Key Terms Explained
Nonbanking Financial Institution (NBFI)
A nonbanking 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 nonbanking 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.
Types of NBFI:
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).
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.
Financial Service Providers
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 the infrastructure to allow surplus resources to be allocated to those individuals and companies with deficits. Additionally, NBFIs provide competition for banks in the provision of financial 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 one particular sector, gaining an informational advantage. By this unbundling, targeting, and specializing, NBFIs promote competition within the financial services industry.(iv)
Because of this competition, established lenders are often reluctant to grant NBFIs access to existing credit-information sharing arrangements. Additionally, nonbanking financial institutions may also lack the technological capabilities necessary to participate in comprehensive information sharing. NBFIs also contribute less information to credit-reporting agencies than do banks.(vi)
Research suggests that there is a high correlation between a financial development and economic growth. A market-based financial system has better-developed NBFIs than a bank-based system. Market-based financial systems contribute to economic growth. (ii,iii)
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.” (v)
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 institutions that comprise the shadow banking system are. In particular, CIVs, hedge funds, and structured investment vehicles, up until the 2007-2012 global financial crisis, were largely overlooked by regulators, who focused NBFI supervision on pension funds and insurance companies.
Because these NBFIs operate without a banking license, their activities, in some countries, are largely unsupervised, both by government regulators and credit reporting agencies. Thus, a large NBFI market share of total financial assets can put the stability of the entire system at risk, the best example of which is the 1997 Asian financial crisis. The lack of NBFI regulation fueled a credit bubble and asset overpricing. When the asset prices collapsed and loan defaults skyrocketed, the resulting credit crunch was a contributing factor to the 1997 Asian financial crisis in which most of Southeast Asia and Japan experienced devalued currencies and a rise in private debt.(iv)
1 Demirguc-Kunt and Levine, (1999)
2 Levine, (1999)
3 Demirguc-Kunt and Maksimovic, (1998)
4 Carmichael, Jeffrey, and Michael Pomerleano. The Development and Regulation of Non-bank Financial Institutions. Washington, D.C.: World Bank, 2002. Print.
5 Greenspan, 1999