Non-Banks Are Now a Big Banking Business: The Rising Influence of NBFIs on Financial Stability and Investment Strategy

The financial landscape has undergone a profound transformation over the past decade, marked by the meteoric rise of non-bank financial institutions (NBFIs). What was once a niche segment of the financial ecosystem has now become a central player, challenging traditional banks' dominance and reshaping systemic risk dynamics. By 2024, NBFIs in the European Union had amassed €50.7 trillion in assets-surpassing the banking sector by over 20%-while in the United States, banks' credit lines to NBFIs grew from 2% of GDP in 2012 to 3% in 2024, reflecting a structural shift in capital allocation. This evolution is not merely a matter of scale but of systemic consequence, as NBFIs increasingly mediate credit, liquidity, and risk in ways that blur traditional boundaries and amplify interconnectedness.

The Systemic Risks of a Non-Bank-Centric Financial System

The growing influence of NBFIs is accompanied by mounting risks to financial stability. Central banks and regulators have sounded alarms about the sector's leverage, liquidity mismatches, and opaque linkages to traditional banking. For instance, the International Monetary Fund found that adverse developments in NBFIs-such as falling collateral values or credit rating downgrades-could trigger significant capital and liquidity shortfalls in banks. In a stress scenario, 10% of U.S. banks and 30% of European banks could see their regulatory capital ratios fall by over 100 basis points, underscoring the fragility of cross-sector interdependencies.

Leverage in investment funds, including hedge funds and liability-driven investment (LDI) funds, has further amplified vulnerabilities. These entities are highly exposed to interest rate fluctuations and market shocks, as evidenced by the European Systemic Risk Board's warnings about liquidity mismatches in open-ended investment funds. During periods of volatility, forced redemptions can trigger asset fire sales, overwhelming dealer capacity and destabilizing bond markets-a risk vividly demonstrated during the March 2020 turmoil.

Capital Allocation Shifts: From On-Balance-Sheet to Off-Balance-Sheet Risk

The shift in capital allocation between banks and NBFIs has introduced new layers of complexity. While on-balance-sheet funding by banks to NBFIs declined from $2.4 trillion to $1.7 trillion between 2012 and 2024, credit lines extended by banks more than doubled, reaching 3% of GDP in 2024. These off-balance-sheet arrangements, though less visible, represent contingent liabilities that could materialize rapidly during crises.

For example, simultaneous drawdowns on credit lines could exacerbate liquidity shortages, creating a feedback loop of stress across sectors.

This reallocation of risk has also been driven by regulatory arbitrage. NBFIs often operate under lighter prudential requirements than banks, incentivizing capital to flow toward less regulated corners of the financial system. By 2021, global NBFIs had accumulated $239 trillion in financial assets-surpassing the $183 trillion in bank sector assets-while dominating half of daily foreign exchange market turnover and a significant share of sovereign bond holdings. Such concentration raises questions about the resilience of a system where critical functions are increasingly outsourced to entities with weaker safeguards.

Regulatory Responses: Progress and Persistent Gaps

Recognizing these risks, regulators have begun to close gaps in oversight. The Financial Stability Board (FSB) has spearheaded efforts to enhance liquidity resilience in open-ended funds, mitigate leverage risks, and improve data transparency. In 2023, the FSB revised its policy recommendations for open-ended funds, while its 2025 guidelines addressed leverage in NBFIs, providing flexible frameworks for targeted interventions. Additionally, the establishment of the Nonbank Data Task Force under the FSB in 2025 marks a critical step toward addressing data challenges, including a test case on leveraged trading strategies in sovereign bond markets.

However, regulatory progress remains uneven. While liquidity and leverage risks are being addressed, interconnectedness and data quality issues persist. The ESRB has highlighted that inadequate data on NBFIs' exposures and activities hampers the ability to monitor systemic risks effectively. This underscores the need for greater coordination and innovation in regulatory approaches to keep pace with the sector's rapid evolution.

Implications for Investors: Navigating a New Normal

For investors, the rise of NBFIs necessitates a recalibration of risk management frameworks. Traditional metrics focused on bank-centric indicators may no longer suffice in a system where nonbanks mediate credit and liquidity. Sectors such as real estate, private credit, and crypto-where NBFIs are particularly active-require heightened scrutiny for leverage and liquidity risks. For example, the collapse of a major private credit fund or a forced deleveraging in LDI strategies could trigger cascading effects across asset classes.

Moreover, investors must consider the indirect risks posed by NBFIs' interconnectedness with banks. A shock in one sector could spill over into others, as seen in the IMF's stress test scenarios. Diversification and scenario analysis should account for these cross-sector linkages, while hedging strategies may need to incorporate derivatives and other instruments to mitigate liquidity shocks.

Conclusion

The ascendancy of NBFIs as a "big banking business" is reshaping the financial ecosystem in ways that demand vigilance and adaptability. While their growth reflects innovation and efficiency, it also introduces systemic vulnerabilities that could destabilize markets during periods of stress. For investors, the challenge lies in balancing the opportunities presented by this new paradigm with the risks it entails. As regulators continue to refine their approaches, the onus is on market participants to stay ahead of the curve-anticipating shocks, diversifying exposures, and embracing a holistic view of risk in an increasingly interconnected world.