What role, if any, can market discipline play in supporting macroprudential policy?

This paper focuses on market discipline as a necessary condition to preserve the signaling content of balance sheet indicators and market prices as macroprudential tools. It argues that market discipline enhances the information content of market prices by reflecting the expected private cost of financial distress, including the systemic importance of particular firms. This paper also argues that three conditions are necessary for market discipline to be effective: adequate and timely information on financial institutions’ risk profiles; financial institutions’ creditors must consider themselves at risk; and the reaction to market signals needs to be observable. The paper relies on the existing financial literature and it is particularly timely because policymakers are considering structural measures of banks’ systemic importance as a benchmark for macroprudential policy.