What Are Nonbank Financial Companies?
Nonbank financial companies (NBFCs), also known as nonbank financial institutions (NBFIs), are financial institutions that offer various banking services but do not have a banking license. Typically, these institutions are not permitted to take traditional demand deposits—readily available funds, such as those in checking or savings accounts—from the public. This restriction keeps them outside the purview of conventional oversight from federal and state financial regulators.
NBFCs fall under the oversight of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which describes them as companies “predominantly engaged in a financial activity” when more than 85% of their consolidated annual gross revenues or consolidated assets are financial in nature. Examples of NBFCs include investment banks, mortgage lenders, money market funds, insurance companies, hedge funds, private equity funds, and P2P lenders.
Key Takeaways
- Nonbank financial companies (NBFCs), also known as nonbank financial institutions (NBFIs), are entities that provide certain bank-like financial services but do not hold a banking license.
- NBFCs are not subject to the banking regulations and oversight by federal and state authorities adhered to by traditional banks.
- Investment banks, mortgage lenders, money market funds, insurance companies, hedge funds, private equity funds, and P2P lenders are all examples of NBFCs.
- Since the Great Recession, NBFCs have proliferated in number and type, playing a key role in meeting the credit demand unmet by traditional banks.
Understanding NBFCs
NBFCs offer services such as loans and credit facilities, currency exchange, retirement planning, money markets, underwriting, and merger activities.
The Dodd-Frank Wall Street Reform and Consumer Protection Act defines three types of nonbank financial companies: foreign nonbank financial companies, U.S. nonbank financial companies, and U.S. nonbank financial companies supervised by the Federal Reserve Board of Governors.
Foreign Nonbank Financial Companies
Foreign nonbank financial companies are incorporated or organized outside the U.S. and are predominantly engaged in financial activities such as those listed above. Foreign nonbanks may or may not have branches in the United States.
U.S. Nonbank Financial Companies
U.S. nonbank financial companies, like their foreign counterparts, are predominantly engaged in nonbank financial activities but have been incorporated or organized in the United States. U.S. nonbanks cannot serve as Farm Credit System institutions, national securities exchanges, or any one of several other types of financial institutions.
U.S. Nonbank Financial Companies Supervised by the Federal Reserve Board of Governors
These NBFCs fall under the supervision of the Federal Reserve Board of Governors due to financial distress or the “nature, scope, size, scale, concentration, interconnectedness, or mix of activities” at these institutions that could threaten U.S. financial stability.
Shadow Banks and the 2008 Financial Crisis
NBFCs existed long before the Dodd-Frank Act. In 2007, they were termed “shadow banks” by economist Paul McCulley to describe the expanding institutions contributing to the easy-money lending environment, which led to the subprime mortgage meltdown and the 2008 financial crisis.
Although the term sounds somewhat sinister, many well-known brokerages and investment firms were engaging in shadow-banking activity. Investment banks Lehman Brothers and Bear Stearns were two of the most notable NBFCs at the center of the 2008 crisis.
As a result of the ensuing financial crisis, traditional banks encountered stricter regulation, leading to a contraction in their lending activities. This made room for NBFCs to rise in numbers and types to meet the credit demand.
NBFC Controversy
Advocates of NBFCs argue that these institutions play an important role in meeting the rising demand for credit, loans, and other financial services. Customers include both businesses and individuals who might have trouble qualifying under the more stringent standards set by traditional banks.
Pros:
- Alternate source of funding and credit
- Direct contact with clients, eliminating intermediaries
- High yields for investors
- Liquidity for the financial system
Cons:
- Less regulated than banks
- Non-transparent operations
- Systemic risk to the financial system and economy
Critics argue that NBFCs’ lack of accountability to regulators and their ability to operate outside customary rules pose a significant risk. They highlight the sector’s role in the 2008 financial crisis and emphasize its continued growth as a potential risk factor.
Real-World Examples of NBFCs
Entities ranging from mortgage provider Quicken Loans to financial services firm Fidelity Investments qualify as NBFCs. However, the fastest-growing segment has been in peer-to-peer (P2P) lending.
P2P lending websites, such as LendingClub and Prosper, connect borrowers with investors willing to provide loans that can offer high yields. These platforms cater to individuals who might not qualify for traditional bank loans.
According to Precedence Research, the peer-to-peer lending market had a size of $18.88 billion in 2022 and is anticipated to grow significantly over the next decade.
Examples of Nonbank Financial Companies
There are many types of NBFCs. Some of the most familiar are:
- Casinos and card clubs
- Securities and commodities firms (e.g., brokers/dealers, investment advisers, mutual funds, hedge funds, or commodity traders)
- Money services businesses (MSB)
- Insurance companies
- Loan or finance companies
- Operators of credit card systems
Distinguishing NBFCs from NBFIs
Generally, there is no difference between NBFCs and NBFIs; they are alternative names for the same type of company.
Why Are NBFCs Called Shadow Banks?
NBFCs are often called shadow banks because they function similarly to banks but with fewer regulatory controls. Most NBFCs cannot accept deposits from people and raise money through bonds or bank loans.
Conclusion
Nonbank financial companies (NBFCs), also known as nonbank financial institutions (NBFIs), provide similar services to banks but do not hold a banking license. They are subject to different and often fewer regulations than banks. Investment banks, mortgage lenders, money market funds, insurance companies, hedge funds, private equity funds, and P2P lenders are all examples of NBFCs.
Since the Great Recession, NBFCs have grown significantly, playing a vital role in meeting the credit demand unmet by traditional banks. While some consider NBFCs as valuable alternate sources of credit and funding, others see them as potential risks to the U.S. economy.
Related Terms: Nonbank Financial Institutions, Investment Banks, P2P Lending, Hedge Funds, Dodd-Frank Act.
References
- U.S. Congress. “Dodd-Frank Wall Street Reform and Consumer Protection Act”. Pages 1391-1392.
- U.S. Congress. “Dodd-Frank Wall Street Reform and Consumer Protection Act”. Pages 1391-1392, 1398.
- Federal Reserve Bank of Kansas City. “Housing, Housing Finance, and Monetary Policy: General Discussion: Housing and Monetary Policy”. Page 485.
- International Monetary Fund. “Shadow Banks: Out of the Eyes of Regulators”.
- National Bureau of Economic Research. “Oh, How the Mighty Have Fallen: The Bank Failures and Near Failures That Started America’s Greatest Financial Panics”.
- Precedence Research. “Peer to Peer (P2P) Lending Market (by Type: Consumer Lending, Business Lending; by End User: Consumer Credit Loans, Small Business Loans, Student Loans, Real Estate Loans; by Business Model: Marketplace Lending, Traditional Lending) – Global Industry Analysis, Size, Share, Growth, Trends, Regional Outlook, and Forecast 2023 – 2032”.
