Market Discipline: What it Means, How it Works

What Is Market Discipline?

Market discipline is the onus on banks, financial institutions, sovereigns, and other major players in the financial industry to conduct business while considering the risks to their stakeholders. It promotes the transparency and disclosure of risks associated with a business or entity, working in concert with regulatory systems to increase market safety and soundness.

Market discipline provides both internal and external governance mechanisms in a free market economy without direct government intervention.

Key Takeaways

• Banks and major financial institutions exercise market discipline to monitor the potential risks to their stakeholders.
• Through market discipline, market participants can monitor the risks of banks and take action if needed.
• Market discipline supports clear financial reporting and encourages timely release of financial information to the public (a company’s assets, liabilities, income, net profit or loss, cash flows, etc.)
• This data helps reduce uncertainty and increase the accountability of financial institutions.

Understanding Market Discipline

Market discipline increases the information available to the public and encourages the release of timely data on a company’s assets, liabilities, income, net profit or loss, cash flows, and other financial information through disclosures and clear financial reporting. It also provides qualitative information surrounding a company’s goals, management, and legal pressures. This data helps reduce uncertainty, increase accountability, and promote the function of the market as an exchange between lenders and borrowers.

For market discipline to work effectively, market participants must have the information, means, and incentives to monitor and influence banks. Government interventions to bail out large financial institutions have reduced long-term incentives to monitor and discipline these banks.

An example of market discipline is public support for raising capital requirements. Banks and depository institutions must have liquidity for a certain level of assets. While regulatory agencies set standards for capital requirements, market discipline pushes banks to uphold and expand them, increasing the public’s confidence in their banks.

Market Discipline and Lessons From the 2008 Financial Crisis

The 2007-08 financial crisis was a credit crunch that resulted from uncertainty surrounding securitized​ loans and mortgage-backed securities (MBS). These loans had structural flaws, including a lack of proper vetting of lenders and teaser rates that, in many cases, guaranteed default. Rating agencies like Moody’s Investors Service and Fitch Ratings gave strong ratings to poor-quality products. Those that developed the products did not properly price in their risks. When the need for liquid capital was high within the global financial system, this mortgage meltdown froze the economy. The situation was so dire that the Federal Reserve had to pump billions into the system to save it; even then, the United States ended up in the Great Recession.

Since then, new market discipline mechanisms have taken root, including enhanced reporting measures, audits, better internal governance (including a diverse mix of independent board members), higher collateral and margin requirements, and more intense supervisory actions.