In general, market discipline is defined as the transparency and disclosure of the risks associated with a business or entity.
In case of banks, market discipline refers to the obligation by the banks and financial institutions to conduct business while considering the risks to their stakeholders in the passage of their day-to-day operations. Therefore, bank managements have strong incentives to avoid risky loans and other investments.
As per three pillars of Basel 3 recommendations, Market Discipline in banks seeks to achieve increased transparency through expanded disclosure requirements of banks under regulatory system. It imposes strong incentives on banks to conduct their business in a safe, sound and efficient manner, including an incentive to maintain a strong capital base as a cushion against potential future losses arising from risk exposures.
The regulatory and supervisory framework of banks based on the three pillars specifies that any investor whether as a depositor or professional investor in debt instruments providing funds to a financial institution must be able to access and monitoring its risk profile and financial position. This would help the investors to move their investments between banks according to their assessments of relative risk and return. In the other words, market participants can influence a financial institution’s conduct through monitoring its risk profile and financial position.