Non-bank financial institution
A non-bank financial institution (NBFI) is a financial institution that does not have a full banking license or is not supervised by a national or international banking regulatory agency. NBFIs facilitate bank-related financial services, such as investment, risk pooling, contractual savings, and market brokering. Examples of these include insurance firms, pawn shops, cashier's check issuers, check cashing locations, payday lending, currency exchanges, and microloan organizations. Alan Greenspan has identified the role of NBFIs in strengthening an economy, as they provide "multiple alternatives to transform an economy's savings into capital investment [which] act as backup facilities should the primary form of intermediation fail."
Role in financial system
NBFIs supplement banks by providing the infrastructure to allocate surplus resources to individuals and companies with deficits. Additionally, NBFIs also introduces competition in the provision of financial services. While banks may offer a set of financial services as a packaged deal, NBFIs unbundle and tailor these service to meet the needs of specific clients. Additionally, individual NBFIs may specialize in one particular sector and develop an informational advantage. Through the process of unbundling, targeting, and specializing, NBFIs enhances competition within the financial services industry.
Some research suggests a high correlation between a financial development and economic growth. Generally, a market-based financial system has better-developed NBFIs than a bank-based system, which is conducive for economic growth.
A multi-faceted financial system that includes non-bank financial institutions can protect economies from financial shocks and enable speedy recovery when these shocks happen. NBFIs provide “multiple alternatives to transform an economy's savings into capital investment, [which] serve as backup facilities should the primary form of intermediation fail.”
However, in the absence of effective financial regulations, non-bank financial institutions can actually exacerbate the fragility of the financial system.
Since not all NBFIs are heavily regulated, the shadow banking system constituted by these institutions could wreak potential instability. In particular, CIVs, hedge funds, and structured investment vehicles, up until the 2007-2012 global financial crisis, were entities that focused NBFI supervision on pension funds and insurance companies, but were largely overlooked by regulators.
Because these NBFIs operate without a banking license, in some countries their activities are largely unsupervised, both by government regulators and credit reporting agencies. Thus, a large NBFI market share of total financial assets can easily destabilize the entire financial system. A prime example would be the 1997 Asian financial crisis, where a lack of NBFI regulation fueled a credit bubble and asset overheating. When the asset prices collapsed and loan defaults skyrocketed, the resulting credit crunch led to the 1997 Asian financial crisis that left most of Southeast Asia and Japan with devalued currencies and a rise in private debt.
Due to increased competition, established lenders are often reluctant to include NBFIs into existing credit-information sharing arrangements. Additionally, NBFIs often lack the technological capabilities necessary to participate in information sharing networks. In general, NBFIs also contribute less information to credit-reporting agencies than do banks.
Insurance companies underwrite economic risks associated with illness, death, damage and other risks of loss. In return to collecting an insurance premium, insurance companies provide a contingent promise of economic protection in the case of loss. There are two main types of insurance companies: general insurance and life insurance. General insurance tends to be short-term, while life insurance is a longer-term contract, which terminates at the death of the insured. Both types of insurance, life and general, are available to all sectors of the community.
Although insurance companies do not have banking licenses, in most countries insurance has a separate form of regulation specific to the insurance business and may well be covered by the same financial regulator that also covers banks. There have also been a number of instances where insurance companies and banks have merged thus creating insurance companies that do have banking licenses.
Contractual savings institutions
Contractual savings institutions (also called institutional investors) give individuals the opportunity to invest in collective investment vehicles (CIV) as a fiduciary rather than a principal role. Collective investment vehicles pool resources from individuals and firms into various financial instruments including equity, debt, and derivatives. Note that the individual holds equity in the CIV itself rather what the CIV invests in specifically. The two most popular examples of contractual savings institutions are pension funds and mutual funds.
The two main types of mutual funds are open-end and closed-end funds. Open-end funds generate new investments by allowing the public to purchase new shares at any time, and shareholders can liquidate their holding by selling the shares back to the open-end fund at the net asset value. Closed-end funds issue a fixed number of shares in an IPO. In this case the shareholders capitalize on the value of their assets by selling their shares in a stock exchange.
Mutual funds are usually distinguished by the nature of their investments. For example, some funds specialize in high risk, high return investments, while others focus on tax-exempt securities. There are also mutual funds specializing 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 investments until a certain date. In return, pension funds are granted large tax breaks in order to incentivize the working population to set aside a portion of their current income for a later date after they exit the labor force (retirement income).
Market makers are broker-dealer institutions that quote a buy and sell price and facilitate transactions for financial assets. Such assets include equities, government and corporate debt, derivatives, and foreign currencies. After receiving an order, the market maker immediately sells from its inventory or makes a purchase to offset the loss in inventory. The differential between the buying and selling quotes, or the bid–offer spread, is how the market-maker makes profit. A major contribution of the market makers is improving the liquidity of financial assets in the market.
Specialized sectoral financiers
They provide a limited range of financial services to a targeted sector. For example, real estate financiers channel capital to prospective homeowners, leasing companies provide financing for equipment and payday lending companies that provide short term loans to individuals that are Underbanked or have limited resources.
Financial service providers
Financial service providers include brokers (both securities and mortgage), management consultants, and financial advisors, and they operate on a fee-for-service basis. Their services include: improving informational efficiency for the investors and, in the case of brokers, offering a transactions service by which an investor can liquidate existing assets.
According to the World Bank, approximately 30% total assets of South Korea's financial system was held in NBFIs as of 1997. In this report, the lack of regulation in this area was claimed to be one reason for the 1997 Asian Financial Crisis.
In the United States
- Carmichael, Jeffrey, and Michael Pomerleano. Development and Regulation of Non-Bank Financial Institutions. World Bank Publications, 2002, 12.
- Non-Bank Financial Institutions:A Study of Five Sectors
- NZ Financial Dictionary, http://www.anz.com/edna/dictionary.asp?action=content&content=non-bank_financial_institution
- Legal Service Commission, Law Handbook Online, "Non-bank financial institutions" http://www.lawhandbook.sa.gov.au/ch07s05s06s03.php
- FRB: Speech, Greenspan - Do efficient financial markets mitigate crises? - October 19, 1999
- Carmichael, Jeffrey, and Michael Pomerleano. The Development and Regulation of Non-bank Financial Institutions. Washington, D.C.: World Bank, 2002. Print
- Levine, (1999)
- Demirguc-Kunt and Maksimovic, (1998)
- Greenspan, 1999
- Carmichael, Jeffrey, and Michael Pomerleano. The Development and Regulation of Non-bank Financial Institutions. Washington, D.C.: World Bank, 2002. Print.
- The World Bank GFDR Report
- Carmichael, Jeffrey, and Michael Pomerleano. Development and Regulation of Non-Bank Financial Institutions. World Bank Publications, 2002, 19.
- Non-Bank Financial Institutions: A Study of Five Sectors, http://osdbu.treas.gov/cooply.html