Separation of functions, Collusion and Supervisors Financial Participation

We derive the optimal principal-supervisor-agent relationship in an incomplete contract setting. We show that while having a three-layer structure with full separation of tasks has no efficiency consequence under a complete contract, it becomes crucial under an incomplete contract and can even lead to a result of irrelevance of the contractual incompleteness. When it is not possible to achieve this outcome, managers non-compliance arises as equilibrium behaviour despite the presence of complying supervisors. However, although always more efficient relative to a bilateral structure, the three-layer structure is prone to collusion and renegotiation. We show that the response to such drawback is to involve financially the supervisor into the venture, with the extent of the participation depending on how costly it is to collude and renegotiate the contract terms. Last, we derive the welfare properties of the various contract forms showing that they depend on the relative scarcity of each form of financing (monitoring/non monitoring), on transaction costs of collusion and on the distribution of cash flows relative to the project size. This allows us to derive the conditions for the emergence of a bilateral structure in which the financing and supervisory task are centralised on to the same subject and to argue that riskier firms, with high risk of collusive behaviour, are more likely to be financed by a single monitoring lender and thus face a higher cost of credit.