What it is:
Market discipline refers to the obligation by banks and financial institutions to manage their stakeholders' risk in the course of their day-to-day operations.
How it works (Example):
Banks and other financial institutions assume some level of risk with each loan they disburse. This risk is passed on to other borrowers and clients as well as stockholders.
Banks and financial companies are required to prepare publicly-available financial and operational documentation pursuant to federal regulations in order to ensure financial transparency and disclosure of information. In this way, market discipline discourages banks and financial companies from assuming excessive or dangerous levels of risk. Doing so might affect not only their ability to make loans, but also compromise the interests of existing stockholders and clients (checking account holders, depositors, and borrowers).
Why it Matters:
Market discipline places constraints on banks' and financial companies' level of risk because such risk would be reflected in financial statements and may deter prospective clients and investors.