Their incentives to manage risk and avoid insolvency will be severely blunted if insolvent banks are merged with stronger banks or simply allowed to continue operating without owners losing their stake or managers losing their jobs. Similarly, bank creditors will exert no market discipline if they run no risk of loss on their claims on banks.
Thus, guarantees for bank creditors will also blunt the incentive of banks to control risk. Market discipline also requires adequate accounting and disclosure standards, to enable bank investors to judge a bank’s condition accurately. An important complement to market discipline in promoting sound risk management is effective bank supervision.