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 entities that offer various banking services but do not possess a banking license. Because they cannot accept traditional demand deposits from the public, NBFCs operate outside the direct scope of conventional financial regulators, although they do fall under oversight such as the Dodd-Frank Wall Street Reform and Consumer Protection Act. Important examples of NBFCs include investment banks, mortgage lenders, and P2P lenders.

How Nonbank Financial Companies Function

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.

Exploring 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.

The Role of U.S. Nonbank Financial Companies

U.S. nonbank financial companies engage in nonbank financial activities and are set up 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.

Understanding Oversight by the Federal Reserve for Certain U.S. Nonbank Financial Companies

These companies differ because they are supervised by 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 Banking and Its Role in the 2008 Financial Crisis

NBFCs have been around long before the Dodd-Frank Act. In 2007, economist Paul McCulley, then managing director at PIMCO, named them "shadow banks" for their role in the easy-money lending scene that led to the 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.

After the financial crisis, traditional banks faced more regulations, leading to a slowdown in their lending. As the authorities tightened up on the banks, the banks, in turn, tightened up on loan or credit applicants.

Stricter regulations led people to seek other funding sources, boosting the growth of nonbank institutions. 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.

Controversies Surrounding Nonbank Financial Companies

Supporters of NBFCs believe they are vital in meeting the growing demand for credit and 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.

Critics worry about NBFCs' lack of regulatory oversight and their ability to bypass standard banking rules. 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.

Practical Examples of Nonbank Financial Companies

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.

Social networking has fueled the growth of P2P lending by connecting like-minded people globally. 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 nonbanks. Investors have the opportunity to build a diversified portfolio of loans by investing small sums across a range of borrowers.

Although P2P lending is a small part of U.S. loans, it still reached $26.3 billion in 2023 according to Precedence Research. 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 U.S. economy; their proponents say they offer a valuable, alternative source of credit and funding.