Restoring Trust in Finance: From Principal-Agent to Principled Agent

Abstract

Banking solves the principal–agent problem with incentive contracts which assume a Homo Economicus representative agent. However, professions can solve the principal–agent problem by assuming a ‘Reasonable Person’ representative agent, from tort law, who reliably tells the truth about hidden action. We describe a non-virtuous circle in finance, which is a negative feedback loop between motivation crowding out arising from incentive contracts, and the subsequent need to offer incentive contacts because agents change from the Reasonable Person to Homo Economicus. We prescribe less reliance on incentive contracts in the practice of finance, and on Homo Economicus in the theory of finance.