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In this paper we investigate the task the supervisor should be optimally charged with in an agency model in which the principal faces corruption concerns. We highlight a fundamental tradeoff between monitoring the agent's effort choice and auditing it ex-post. Monitoring proves more effective in tackling corruption since the supervisor sends the report before the profit realization. By taking advantage of the supervisor's uncertainty about the state of nature, the principal can design a compensation scheme which prevents all forms of corruption at a lower cost. Conversely auditing reduces the cost of supervision as the principal hires the supervisor only if the profit does not convey enough information about the compensation due to the agent. We show that the ultimate choice between monitoring and auditing depends on the supervisor's ability to falsify information and the cost of performing an inspection.

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Tighter regulation and more powerful supervision are being enacted after the global financial crisis. Although this trend may have positive welfare effects, it may also impose large social costs due to the strong reliance on supervisory information. We argue that offering banks a Flexible Supervision contract, designed to be chosen by those banks that will otherwise attempt to capture the supervisor, is a mechanism to implement the most efficient regulation under asymmetric information. The result that Flexible Supervision outperforms Mandatory Supervision remains robust to a series of extensions to our baseline model.