Nonbank Financial Companies (NBFCs)

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

Dodd-Frank 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. NBFCs can offer services such as loans and credit facilities, currency exchange, retirement planning, money markets, underwriting, and merger activities.

Foreign Nonbank Financial Companies

Foreign nonbank financial companies are incorporated or organized outside the U.S. and 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 Meltdowns

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

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, proponents say, they also offer more efficient ones. NBFCs cut out the middleman — 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 humming.

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 cite that, after all, they have only increased in numbers since then.

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 Brand Essence Research suggests that:

Global Peer-to-Peer Lending (P2P) Market is valued at USD 34.16 Billion in 2018 and expected to reach USD 589.05 Billion by 2025 with a CAGR of 50.2% over the forecast period. Universal advancements in technologies which command the processes connected to money lending majorly driving the Global Peer to Peer (P2P) Market.