“Direct” market discipline is exerted through risk-sensitive debt instruments when a banking organization’s expected cost of issuing those instruments increases substantially with an increase in its risk profile. For this to occur, investors must gather and collect information about the banking organization’s risks and prospects, and then incorporate that information into their decisions to buy the organization’s debt.
The anticipation of higher funding costs provides an incentive for the banking organization to refrain from excessive risk-taking. “Indirect” market discipline is exerted through risk-sensitive debt and equity instruments when private parties, and possibly government supervisors, monitor secondary market prices of those instruments in order to help determine the risk exposure (or default probability) of a banking organization.