Non-banks as a source of systemic risk

Nonbank financial institutions (or shadow banks) play a growing role in credit markets by securitizing debt and supplying liquidity without being subject to traditional banking regulations.

Their expansion is rooted in the macroeconomic system’s dependence on continuous debt creation to sustain aggregate demand, especially amid stagnant wages and weak public spending.

While nonbanks provide credit efficiently during stable times, their off-balance sheet guarantees and high leverage make them vulnerable during crises.

When borrowers default—such as in a recession—nonbanks face large losses, triggering fire sales of assets like homes, falling collateral values, and spreading contagion to other financial sectors.

Introduction

The rapid expansion of nonbank financial institutions has transformed global credit markets. Unlike traditional banks, these entities—often referred to as shadow banks—operate outside the regulatory perimeter, particularly in terms of capital adequacy and liquidity requirements. They gained prominence through their central role in asset-backed securities (ABSs), which allowed loans to be repackaged and sold as investable instruments.

But this transformation has come with systemic consequences. Nonbanks’ risk exposure is not merely a matter of poor risk management or leverage. Rather, it reflects a deeper macroeconomic fragility: the modern economy’s reliance on continuous debt creation to maintain consumption, investment, and overall demand (Minsky, 1986; Borio & Disyatat, 2011).

What is a non-bank institution?

Non-bank financial institutions (NBFIs) are financial entities that provide credit, investment, and liquidity services without holding a full banking license and without access to central bank deposit facilities. They operate outside the traditional deposit–loan banking model, yet they are deeply integrated into the financial system through funding markets, asset management, and credit intermediation.

Zoltan Pozsar (2011) highlights that large institutional cash pools—the concentrated cash balances of corporations, asset managers, pension funds, and other institutional investors—are a central driver of NBFI growth. These pools often exceed government deposit insurance limits, making traditional bank deposits unattractive for safety and liquidity purposes. As a result, they are placed in short-term instruments such as repurchase agreements (repos), commercial paper, and money market funds, much of which is facilitated by NBFIs rather than banks.

By intermediating these large cash balances, NBFIs create an alternative “shadow” banking system that performs bank-like functions—credit transformation, maturity transformation, and liquidity provision—without being subject to the same regulatory capital and liquidity requirements as banks. This allows for flexibility and innovation but can also increase systemic risk.

Regulatory Roots of Non-Bank Emergence

1. Regulation Q (1933–1986)

• Introduced under the U.S. Banking Act of 1933, Regulation Q prohibited banks from paying interest on demand deposits and capped the rates they could offer on savings accounts.

• The intent was to stabilize banks, prevent destructive interest rate competition, and promote lending discipline.

• By the late 1960s–70s, rising inflation and interest rates meant market rates often exceeded the ceilings. Large depositors, especially corporations and institutional investors, began seeking alternatives to bank deposits.

• This disintermediation channeled funds into money market mutual funds (MMFs), commercial paper markets, and other non-bank vehicles that could offer competitive returns without being bound by Reg Q.

  
  

2. Capital and Liquidity Requirements

• Prudential regulations (e.g., Basel I in 1988 and subsequent Basel accords) imposed minimum capital ratios and liquidity requirements on banks.

• These increased the cost of holding certain risky or long-dated assets inside banks, encouraging the migration of such activities to less-regulated entities — securitization conduits, hedge funds, and finance companies.

• Non-banks could perform credit intermediation without holding the same regulatory buffers, enabling cheaper funding and more flexible leverage.

• The Glass–Steagall Act (1933) separated commercial and investment banking. While banks could not directly engage in securities underwriting or trading, investment banks and other non-banks filled the gap.

• Even after the Gramm–Leach–Bliley Act (1999) repealed key Glass–Steagall provisions, the non-bank sector had already matured and entrenched its role in securities markets.

  
  

4. Deposit Insurance Limits

• FDIC insurance caps (historically $100,000 before being raised to $250,000 in 2008) meant large corporate and institutional cash pools exceeded safe bank deposit limits.

• Zoltan Pozsar (2011) highlights that these institutional cash pools instead flowed into repo markets, MMFs, and other wholesale funding channels — almost all dominated by NBFIs.

Outcome

These regulatory constraints unintentionally fostered the “shadow banking” system, a parallel financial network outside the perimeter of bank regulation.

• NBFIs could offer market-based interest rates, avoid reserve requirements, and structure products (like asset-backed securities) in ways banks could not.

• The sector expanded rapidly from the 1970s onward, driven by institutional demand for higher returns and by regulatory arbitrage.

Major Types and Examples of Large Non-Bank Financial Institutions (NBFIs)

Non-bank financial institutions operate across diverse business models, often specializing in asset management, insurance, pensions, or alternative investments. Their scale—measured by assets under management (AUM) or total assets—demonstrates their systemic importance.

1. Asset Management Firms

These institutions pool capital from individuals and institutions to invest in equities, bonds, alternatives, and money market instruments. They often manage large institutional cash pools (Pozsar, 2011).

• BlackRock – World’s largest asset manager, $11.6 trillion AUM (2025).

• Vanguard Group – Index and ETF pioneer, $10.1 trillion AUM (2025).

• Fidelity Investments – Large mutual fund and brokerage provider, $5.9 trillion AUM (2025).

• State Street Global Advisors – ETF giant, $4.67 trillion AUM (2025).

• Apollo Global Management – Alternative investments, credit, and real assets, $840 billion AUM (Q2 2025).

• Barings LLC – Global investment manager, $381 billion AUM (2023).

• New York Life Investments – Insurance-linked asset manager, $750 billion AUM (2024).

2. Money Market Mutual Funds (MMFs)

MMFs provide deposit-like functionality for large cash balances, investing in Treasury bills, repos, and commercial paper. They are a major destination for institutional cash pools.

• Examples: Vanguard Money Market Fund, Fidelity Government Cash Reserves.

3. Hedge Funds and Hedge Fund Administrators

Hedge funds use leveraged and complex strategies to seek returns, often relying on short-term funding. Administrators provide operational infrastructure for these funds.

• Bridgewater Associates – Largest hedge fund, over $100 billion AUM.

• Citadel – Multi-strategy hedge fund, ~$60 billion AUM (2025).

• Citco – Leading hedge fund administrator, $1.5 trillion AuA (2020).

4. Private Equity (PE) Firms

PE firms acquire and restructure companies, often using leveraged buyouts. They are key players in alternative credit provision.

• Blackstone Group – Largest PE firm, over $1 trillion AUM (2024).

• KKR – Global investment firm, $578 billion AUM (2025).

• Carlyle Group – Diversified alternative asset manager, $425 billion AUM (2024).

5. Insurance Companies

Insurers are major long-term investors, holding large portfolios of bonds, equities, and alternative assets to meet policyholder obligations.

• Allianz – Germany-based, $1.11 trillion total assets (2025).

• Ping An Insurance – China’s largest insurer, $961 billion total assets.

• Berkshire Hathaway – Diversified conglomerate with insurance core, $948 billion total assets.

• China Life Insurance – State-owned insurer, $958 billion total assets.

• Prudential Financial (U.S.) – $721 billion total assets.

• AXA – France-based insurer, $711 billion total assets.

• MetLife – U.S. life insurer, $687 billion total assets.

• Legal & General – UK-based insurer, $665 billion total assets.

6. Pension Funds

Pension funds manage retirement savings with a long-term investment horizon, often allocating to infrastructure, private equity, and public markets.

• CPP Investments (Canada) – C$714 billion AUM (2025).

• CalPERS (U.S.) – Largest U.S. public pension, ~$500 billion AUM (2025).

• Netherlands’ ABP – ~€500 billion AUM (2025).

7. Sovereign Wealth Funds (SWFs)

State-owned investment vehicles that deploy national reserves into diversified portfolios.

• Norway Government Pension Fund Global – $1.5 trillion AUM (2025).

• China Investment Corporation (CIC) – $1.35 trillion AUM.

• Abu Dhabi Investment Authority (ADIA) – ~$993 billion AUM.

Non-Banks Serving High-Net-Worth Clients

A distinct segment of the non-bank financial sector exists to serve high-net-worth individuals (HNWIs) and institutional investors, providing bespoke investment solutions that bypass the regulatory constraints faced by traditional banks. Historically, interest rate ceilings under Regulation Q (in effect until 1986) and prudential restrictions on risky asset holdings limited banks’ ability to offer competitive yields to wealthy depositors (Pozsar, 2011). This regulatory environment encouraged the creation of investment vehicles outside the banking system, allowing affluent clients to earn higher, market-based returns without the limits imposed on insured deposits.

Private equity funds, hedge funds, family offices, and certain investment trusts fall into this category. These entities often employ strategies involving leverage, derivatives, and illiquid investments, generating returns far above regulated deposit rates—albeit with higher risk (Lysandrou, 2016). By doing so, they “liberate” wealthy clients’ assets from capital and liquidity requirements that safeguard the banking sector but also cap profitability (Claessens & Ratnovski, 2014).

The shadow banking ecosystem amplifies this effect. For instance, hedge funds finance leveraged positions through repo markets and prime brokerage services provided by banks’ investment arms, yet operate outside the scope of capital adequacy regulations. Family offices—private entities managing the wealth of ultra-rich families—often invest in private credit markets, real estate, and venture capital, further blurring the line between traditional finance and shadow intermediation (Chernenko & Sunderam, 2014).

While such institutions enhance portfolio returns for the wealthy, their activities can magnify systemic risk. Concentrated positions, high leverage, and liquidity mismatches mean that distress in these entities can transmit quickly to core funding markets, as seen in the Archegos Capital Management collapse of 2021, which caused multi-billion-dollar losses for major prime brokers.

The Debt-Driven Economy and the Rise of Nonbanks

In a financialized economy with stagnant wages and widening inequality, aggregate demand increasingly relies on credit expansion (Cynamon & Fazzari, 2008). Traditional banks, constrained by regulation, cannot meet this demand alone. Nonbanks fill the gap by creating, guaranteeing, and distributing ABSs that recycle household and corporate debt into marketable securities.

This form of financial intermediation allows credit to expand beyond traditional balance sheets. Through structures like mortgage-backed securities (MBSs), credit card debt pools, or auto loan securitizations, nonbanks supply the credit needed to sustain consumer activity—even when underlying income growth is insufficient. In this sense, nonbanks are not merely intermediaries—they are structural enablers of demand (Pozsar et al., 2013).

Fragility and Contagion: When the Cycle Reverses

The liquidity and profitability of ABSs depend on a stable economic environment. When conditions deteriorate—such as during a recession or financial panic—the weaknesses of this structure are exposed:

1. Mass defaults on household loans (e.g., mortgages) cause cash flows to cease.

2. Nonbanks, as guarantors of these securities, must cover the losses (Acharya et al., 2010).

3. Asset fire sales—particularly of homes—depress collateral values, intensifying losses.

4. Contagion spreads to other ABS products like asset-backed commercial paper (ABCP) (Covitz et al., 2013).

5. Liquidity evaporates, and businesses relying on short-term funding are unable to roll over their debt.

The failure of nonbanks during this phase threatens the stability of the entire financial system. As they are not typically included in lender-of-last-resort mechanisms, liquidity freezes lead to insolvency unless central banks intervene. This happened during the 2008 Global Financial Crisis, when the Federal Reserve expanded its facilities to include nonbank institutions (Gorton & Metrick, 2012).

The Role of Credit in Sustaining Demand

Why does the system become so dependent on fragile financial instruments? Because modern macroeconomic growth depends on the continuous expansion of credit. In the absence of real wage growth or countercyclical fiscal policy, credit creation—particularly household credit—is the mechanism by which consumption is maintained (Jordà et al., 2016; Mian & Sufi, 2014).

Nonbanks enable this mechanism by securitizing consumer and mortgage debt, allowing further lending without balance sheet constraints. But this structure is inherently pro-cyclical: when the economy weakens, defaults rise, securitized products collapse in value, and credit tightens—further weakening the economy. The entire model is thus endogenously fragile (Minsky, 1986).

Regulating Non-Bank Financial Institutions: Policy Recommendations

Non-bank financial institutions (NBFIs) now hold over half of global financial assets, making their stability critical to systemic resilience (FSB, 2024). Their growth was largely fueled by regulatory arbitrage—arising from constraints such as Regulation Q, capital requirements, and activity restrictions on traditional banks (Pozsar, 2011; Gorton & Metrick, 2010). To address emerging risks while preserving market efficiency, the following regulatory measures are recommended:

1. Extend Macroprudential Oversight to NBFIs

Macroprudential regulation, currently bank-centric, should be adapted to NBFIs. This includes applying capital buffers, leverage limits, and liquidity coverage requirements proportionate to systemic importance (Adrian & Ashcraft, 2012). Such oversight would mitigate maturity transformation and excessive leverage risks.

2. Close Regulatory Gaps in Shadow Banking

Activities like securities financing transactions, derivatives trading, and securitization should be monitored under a unified regulatory framework, regardless of whether they occur inside or outside the banking perimeter (Claessens & Ratnovski, 2014). Harmonizing rules between banks and NBFIs reduces incentives for regulatory arbitrage.

3. Strengthen Liquidity Management Standards

Money market funds (MMFs) and open-ended funds should hold higher liquidity buffers and implement redemption gates during stress to prevent fire sales (IOSCO, 2022). Similar measures could apply to non-bank mortgage lenders and finance companies reliant on wholesale funding.

4. Enhance Data Collection and Transparency

Authorities need granular, high-frequency data on NBFI exposures, funding structures, and interconnectedness (FSB, 2024). A global NBFI monitoring system—similar to bank stress tests—could detect vulnerabilities before they spill over to core markets.

5. Coordinate Cross-Border Regulation

Given the international scope of NBFIs, national reforms must be complemented by global coordination through bodies such as the Financial Stability Board (FSB) and International Organization of Securities Commissions (IOSCO) (Carstens, 2021). This would prevent risk migration to less regulated jurisdictions.

Conclusion

Non-bank financial institutions (NBFIs) emerged partly as a response to banking regulations that limited deposit interest rates, asset risk-taking, and leverage—most notably under rules such as the now-repealed Regulation Q. By operating outside the traditional banking framework, NBFIs offer credit, investment, and liquidity services without being subject to the same prudential requirements as banks.

They encompass a broad range of entities—money market funds, hedge funds, private equity, securitization vehicles, insurance companies, and family offices. While some NBFIs serve mass-market investment needs, a distinct subset caters to high-net-worth individuals (HNWIs) and institutional investors. These wealth-focused non-banks “free” affluent clients’ capital from capital and liquidity constraints, enabling strategies that employ leverage, derivatives, and illiquid investments to generate higher returns.

NBFIs have become integral to modern finance, deepening capital markets and providing credit in areas underserved by banks. However, their activities—especially in wholesale funding markets and securitization chains—also amplify systemic risk. They are prone to procyclicality, liquidity mismatches, and rapid deleveraging in stress periods, as seen during the 2008 Global Financial Crisis and the March 2020 COVID-19 market turmoil. Episodes like the 2021 Archegos collapse illustrate the dangers of concentrated, leveraged positions in the wealth-focused segment.

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