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A “Principal-Agent” Problem arises whenever a Principal, such as a lender or creditor, and Agent, such as a borrower, have conflicting objectives. In typical credit transactions, the agent has a lot of private information related to the transaction that is costly for the principal to obtain. This results in “information asymmetry.” For example, consider the case of commercial lending by banks, and small business borrowers.

The bank’s objective is repayment of a loan and for conditions of the loan to be satisfied by the borrower to ensure the bank is properly compensated, including for the default risk.

The borrower’s objective is to use the money to purchase goods and/or services for their business to maximize future profits.

The Principal-Agent Problem arises when a the creditor or lender has difficulty observing the financial behavior of borrowers. This leads to concerns around whether or not funds will be used for the purpose for which the loan was intended.

The Principal–Agent pProblem itself contains two subcategories of potential conflict based on informational asymmetry.

The first, known as “adverse selection,” involves problems arising from hidden knowledge. For example, the borrower’s true assessment of their own risk of repayment based on their private information may be hidden from the creditor.

The second, known as “moral hazard“, involves problems arising from hidden actions. For example, a borrower may make riskier investments or engage in more risky behavior after the loan is funded, increasing the credit default risk.

Both parties benefit from transparency and breaking down the information asymmetry. The principal can ease concerns around the risk of default and take fewer costly measures to protect against loss and the agent is able to receive much better credit terms.

Crediture’s data analytics are designed to help bridge the gap between principals and agents and build a foundation of trust between creditors and lenders. In identifying and capturing critical data and generating valuable reports, Crediture’s data analytic capabilities can serve both principals, such as creditors and lenders, and agents, such as borrowers and small businesses. In helping to overcome Principal-Agent Problems in credit markets, Crediture builds trust that can facilitate more credit transactions, thereby encouraging further economic growth and development in underserved communities.

Francois Melese, Ph.D.

Author Francois Melese, Ph.D.

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