Nonbank Financial Institutions: What They Are and How They Work

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. Generally, these institutions are not allowed to take traditional demand deposits—readily available funds, such as those in checking or savings accounts—from the public. This limitation keeps them outside the scope of conventional oversight from federal and state financial regulators.

Nonbank financial companies 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.

Understanding NBFCs

NBFCs can 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 nonbank counterparts, are predominantly engaged in nonbank financial activities but have been incorporated or organized in the United States. U.S. nonbanks are restricted from serving 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 Board of Governors

The main difference between these nonbank financial companies and others is that they fall under the supervision of the Federal Reserve Board of Governors. This is based on a determination by the Board that financial distress or the “nature, scope, size, scale, concentration, interconnectedness, or mix of activities” at these institutions could threaten the financial stability of the United States.

Shadow Banks and the 2008 Financial Crisis

NBFCs existed long before the Dodd-Frank Act. In 2007, they were given the moniker "shadow banks" by economist Paul McCulley, at the time the managing director of Pacific Investment Management Company LLC (PIMCO), to describe the expanding matrix of institutions contributing to the then-current easy-money lending environment—which in turn led to the subprime mortgage meltdown and the subsequent 2008 financial crisis.

Although the term sounds somewhat sinister, many well-known brokerages and investment firms were engaging in shadow-banking activity. Investment bankers Lehman Brothers and Bear Stearns were two of the most well-known NBFCs at the center of the 2008 crisis.

As a result of the ensuing financial crisis, traditional banks found themselves under closer regulatory scrutiny, which led to a prolonged contraction in their lending activities. As the authorities tightened up on the banks, the banks, in turn, tightened up on loan or credit applicants.

The more stringent requirements gave rise to more people needing other funding sources—and hence, the growth of nonbank institutions that were able to operate outside the constraints of banking regulations. In short, in the decade following the financial crisis of 2007-08, NBFCs proliferated in large numbers and varying types, playing a key role in meeting the credit demand unmet by traditional banks.

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—especially those who might have trouble qualifying under the more stringent standards set by traditional banks.

Not only do NBFCs provide alternate sources of credit, proponents say, they also offer more efficient ones. NBFCs cut out the intermediary—the role banks often play—to let clients deal with them directly, lowering costs, fees, and rates, in a process called disintermediation. Providing financing and credit is important to keep the money supply liquid and the economy working well.

Even so, critics are troubled by NBFCs' lack of accountability to regulators and their ability to operate outside the customary banking rules and regulations. In some cases, they may face oversight by other authorities— such as the Federal Trade Commission (FTC), the Securities and Exchange Commission (SEC) if they're public companies, or the Financial Industry Regulatory Authority (FINRA) if they're brokerages. However, in other cases, they may be able to operate with a lack of transparency.

All of this could put an increasing strain on the financial system. NBFCs were at the epicenter of the 2008 financial crisis that led to the Great Recession. Critics point out that they have increased in numbers since then, and therefore represent a greater risk than ever before.

Real-World Example of NBFCs

Entities ranging from mortgage provider Quicken Loans to financial services firm Fidelity Investments qualify as NBFCs. However, the fastest-growing segment of the non-bank lending sector has been in peer-to-peer (P2P) lending.

The growth of P2P lending has been facilitated by the power of social networking, which brings like-minded people from all over the world together. P2P lending websites, such as LendingClub and Prosper, are designed to connect prospective borrowers with investors willing to invest their money in loans that can generate high yields.

P2P borrowers tend to be individuals who could not otherwise qualify for a traditional bank loan or who prefer to do business with non-banks. Investors have the opportunity to build a diversified portfolio of loans by investing small sums across a range of borrowers.

Although P2P lending only represents a small fraction of the total loans issued in the United States, Precedence Research reported that the peer to peer lending market had a size of $18.88 billion in 2022. This market size is expected to continuously grow over the next decade.

The Bottom Line

Nonbank financial companies (NBFCs), also known as nonbank financial institutions (NBFIs), are entities that provide similar services to a bank but do not hold a banking license. As a result, they are subject to different regulations than banks, and in many regards are less regulated than banks. There are many NBFCs. 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. Their critics say that they pose a risk to the US economy; their proponents say they offer a valuable, alternative source of credit and funding.