This chapter offers a new understanding of how financial markets work. The key departure from conventional theory is to recognize that investors do not invest directly in securities but through agents such as fund managers. Agents have better information and different objectives than their customers (principals) and this asymmetry is shown as the source of inefficiency - mispricing, bubbles and crashes. A separate outcome is that agents are in a position to capture for themselves the bulk of the returns from financial innovations. Principal-agent problems do a good job of explaining how the global finance sector has become so bloated, profitable and prone to crisis. Remedial action involves the principals changing the way they contract with, and instruct, agents. The chapter ends with a manifesto of policies that pension funds and other large investors can adopt to mitigate the destructive features of delegation both for their individual benefit and to promote social welfare in the form of a leaner, more efficient and more stable finance sector.
Published in the The Future of Finance - The LSE Report.
