Key Terms Explained
Nonbanking financial institution
Anonbank financial institution (NBFI) is a financial institution that does not have a full banking license and cannot accept deposits from the public. However, NBFIs do facilitate alternative financial services, such as investment (both collective and individual), risk pooling, financial consulting, brokering, money transmission, and check cashing. NBFIs are a source of consumer credit (along with licensed banks). Examples of nonbank financial institutions include insurance firms, venture capitalists, currency exchanges, some microloan organizations, and pawn shops. These non-bank financial institutions provide services that are not necessarily suited to banks, serve as competition to banks, and specialize in sectors or groups.
Risk pooling institutions
Insurance companies underwrite economic risks associated with death, illness, damage to or loss of property, and other risk of loss. They provide a contingent promise of economic protection in the case of loss. There are two main types of insurance companies: life insurance and general insurance. General insurance tends to be short-term, while life insurance is a longer contract, ending at the death of the insured. Both types of insurance, life and property, are available to all sectors of the community. Because of the nature of the insurance industry (companies must access a plethora of information to assess the risk in each individual case), insurance companies enjoy a high level of information efficiency.
Life insurance companies insure against economic loss of the insured’s premature death. The insured will pay a fixed sum as an insurance premium every term. Because the probability of death increases with age while premiums remain constant, the insured overpays in the earlier stages and underpays in the later years. The overpayment in the early years of the agreement is the cash value of the insurance policy.
General insurance is further divided into two categories: market and social insurance. Social insurance is against the risk of loss of income due to sudden unemployment, disability, illness, and natural disasters. Because of the unpredictability of these risks, the ease at which the insured can hide pertinent information from the insurer, and the presence of moral hazard, private insurance companies frequently do not provide social insurance, a gap in the insurance industry which government usually fills. Social insurance is more prevalent in industrialized Western societies where family networks and other organic social support groups are not as prevalent.
Market insurance is privatized insurance for damage or loss of property. General insurance companies take a single premium payment. In return, the companies will make a specified payment contingent on the event that it is being insured against. Examples include theft, fire, damage, natural disaster, etc.
Contractual savings institutions
Contractual savings institutions (also called institutional investors) provide the opportunity for individuals to invest in collective investment vehicles in a fiduciary rather than a principle role. Collective investment vehicles invest the pooled resources of the individuals and firms into numerous equity, debt, and derivatives promises. The individual, however, holds equity in the CIV itself rather what the CIV invests in specifically. The two most popular examples of contractual savings institutions are mutual funds and private pension plans.
The two two main types of mutual funds are open-end and closed-end funds. Open-end funds generate new investments by allowing the public buy new shares at any time. Shareholders can liquidate their shares by selling them back to the open-end fund at the net asset value. Closed-end funds issue a fixed number of shares in an IPO. The shareholders capitalize on the value of their assets by selling their shares in a stock exchange.
Mutual funds can be delineated along the nature of their investments. For example, some funds make high-risk, high return investments, while others focus on tax-exempt securities. Still others specialize in speculative trading (i.e. hedge funds), a specific sector, or cross-border investments.
Pension funds are mutual funds that limit the investor’s ability to access their investment until after a certain date. In return, pension funds are granted large tax breaks in order to incentivize the working public to set aside a percentage of their current income for a later date when they are no longer amongst the labor force (retirement income).
Other nonbank financial institutions
Market makers are broker-dealer institutions that quote both a buy and sell price for an asset held in inventory. Such assets include equities, government and corporate debt, derivatives, and foreign currencies. Once an order is received, the market maker immediately sells from its inventory or makes a purchase to offset the loss in inventory. The difference in the buying and selling quotes, or the bid-offer spread, is how the market-maker makes profit. Market makers improve the liquidity of any asset in their inventory.
Specialized sectoral financiers provide a limited range of financial services to a targeted sector. For example, leasing companies provide financing for equipment, while real estate financiers channel capital to prospective homeowners. Leasing companies generally have two unique advantages over other specialized sectoral financiers. They are somewhat insulated against the risk of default because they own the leased equipment as part of their collateral agreement. Additionally, leasing companies enjoy the preferential tax treatment on equipment investment.
Other financial service providers include brokers (both securities and mortgage), management consultants, and financial advisors. They operate on a fee-for-service basis. For the most part, financial service providers improve informational efficiency for the investor. However, in the case of brokers, they do offer a transactions service by which an investor can liquidate existing assets.
Role in financial system
NBFIs supplement banks in providing financial services to individuals and firms. They can provide competition for banks in the provision of these services. While banks may offer a set of financial services as a package deal, NBFIs unbundle these services, tailoring their services to particular groups. Additionally, individual NBFIs may specialize in a particular sector, gaining an informational advantage. By this unbundling, targeting, and specializing, NBFIs promote competition within the financial services industry.
Having a multi-faceted financial system, which includes non-bank financial institutions, can protect economies from financial shocks and recover from those shocks. NBFIs provide multiple alternatives to transform an economy's savings into capital investment, which act as backup facilities should the primary form of intermediation fail.
However, in countries that lack effective regulations, non-bank financial institutions can exacerbate the fragility of the financial system. While not all NBFIs are lightly regulated, the NBFIs that comprise the shadow banking system are. In the runup to the recent global financial crisis, institutions such as hedge funds and structured investment vehicles, were largely overlooked by regulators, who focused NBFI supervision on pension funds and insurance companies. If a large share of the financial system is in NBFIs that operate largely unsupervised by government regulators and anybody else, it can put the stability of the entire system at risk. Weaknesses in NBFI regulation can fuel a credit bubble and asset overpricing, followed by asset price collapse and loan defaults.
Bank/non-bank integration and supervisory integration
The banking, securities, and insurance markets have become increasingly integrated, with linkages across the markets rapidly increasing. In response, one of the most notable developments in financial sector regulation in the past 20 years has been a shift from the traditional sector-by-sector approach to supervision (with separate supervisors for banks, securities markets, and insurance companies) toward a greater cross-sector integration of financial supervision (Čihák and Podpiera 2008). This had an important impact on the practice of supervision and regulation around the globe.
Three broad models are being used around the world: a three-pillar or “sectoral” model (banking, insurance, and securities); a two-pillar or “twin peak” model (prudential and business conduct); and an integrated model (all types of supervision under one roof). One of the arguably most remarkable developments of the past 10 years, confirmed by the World Bank’s Bank Regulation and Supervision Survey, has been a trend from the three-pillar model toward either the two-pillar model or the integrated model (with the twin peak model gaining traction in the early 2000s). In a recent study, Melecky and Podpiera (2012) examined the drivers of supervisory structures for prudential and business conduct supervision over the past decade in 98 countries, finding among other things that countries advancing to a higher stage of economic development tend to integrate their supervisory structures, small open economies tend to opt for more integrated supervisory structures, financial deepening makes countries integrate supervision progressively more, and the lobbying power of the concentrated and highly profitable banking sector acts as a negative force against business conduct integration. (The related data on the structure of supervision are available on this website, http://www.worldbank.org/financialdevelopment.)
How do these various institutional structures compare in terms of crisis frequency and the limiting of the crisis impact? Cross-country regressions using data for a wide set of developing and developed economies provide some evidence in favor of the twin peak model and against the sectoral model (ˇCihák and Podpiera 2008). Indeed, during the global financial crisis, some of the twin peak jurisdictions (particularly Australia and Canada) have been relatively unaffected, while the United States, a jurisdiction with a fractionalized sectoral approach to supervision, has been at the crisis epicenter. However, the crisis experience is far from black and white, with the Netherlands, one of the examples of the twin peaks model, being involved in the Fortis failure, one of the major European bank failures. It is still early to make a firm overall conclusion, and isolating the effects of supervisory architecture from other effects is notoriously hard.
Carmichael, Jeffrey, and Michael Pomerleano. 2002. The Development and Regulation of Non-bank Financial Institutions. World Bank, Washington, DC.
Čihák, Martin, and Richard Podpiera. 2008. “Integrated Financial Supervision: Which Model?” North American Journal of Economics and Finance 19: 135–52.
Melecky, Martin, and Anca Podpiera. 2012. “Institutional Structures of Financial Sector Supervision, Their Drivers, and Emerging Benchmark Models.” MPRA Paper 37059, University of Munich, Germany.
World Bank. 2012. Global Financial Development Report 2013: Rethinking the Role of the State in Finance. World Bank, Washington, DC (http://www.worldbank.org/financialdevelopment)