What is a Non-Banking Financial Company (NBFC)?
A non-banking financial company, also known as non-banking financial institutions, are companies that offer financial services and products but are not officially recognized as a bank with a full banking license.
Generally, the distinction between a recognized bank and a non-banking financial company is the fact that non-bank companies cannot accept traditional demand deposits. Demand deposits are funds held in a bank account that can be withdrawn at any time, usually in the form of a checking account.
Non-Banking Financial Company Explained
Non-banking financial companies are not subject to banking regulations or the usual oversight by federal authorities that are usually followed by recognized banks. Types of companies that are considered NBFCs are the following:
- Risk-pooling institutions
- Savings institutions
- Pension funds
- Mutual funds
- Money-market funds
- Private equity funds
- Hedge funds
- Venture capital funds
- Market makers
- Broker-dealer institutions
- Specialized lenders
- Real estate lenders
- Leasing companies
- Payday lenders
- General financial service providers
- Investment banking companies
- Credit rating agencies
- Management consulting companies
- Financial advisors
- Securities traders and brokers
NBFCs in the United States generally fall under the regulations of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The legislation was passed in 2010 among the broad financial reform within the United States as a response to the 2008 Global Financial Crisis.
The purpose of the Dodd-Frank Act was to reform the specific sectors of the financial system that were at the root of the financial crisis. The companies included banks, mortgage lenders, and credit rating agencies.
Effects of the 2008 Global Financial Crisis
NBFCs before the Dodd-Frank Act were referred to as “shadow banks” to describe them as the fast-expanding plethora of institutions that contributed to the easy-money lending environment. The subprime mortgage meltdown and financial crisis that followed was a direct product of the “shadow banks” becoming too prominent and lacking enough regulation.
Many very large and prominent investment companies and brokerages were involved with the activities that led to the financial crisis. After the financial crisis, traditional banks found themselves under an intense regulatory microscope. It led to a large contraction of lending activities, as regulations for lending and other credit activities tightened. However, the demand for borrowing remained the same, and NBFCs were able to fill the void of funding.
After the 2008 Global Financial Crisis, NBFCs were able to grow very quickly, and in various industries.
Differences Among Countries
The existence of NBFCs is more prominent in some geographical locations than others. For example, in Canada, NBFCs are far less prominent than in the U.S. It is due to different competitive environments between the two countries. Canada’s banking industry is much more concentrated, resembling an oligopoly.
An oligopoly is an industry that is dominated by a small group of large companies. The companies exercise strong pricing power and more market control than other companies normally would. Canadian banks are fully diversified and provide a full range of financial services, including most functions that a non-banking financial company would normally perform, such as insurance, wealth management, investment banking, and brokerage services.
In contrast, the U.S. banking industry is far more fragmented. A fragmented industry is one where the companies compete heavily, and there is no group of companies that dominate. It means that there is much more competition among smaller companies and more opportunities for NBFCs to flourish.
Controversy with NBFCs
Many would argue that NBFCs are essential services that provide other services that are not met by traditional banks and are able to specialize in the services and perform better. Such institutions help meet the demand for credit required by individuals and businesses that banks are not able to provide.
However, the fact that NBFCs are not regulated as heavily as banks pose an additional risk. Such a risk was highlighted during the 2008 Global Financial Crisis when the lending practices of the companies went unchecked and resulted in a disastrous outcome.
Going forward, it is clear that the companies are necessary to meet the demands of the financial markets. However, more regulatory oversight should be instituted to make sure that poor practices are not being followed as they were in 2008.
CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
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