Market discipline is a term which describes the restraint implicitly required of financial services companies in order to remain solvent and financially strong in the face of market pressure instead of regulatory pressure.

The markets can sometimes make a ruling on which companies were conducting their business according to prudent and ethical guidelines, without the need of an SEC audit or the intervention of any other regulatory agency. The companies that weren’t will lose their customers and go bankrupt, in no particular order.

Most of the regulations in place for the financial services industry are there to protect the consumers and the economy as a whole, but the banks and companies involved usually have an interest in self-preservation, and in looking good for their customers and shareholders, that leads them to take precautionary measures over and above the requirements of any regulations.

Banks and insurance companies, for example, have very well-defined capital reserve requirements, but market discipline will often lead them to exceed the requirements. In the new international banking resolutions of the Basel Accord, the 3rd Pillar is market discipline.

They gently force market discipline on to banks by recommending and in some cases requiring that their books are transparent and visible to market participants. This allows the market to self-regulate when it has enough information to work with.

Part of the reason that the other pillars of the Basel Accord had to be mandated is because the market discipline had been largely removed from the banking industry over the years due to the removal of much of the risk for making loans through mortgage insurance and collateralized debt.

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