Harvard Business School professor explains the most important problem we have in finance today and how to fix it

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June 5, 2017 4:22 PM

Harvard Business School professor Mihir Desai explains the most important problem we have in finance today.

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Mihir Desai, a professor of Harvard Business School and the author of "Wisdom of Finance" explains why having shareholders who are separate from the managers hold great danger for finance today. Following is a transcript of the video.

Josh Barro: So wait, let's walk through the principal-agent problem and the producers. So why - what's the principle-agent problem?

Mihir Desai: So the underlying principal-agent problem in today's society is we have shareholders who are separate from the managers. 120 years ago, most of us worked for ourselves or had the privilege of working for ourselves. Today, we have ownership in one place and management in another. That is the kind of central problem today because the managers don't necessarily operate on behalf of the owners. That's pretty well-embodied in the story of the producers where Bialystok and Bloom basically raise 25,000% of what they need and then they try to create a movie - sorry, they try to create a play that will surely fail so they don't have to repay their investors. Of course, it's "Springtime for Hitler," it becomes a great hit and they go to jail. But that underlying problem of investors, in their case, these old ladies who they raised money from, it is the problem of investing in companies today which is how do you create incentives and how do you monitor managers so they do the right thing. I think that's - I really believe that's arguably the most important problem in capitalism today. That principal-agent problem and how we solve it.

Barro: How do you fix that?

Desai: Well, we've been trying a lot of different things, right? So if you think about the revolution of equity compensation that has been about trying to solve that underlying problem -

Barro: So this is where it's actually the huge spike in CEO pay, it's that people are being paid in stock and stock options and things so theoretically, for them to make money, the company has to make money.

Desai: I think there's two different issues there, right? One is the level and one is the form. I actually don't care that much about the level, I care more about the form of the form it's taking, which is equity. It was meant to solve this problem but as you know well, and as I think we all know, that revolution has its own set of problems. You know, private equity is a response to that problem - we'll have one strong owner who is going to solve that. Boards are a solution to that problem, accounting is a solution to that problem so it's a really powerful lens. And what I tried to do in the book is then take that lens to parts of your life, you know, once you start thinking about the principal-agent problem, you'll see it everywhere.

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