Market discipline is a collective term for the various factors that have a tendency to establish parameters on the investing and lending activity that is undertaken by individual investors and financial institutions. When interpreted accurately, these factors can help prevent an investor from acquiring a security that carries relatively little chance of earning a return. In like manner, market discipline can also help a financial institution to make wise investments with available resources, including what loans to underwrite and which ones to reject. Essentially, market discipline helps to narrow the range of financial decisions that are likely generate a decent return, while omitting others that show less promise.
A number of factors are involved in market discipline. One has to do with transparency in business dealings. The idea is to make sure that both buyers and sellers provide full disclosure, allowing all parties involved to determine if the transaction is likely to be in the best interests of everyone involved. Another common factor has to do with the financial stability of the parties involved. If either party misrepresents their true financial status, possibly through the use of creative accounting, then the degree of risk is significantly increased.
Both buyers and sellers utilize market discipline to minimize the degree of risk while also maximizing the potential for a return. For buyers, the goal is to secure assets at prices they can readily afford, without creating undue financial hardship. This helps to minimize the chances of enduring a financial setback that leads to bankruptcy. At the same time, sellers are seeking to earn the highest return possible from the assets they sell, and thus generate revenue that keeps them financially solvent, and relatively immune to the possibility of bankruptcy.
Banks, in particular, are concerned with market discipline. The goal is to keep the institution financially sound while also seeking to make the most effective use of its assets to generate additional revenue. In order to accomplish this, the bank must attract more customers, as well as maintain the current clientele, including investors. One of the ways this is accomplished is by providing full disclosure to the general public. This practice allows potential customers to evaluate the stability of the banking institution, and thus be somewhat sure that any money they invest or deposit with the bank will be managed in an ethical and professional manner.
Market discipline is about providing accurate and true data for any type of proposed transaction, properly evaluating the current movements of the marketplace to determine if a given transaction is feasible, and deciding if the transaction is to the benefit of all parties concerned. Whether used to evaluate a loan application, buy a certain stock, or enter into a business partnership, taking the time to consider these key factors and how they fit into the marketplace is extremely important. Failure to do so will likely lead to losses that could undermine the general financial well being of one or more parties involved in the transaction.