Definition of 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. Market discipline is a market-based promotion of the transparency and disclosure of the risks associated with a business or entity. It works in concert with regulatory systems to increase the safety and soundness of the market.
In the absence of direct government intervention in a free market economy, market discipline provides both internal and external governance mechanisms.
Breaking Down Market Discipline
Through the support of disclosures and clear financial reporting systems, 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. In addition, qualitative information surrounding a company’s goals, management, and any legal pressures also becomes more readily available. This data helps reduce uncertainty, increase accountability, and promote the function of the market as an exchange between lenders and borrowers.
An example of market discipline is public support for raising capital requirements. Banks and other depository institutions must have liquidity for a certain level of assets. While regulatory agencies like the Bank for International Settlements, the Federal Deposit Insurance Corporation (FDIC) or the Federal Reserve Board set standards for capital requirements, market discipline pushes banks to uphold and even expand them. In turn, this can increase 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 spun out of control, due to 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. Ratings agencies like Moody's Investors Service and Fitch Ratings were generous in giving 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.