Publication Date01 February 2008
AuthorAnna Maria C. Menichini
Date01 February 2008
Anna Maria C. Menichini
Within an incomplete contract setting, the paper analyses the role of third parties
in ameliorating incentive problems arising in the context of financial contracts with
costly verification and lender’s bargaining power. Contrary to the findings of the
bilateral lender–borrower relationship, characterised by no information revelation
and possibly a breakdown of the market, it is shown that, in the presence of third
parties, an optimal contract exists featuring partial information revelation and
random monitoring. The importance of third parties is therefore not limited to
improving efficiency, as it is when the contract offer comes from the informed
party, but to ensure project realisation, and thus to ensure that the surplus that can
arise from the project does not get lost.
I Intro ductio n
Several studies in recent years have focused on the design of the optimal
principal-agent contract when the agent has private information, which is costly
to verify and the verification strategy is non-contractible. In these cases, the
revelation principle does not apply and the contract must be set so as to provide
the incentives to monitor (Hart, 1995). The literature has proposed two ways to
achieve this: first, fully reimburse the principal for the verification cost incurred
even when monitoring detects truth-telling, so as to induce the agent to
truthfully reveal his cash flows (Jost, 1996; Persons, 1997); second, have the
agent ‘misrepresent’ the true state with positive probability, thus using the
possibility of punishing the agent for false reporting as an incentive to monitor
(Khalil, 1997; Persons, 1997; Choe, 1998; Khalil and Parigi, 1998). When the act
of monitoring is not publicly observable, the first of these alternatives is not
implementable (Menichini and Simmons, 2006).
The incentive to monitor can
`di Salerno, CSEF and CELPE
To be viable, this route requires repayments to be contingent upon verification: the monitor
is fully covered of the verification cost incurred when monitoring detects compliance and the
contract induces full information revelation. However, if verification is non-observable or non-
verifiable and there is no hard evidence in support of the monitor’s claim, the monitor will
always claim to have monitored even if she has not in order to cash the reward for monitoring
Scottish Journal of Political Economy, Vol. 55, No. 1, February 2008
r2008 The Author
Journal compilation r2008 Scottish Economic Society. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA
thus arise only from the possibility of collecting a penalty for detected false
reporting, and a contract inducing misrepresentation in equilibrium will arise,
i.e. a contract in which there is diversion of cash flows. The occurrence of this
scenario, however, relies either on the assumption that the agent has all the
bargaining power, or, when it is the principal who has the bargaining power,
that the penalty for false reporting is set exogenously and can exceed the agent’s
total income, as in Khalil (1997).
This paper studies the effects on the properties of the optimal contract of
giving all the bargaining power to the uninformed party, while setting the
penalty for misreporting endogenously. In particular, we study the properties of
the contract offered by a risk-neutral lender to a risk-neutral borrower when the
latter has ex ante private information about the return of an investment project,
which the lender can verify at a cost, but she cannot commit to do so. We show
that, under limited liability, the joint effect of the lender’s bargaining power and
contractual incompleteness induces no information revelation and leads to an
equilibrium in which the borrower’s reporting strategy is to always lie, while the
lender’s monitoring strategy depends only on the size of the observation cost.
When this is sufficiently high relative to the expected return from monitoring,
the lender will no longer have an incentive to monitor and will get a payoff no
higher than the low-type project returns. This has dramatic implications when
the lender is called to finance an investment project of fixed size, as in the present
work, since the low-type project returns fall short of the size of the loan: the
project has negative NPV for the lender and will not be financed, thus causing a
breakdown of the market and a consequential welfare loss. When the
observation cost is sufficiently low, instead, knowing that she can catch a lying
borrower, the lender still has an incentive to monitor and get the exact
repayment. Thus, a contract with partial or no information revelation and
deterministic monitoring arises. We argue that these equilibria are very costly
and that it is possible to do better by involving a third party with the role of
mitigating the borrower’s incentive to lie, even when the monitor has all the
bargaining power. In particular, we show that the incentive to cheat is reduced
when a second risk-averse financier, who has neither bargaining nor monitoring
power, is called to cofinance the investment project. The tool for controlling this
incentive is the structure of repayments. In the bilateral setup, whatever the
project’s type, the borrower gets his reservation utility, with any rent entirely
seized by the monitor. The introduction of a third party allows the monitor to
structure repayments so as to leave a rent to the borrower who truthfully reports
to have a high project type. This increases the borrower’s incentive to tell the
(the reimbursement of the verification cost). To prevent this, repayments following a truthful
monitored low state report cannot be contingent upon monitoring.
If the agent has the power to set the contract terms, he can hold the principal down to her
reservation utility, keeping any residual left in truthful reporting. This increases both the
expected cost of deception for the agent and the expected benefit of monitoring for the
principal: because the principle of maximum deterrence holds, detected misreporting implies
the loss of the entire surplus and its collection by the principal. When the principal has
the bargaining power and the punishment for misreporting is set exogenously, cheating involves
a net cost for the agent.
r2008 The Author
Journal compilation r2008 Scottish Economic Society

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