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 traditionaldemand deposits—readily available funds, such as those in checking or savings accounts—from the public. This limitation keeps them outside the scope of conventionaloversight 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.
- 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.
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 ofPacific 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.
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.
Alternate source of funding and credit
Direct contact with clients, eliminating intermediaries
High yields for investors
Liquidity for the financial system
Non-regulated, not subject to oversight
Systemic risk to financial system, economy
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—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 Corp. (LC), StreetShares, 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,a report from IBIS World suggests that $938.6 million is held in Peer-to-Peer Lending Platforms in the US in 2022 and that this has increased 7.9% over the past year.
What Are Examples of Nonbank Financial Companies?
There are many types of NBFC. 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
What Is the Difference Between NBFCs and NBFIs?
Generally, none. These are alternative names for the same type of company.
Why Are NBFCs Called Shadow Banks?
NBFCs are often called shadow banks as they function a lot like banks but with fewer regulatory controls. Barring a few, they cannot accept deposits from people and so raise money from bonds or borrow from banks.
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. Because of this, they are not regulated or overseen by federal and state authorities. 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.
As an enthusiast and expert in the field of nonbank financial companies (NBFCs) and nonbank financial institutions (NBFIs), I bring a wealth of knowledge and first-hand expertise to shed light on this complex and dynamic sector. My understanding extends beyond the surface, allowing me to provide a comprehensive overview of the concepts discussed in the article.
The concept of NBFCs revolves around financial institutions that offer banking services without holding a banking license. This distinction is crucial, as it places them outside the purview of traditional banking regulations and oversight by federal and state authorities. My expertise in this area encompasses a deep understanding of the regulatory framework, with a specific focus on the Dodd-Frank Wall Street Reform and Consumer Protection Act.
I am well-versed in the diverse landscape of NBFCs, which includes entities such as investment banks, mortgage lenders, money market funds, insurance companies, hedge funds, private equity funds, and peer-to-peer (P2P) lenders. These institutions play a pivotal role in meeting credit demand unmet by traditional banks, a phenomenon that gained prominence after the Great Recession.
The Dodd-Frank Act categorizes NBFCs into three types: foreign nonbank financial companies, U.S. nonbank financial companies, and U.S. nonbank financial companies supervised by the Federal Reserve Board of Governors. Each category has distinct characteristics and regulatory implications, showcasing the intricate nature of the NBFC landscape.
The term "shadow banks," introduced by economist Paul McCulley in 2007, refers to the expanding matrix of institutions that played a significant role in the 2008 financial crisis. Lehman Brothers and Bear Stearns, both well-known investment banks, were prominent examples of NBFCs at the center of the crisis. This historical context is essential for understanding the origins and implications of NBFCs in the broader financial landscape.
My expertise also encompasses the controversy surrounding NBFCs, with advocates highlighting their role in meeting the rising demand for credit and financial services. On the other hand, critics express concerns about the lack of accountability, regulatory oversight, and the potential systemic risk posed by these institutions. I can delve into the pros and cons of NBFCs, offering a nuanced perspective on their impact on the financial system and the economy.
Furthermore, I bring real-world examples into the discussion, showcasing how entities like Quicken Loans, Fidelity Investments, and the growing segment of peer-to-peer lending exemplify the diverse range of NBFCs. My knowledge extends to the intricacies of P2P lending, emphasizing its role in providing an alternative source of funding and credit.
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