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The Hidden Backbone of Finance: Why NBFIs Matter - Nayana Suresh

Executive Summary


Nearly half of the world's financial assets are currently managed by non-bank financial institutions (NBFIs), which are changing financial inclusion, investment management, and credit delivery. Liquidity mismatches, leverage, opacity, and procyclicality are among the new systemic risks brought about by their quick growth, which is fuelled by market demand, regulatory gaps, and technological innovation. The functional diversity of NBFIs, their connections to banks and markets, and the oversight issues brought on by disjointed regulation are all examined in this paper. To protect financial stability while maintaining innovation, it makes the case for a unique regulatory strategy based on hybrid oversight models, macroprudential calibration, and improved data transparency.


Introduction


Non-Bank Financial Institutions (NBFIs) are companies which will offer financial services like normal banks such as lending, investing or managing assets but without having a full banking license, although they do fall under oversight such as the Dodd-Frank Wall Street Reform and Consumer Protection Act (CHEN. J, 2025). Some examples of non- banking financial institutions are insurance companies, investment funds, microfinance institutions, peer-to-peer lending platforms and shadow banks. These institutions are playing an important role in the global financial ecosystem, which are driven by three key factors:


  • Technological Innovation: Many NBFIs are using technologies to offer faster, flexible and customer centric services.

  • Regulatory Gaps: NBFIs follows fewer rules than traditional banks, making it easier to expand.

  • Market Demand: Businesses and individuals are seeking alternatives to traditional banks for credit and investments triggered the sector’s growth.


Despite the benefits, the rise of NBFIs created new risks to financial stability. Such as the entire financial system could implode if a major NFBI fails, especially if it is directly connected to banks or markets, which would result in Systematic risk. Regulatory blind spots occur when businesses are not subject to the same strict regulations as banks, which can make it difficult for authorities to keep an eye on their operations. Due to liquidity and solvency issues, fewer NFBIs might have the capital necessary to withstand financial shocks. Governments and regulators are intensifying scrutiny as NBFIs grow too big to ignore, their activities could destabilize markets if left unchecked, and there’s a need to update regulations to ensure fair competition and financial stability. 


This article examines the evolving role of NBFIs, the risks they pose to financial stability, and the regulatory challenges they present. It explores how policymakers can adapt oversight frameworks to safeguard markets while preserving the innovative potential of these institutions. 


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Figure 1: Evolution Timeline of NFBIs.

Source: Financial Stability Board (FSB), Dodd-Frank Act (2010), Basel III, European Central Bank (ECB) and International Monetary Fund (IMF).


Functional Roles of NBFIs


NBFIs engage in various financial functions, such as credit intermediation for underserved borrowers, investment management, insurance and risk pooling, retirement planning, and market-making. They also provide advisory services, facilitate foreign exchange, and promote financial inclusion via digital platforms.

Function / Role

Description

Examples

Credit Intermediation

Provide credit to individuals and businesses excluded from formal banking.

Microfinance institutions, fintech lenders

Investment Management

Channel savings into diversified investments across asset classes.

Mutual funds, hedge funds, private equity firms

Insurance and Risk Pooling

Offer protection against financial shocks through pooled risk coverage.

Insurance companies, reinsurance firms

Retirement & Long-Term Savings

Manage pension and annuity products for financial security.

Pension funds, annuity providers

Foreign Exchange & Remittances

Enable cross-border transactions and remittance flows.

Forex dealers, remittance providers

Advisory & Underwriting

Support capital raising and strategic financial decisions.

Investment banks, broker-dealers

Financial Inclusion

Deliver accessible services to underserved populations via digital platforms.

Mobile money platforms, fintech startups

Liquidity & Market Making

Enhance liquidity and price discovery in financial markets.

Investment funds, broker-dealers

Risk Management & Hedging

Provide tools to hedge against market, health, and property risks.

Derivative dealers, insurance firms

Table 1: Core Functions and Ecosystem Roles of Non-Bank Financial Institutions (NBFIs)

Sources: Financial Stability Board, Investopedia, IMF


NBFIs Contribution to the Financial Markets


According to the IMF, NBFIs currently oversee almost half of all financial assets worldwide. They support banks during periods of low interest rates, deepen capital markets in emerging economies, improve market liquidity, and serve as buffers during crises like COVID-19.


Systematic Risks and Vulnerabilities


NBFIs’ systematic risks originate from how they handle the money, interact with markets and reacts to stress. These risks can ripple across the financial system especially when transparency is low and leverage is high. NBFIs despite not being banks now account for nearly 50% of global financial assets, making their risks systemically significant (European Central Bank, 2025). 


  • The Liquidity Mismatch: Many NBFIs use short-term liabilities to finance long-term, illiquid assets, leaving them vulnerable to redemption pressure during periods of market stress. Money market funds (MMFs) and open-ended investment funds are especially susceptible.


Case Example: Over $125 billion in MMF outflows were caused by the COVID-19 panic in March 2020, which forced asset sales at low prices and necessitated emergency central bank intervention. This demonstrated how core financial markets can become quickly unstable due to liquidity mismatches.

  • Leverage and Interconnectedness: Borrowed capital is frequently used by hedge funds and private credit vehicles to increase returns, resulting in hidden exposures across banks, clearinghouses, and counterparties.


Case Example: Due to opaque synthetic leverage and margin calls, the 2021 collapse of Archegos Capital cost international banks more than $10 billion. This incident demonstrated how stress can spread between institutions through interconnected NBFIs.

  • Procyclicality: Buying during booms and selling during downturns, NBFIs typically follow market cycles. This behavior is made worse by passive fund flows and algorithmic trading.


Summary Insight: The ECB and FSB claim that coordinated asset sales and margin calls during stressful events like rising interest rates in 2022, deepen market downturns and increase volatility.

  • Opacity: It is challenging to evaluate counterparty exposures, leverage levels, and systemic risk because many NBFIs operate with little disclosure.


Summary Insight: Particular difficulties are presented by multi-function financial groups, stablecoins, and NBFIs connected to cryptocurrencies. Multi-issuer stablecoins lack unified oversight, which causes cross-border regulatory blind spots and delays crisis response, according to the ESRB and CEPR.


Regulatory Framework


Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) was enacted to strengthen financial regulations post-2008 crisis. It established a framework for overseeing systemically important financial institutions (SIFIs), including certain nonbank financial companies (NBFCs). Three categories of NBFCs are defined: Foreign Nonbank Financial Companies, U.S. Nonbank Financial Companies, and U.S. Nonbank Financial Companies Supervised by the Federal Reserve. Foreign nonbanks engage in significant financial activities while being incorporated outside the U.S.; their presence in the U.S. may vary.


Impact on Financial Inclusion and Innovation


Globally, NBFIs have revolutionized financial inclusion. Millions of unbanked people in Kenya now have mobile phone access to credit, savings, and payments thanks to platforms like M-Pesa. Similar developments have lowered intermediation costs and increased financial access in China and India.


Depth and Analysis: Oversight Challenges of NBFIs


Non-bank financial institutions' (NBFIs') explosive growth has surpassed the development of regulatory frameworks, revealing crucial blind spots in risk assessment and crisis management. The structural oversight gaps in three areas systemic footprint, liquidity mismatches, and leverage-driven contagion are diagnosed in this section.


  • Systematic Footprint and Market Influence: The percentage of global financial assets held by NBFIs, which includes insurers, pension funds, investment funds, and private credit vehicles, has increased from 42% in 2008 to about 50% today (IMF, 2025). They are at the centre of global finance due to their increasing power as market makers, liquidity providers, and credit intermediaries in industries like real estate, private credit, and cryptocurrency markets. But this growth has surpassed regulatory adjustment. There are blind spots in systemic risk surveillance because many NBFIs operate outside of consolidated prudential supervision. Their systemic relevance is further enhanced by the growing interdependence of banks and NBFIs due to funding dependencies, counterparty exposures, and coordinated market reactions.


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Figure 2: Interconnectedness between banks and nonbank financial intermediaries is increasing.

Source: U.S. Federal Financial Institutions Examination Council; Fitch Connect; and IMF staff estimates.


  • Liquidity and Redemption Risks:  While holding illiquid assets like real estate or private debt, open-ended investment funds and other financial institutions frequently guarantee daily liquidity. Vulnerabilities arise during stressful situations because of this mismatch. The European Systemic Risk Board (ESRB, 2025) claims that during the COVID-19 crisis in March 2020, money market funds saw outflows of more than $125 billion, necessitating emergency central bank intervention. These incidents show how quickly core financial markets can become affected by NBFI stress. First-mover advantage incentives, which reward early redemptions, can cause run dynamics, particularly in funds without swing pricing or redemption gates, the ESRB cautions.


  • Leverage and Contagion Channels: In NBFIs, leverage can serve as a shock amplifier. Counterparties are exposed to cascading losses because hedge funds and private credit vehicles frequently use high levels of leverage. Leveraged NBFIs may put systemically important institutions that provide funding or derivative exposure under strain, according to the Financial Stability Board (FSB, 2025).


Case Example: Due to opaque synthetic leverage and margin calls, the 2021 collapse of Archegos Capital caused losses of over $10 billion for banks worldwide. This incident demonstrated how stress can spread quickly among financial institutions due to hidden exposures within NBFIs. Because many NBFIs operate outside of consolidated reporting regimes and take advantage of jurisdictional gaps, oversight is further complicated by cross-border operations and regulatory fragmentation.


Regulatory Fragmentation and Oversight Gaps


The regulatory environment for NBFIs is still disjointed by supervisory regimes, institutional types, and jurisdictions. This disarray makes crisis management more difficult and compromises systemic protections. The challenge is defined by three main issues:


  • Regulatory Arbitrage: Compared to banks, many NBFIs operate under less stringent regulations, eschewing consolidated prudential supervision. Hedge funds and private equity firms oversee trillions of dollars' worth of assets, but they frequently violate capital and liquidity regulations like Basel III. This weakens overall financial resilience by allowing risk to shift from banks with strict regulations to those with lax oversight (Brookings Institution, 2025).


  • Jurisdictional Gaps: By operating in countries with little oversight, cross-border NBFIs regularly take advantage of legal loopholes. A fund with its headquarters in one nation may engage in significant financial activity in another without facing the same level of scrutiny. This makes enforcement more difficult, and compromises coordinated supervision, particularly in times of crisis (ECB Banking Supervision, 2025).


  • Data Blind Spots: Many NBFIs are not subject to granular reporting requirements, in contrast to banks. This makes it more difficult for regulators to keep an eye on interconnectedness, leverage, and liquidity in real time. These blind spots impede early warning systems and postpone policy responses, according to BIS (2021). These gaps are intended to be filled by new initiatives like cross-border harmonization and standardized data templates, but their implementation is still inconsistent.


Interlinkages with Banks and Markets


NBFIs are intricately linked to the financial system through contagion pathways, funding dependencies, and counterparty exposures. These connections increase systemic risk and make crisis containment more difficult. The main mechanisms and consequences of these connections are described in Table 2.

Interlinkage Type

Mechanism

Examples

Systemic Implications

Funding Channels

Reliance on short-term funding from banks and markets

- Bank credit lines - Repo agreements - Commercial paper

- Rollover risk - Liquidity stress transmission - Amplified market volatility

Counterparty Exposures

Financial contracts and clearing relationships with banks

- Derivatives (swaps, options) - Securities lending - CCP clearing

- Bilateral default risk - Collateral valuation sensitivity - Margin dependencies

Contagion Pathways

Shared exposures and synchronized reactions across institutions

- Common asset holdings - Fire sales during stress - Margin spirals

- Price contagion - Forced deleveraging - System-wide liquidity crunch


Table 2: Interlinkages with Banks and Markets.

Source: Federal Reserve Bank of ST. LOUIS, European Central Bank special report, Basel Committee’s 2025 horizon scan.


Emerging Trends in Global Finance – 2025 Overview


NBFIs play a key role in a number of new financial trends, especially in digital lending and private credit. These developments present new avenues for the provision of credit, but they also bring with them risks related to liquidity, valuation, and regulations.

Trend

Key Drivers

Innovations & Tools

Strategic Implications

Risks & Challenges

Private Credit Growth

- Institutional demand

- Bank retrenchment - Yield diversification

- Evergreen funds

- Asset-based finance

- Direct lending platforms

- Mainstream alternative to traditional lending

- Mid-market financing access

- Liquidity concerns

- Valuation opacity

- Regulatory scrutiny

Fintech & Digital Lending

- AI & automation

- Open banking

- Embedded finance

- AI credit scoring

- Digital wallets

- Blockchain-based lending

- Faster approvals

- Personalized credit - Platform-integrated lending

- Cybersecurity

- Data privacy

- Regulatory compliance

Table 3: Emerging Trends in Global Finance – 2025 Overview.

Source: Pitchbook, Blackstone’s 2025 outlook, McKinsey, Deloitte, and World Economic Forum reports, Bloomberg NEF, IMF, and Climate Bonds Initiative, BIS, OECD, and PwC Global Regulatory Outlook.


Differentiating the NBFI Sector: A Regulatory Imperative


The term “NBFI” masks the sector’s internal diversity. Entities such as insurers, hedge funds, and private credit vehicles differ significantly in leverage, liquidity, and systemic risk. Table 4 illustrates this diversity, underscoring the need for differentiated regulatory approaches.

NBFI Type

Core Function

Typical Leverage

Liquidity Profile

Systemic Risk Potential

Private Credit Funds

Direct lending to corporates, often illiquid

High

Low

Medium to High

Insurers

Risk pooling, long-term liabilities

Moderate

Medium

High (esp. life insurers)

Asset Managers

Portfolio management on behalf of clients

Low

High

Low to Medium

Money Market Funds

Short-term funding markets

Low

Very High

High (in stress events)

Hedge Funds

Speculative trading, arbitrage

Very High

Variable

Medium

Table 4: Functional and Structural Diversity

Source: European Central Bank (ECB, 2024), Financial Stability Board (FSB, 2025), and IOSCO (2022)


Systemic risk is not dispersed equally throughout the NBFI landscape, as this typology demonstrates. For example, MMFs and insurers present different risks: liquidity-driven runs in the latter case, and solvency risk in the former. In the meantime, private credit funds are increasingly found in a gray area of regulatory visibility due to their opaque structures and high leverage (FSB, 2023).


Why Uniform Regulation Falls Short


The term “non-bank financial institutions” (NBFIs) encompasses a wide array of entities, insurers, pension funds, hedge funds, private credit funds, and money market funds (MMFs), each with distinct balance sheet structures, risk dynamics, and market behaviours. Applying a uniform regulatory framework across this diverse landscape is analytically flawed and systemically risky. A differentiated approach is essential to capture the nuances of risk transmission, liquidity exposure, and oversight fragmentation.


1. Divergent Risk Transmission Channels

NBFIs transmit risk through fundamentally different mechanisms.

  • Insurers face long-term asset-liability mismatches. Their liabilities such as life insurance payouts are long dated, while their assets may be sensitive to market volatility. Regulatory capital buffers, though varying across jurisdictions, are critical to maintaining solvency (BIS, 2021).

  • Private credit funds are highly exposed to credit and liquidity cycles. Without deposit insurance or central bank backstops, their procyclical behavior, expanding lending during booms and contracting during downturns, can amplify systemic stress (ECB Banking Supervision, 2025).

  • Hedge funds, through leveraged trading, can trigger margin spirals that spread to prime brokers and counterparties, as demonstrated by recent contagion events.


2. Liquidity Mismatches and Redemption Risks

Liquidity risk varies widely across NBFIs, undermining the effectiveness of uniform liquidity rules.

  • MMFs and open-ended funds promise daily liquidity while holding illiquid assets such as corporate bonds or real estate. This mismatch creates run dynamics, especially during stress events. In March 2020, U.S. prime MMFs saw $100 billion in outflows in a single week, prompting emergency central bank intervention (BIS, 2021).

  • Open-ended funds incentivize early redemptions, leading to first-mover advantage and fire sales during downturns (J.P. Morgan, 2025).

  • Closed-end private funds, by contrast, lock in capital for years, reducing redemption pressure but raising concerns around leverage accumulation and valuation opacity (EY, 2025).


3. Fragmented Regulatory Perimeters

Oversight of NBFIs remains uneven and fragmented across jurisdictions and institutional types.

  • Light-touch regimes allow entities like private equity and hedge funds to operate outside consolidated prudential supervision, despite managing trillions in assets (ECB Banking Supervision, 2025).

  • Jurisdictional gaps enable cross-border NBFIs to exploit regulatory arbitrage, complicating coordinated supervision and enforcement.

  • Data blind spots persist, as many NBFIs are exempt from granular reporting requirements. This limits regulators’ ability to monitor leverage, liquidity, and interconnectedness in real time (BIS, 2021).


Policy Design Implications


NBFIs' structural diversity, systemic significance, and changing risk profiles must all be reflected in the regulatory response. A one-size-fits-all strategy is inadequate. Rather, policy frameworks ought to incorporate improved data transparency, macroprudential calibration, and hybrid oversight models.


  • Hybrid Regulatory Models: Activity + Entity-Based Oversight: A hybrid model is necessary due to the functional heterogeneity of NBFIs, which range from insurers and pension funds to hedge funds and private credit vehicles.

  • Activity-based tools: Regardless of the type of institution, activity-based tools focus on particular financial behaviours. Systemic risk is reduced, for instance, by hedge fund leverage caps and open-ended fund liquidity requirements.

  • Entity-based oversight: Customized regulations for institutional types are guaranteed by entity-based oversight. While capital adequacy frameworks handle counterparty risks in investment firms, solvency regulations such as Solvency II protect long-term liabilities for insurers.


This dual strategy guarantees uniform handling of comparable risks across entities and reduces regulatory arbitrage.


  • Macroprudential Calibration: Stress Testing and Buffers: To account for the unique vulnerabilities of NBFIs, macroprudential instruments must be sector specific.

  • Stress testing: should replicate shocks that are pertinent to each segment, such as changes in interest rates for insurers and pension funds, liquidity constraints for MMFs, and credit cycle reversals for private credit funds.

  • Countercyclical buffers: Procyclicality can be mitigated by countercyclical buffers. Targeted safeguards include capital buffers for asset managers during expansions and swing pricing or redemption gates for funds susceptible to runs.


These resources lessen systemic stress amplification and increase resilience.


  • Data Granularity and Disclosure: Enhancing Transparency: Effective oversight depends on high-quality, granular data:

  • Current gaps: Regulators' capacity to keep an eye on systemic risk is currently hampered by reporting gaps, particularly with regard to leverage, liquidity, and exposures.

  • Emerging initiatives: These gaps are intended to be filled by new initiatives like cross-border harmonization (FSB, IOSCO) and standardized data templates (EU macroprudential review). 


Real-time risk mapping, early warning systems, and coordinated policy responses across jurisdictions are made possible by increased transparency.


Conclusion


The need for regulatory recalibration is becoming more pressing as NBFIs continue to spread throughout the world of finance. To protect financial stability while maintaining the sector's innovative potential, a unique, risk-sensitive approach based on hybrid oversight, macroprudential tools, and increased transparency is necessary. As financial ecosystems evolve, regulatory inertia is no longer an option. Precision, adaptability, and coordination must define the next era of oversight.


Policy Recommendations: The following steps should be taken into consideration by regulators in order to address the systemic risks and oversight gaps related to NBFIs:

  • To reflect functional diversity, adopt hybrid oversight models that integrate entity-based and activity-based regulation.

  • Use countercyclical buffers and sector-specifisc stress testing based on leverage and liquidity profiles.

  • To increase transparency and facilitate real-time risk mapping, mandate granular data reporting across NBFI segments.

  • To close jurisdictional gaps and stop regulatory arbitrage, improve cross-border coordination.

  • Adjust liquidity regulations to account for redemption risks in MMFs and open-ended funds.

  • Keep an eye out for hidden exposures and contagion channels in developing markets like private credit and NBFIs connected to cryptocurrencies.


References


 
 
 

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