A financial contract is a money todaymoney tomorrow deal is a
certain saying in financial markets (Stiglitz 1994, pp. 20911) 12. As these
markets deals with future trade; a nature of uncertainty is a main
characteristic of such markets. The foreseen and uncertain nature of the
information together with the risk associated with borrowing and lending on a
long-term base; marks the specialty of these markets and their need for a
proper monitoring that control the uncertainty and provide promises these
markets prolong for. However, although these markets seek monitoring, there
has been some factors that play a major role in in making monitoring
activities difficult. For example: individuals possess limited amount of
information making their ability to monitor and screening to be limited by
bounded rationality and uncertainty. Moreover, monitoring activities tend to
be costly and necessarily imperfect; due to: the uncertainty in credit risk
assessments (the difficulty of estimating the subjective probability of default),
and the asymmetries nature of information transferred between banks and
supervisors, which result in inefficient protective structure, and create moral
hazard problems in the loan portfolio management by banks. This paper has
provided detailed information regarding the four major factors that are
12 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring
System under Institutional and Transition Failures, Palgrave Macmillan. P

believed to have a significant role in making monitoring activities difficult

(ArrowDebreu general equilibrium model, the principalagent problem,
Bounded Rationality, and Uncertainty).

Conclusion:
In conclusion, the paper suggests recommendations to limit the role of these
factors. For example, for the incentive approach (principle-agent problem),
Stiglitz claims that information related to the firms financial situation is a
public good (Stiglitz 1994, p. 211)13. Private rating agencies have been having
a role in providing private incentives for disclosure as good ratings reduce the
cost of capital for borrowers. Moreover, in order to furtherly improve the
availability of information in a way that will ensure effective monitoring for
both borrowers and banks, governments have emphasized the international
disclosure requirements, such as the requirement by the BCBS. We need to
assess the extent to which these types of international codes of monitoring,
and the development of private ratings for quantifying credit risks, are
effective in providing banks or financial institutions the appropriate
information and incentives for improving their monitoring. Thus, the
economics of information has identified a series of market failures in credit
markets that can lead to credit rationing even in equilibrium, caused by
information asymmetries between lenders and borrowers. Information
economics insists that the incomplete information paradigm explains why
financial markets cannot be complete and shows why banks as financial
intermediaries exist. This approach makes a significant contribution to our
understanding of the importance of banks as monitoring actors and the
incentives of monitoring for bank managers, bank shareholders and
13 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring
System under Institutional and Transition Failures, Palgrave Macmillan. P

regulators that are collectively required to achieve effective financial

intermediation (Suzuki 2011, p25)14. As for bounded rationality, in order to
enhance effectiveness, individuals should accept information and advice from
social groups of which they are members of. By doing so, individuals will have
a great advantage in fitting their information with the information of others
(Simon 1996, p. 45).15 Working toward such recommendation will improve the
trust in the market, the transactions, and the regulation flow. Governments
can play a major role in controlling the implementation of such
recommendations and ensuring the regulation of financial markets.
Entrusting the implementation of a monitoring improvement in the markets
to the individuals or banks, although may be effective, is not sufficient.
Therefore, regulations by governments are needed for successful
implementation.

Financial markets work best when investors are fully informed and
the markets are free of fraud and manipulation.

14 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring

System under Institutional and Transition Failures, Palgrave Macmillan. P
15 Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring
System under Institutional and Transition Failures, Palgrave Macmillan. P27

References:
Bi ggar, D., & Heimler, A. (2005). AN INCREASING ROLE FOR COMPETITION IN
THE REGULATION OF BANKS. Retrieved May 13, 2016, from
http://www.internationalcompetitionnetwork.org/uploads/library/doc382.pdf
Dodd, R. (2003). Should the government do more to regulate financial
markets. Retrieved May 13, 2016, from
http://www.financialpolicy.org/FPFwsjclassroom.htm
Holmstrom, B., & Milgrom, P. (1991). Multitask Principal-Agent Analyses:
Incentive Contracts, Asset Ownership, and Job Design. Journal of Law,
Economics, & Organization, 7, 24-52. Retrieved May 13, 2016, from
https://faculty.fuqua.duke.edu/~qc2/BA532/1991 JLEO Holmstrom
Milgrom.pdf.
Suzuki, Y. 2011. Japans Financial Slump: Collapse of the Monitoring System
under Institutional and Transition Failures, Palgrave Macmillan
Arrow, K. J.; Debreu, G. (1954). "Existence of an equilibrium for a competitive
economy", The Econometric Society