Banking is one of the largest industries in the world, and even though banks are central to the global economy, many people are sitting on the sidelines of the financial system.
21.7% of U.S. households are unbanked, meaning they do not have a traditional bank account because they can’t meet the minimum balances at traditional banks, meaning that millions of people and businesses can’t access banking services like checking or savings accounts. Regulations and company policies are largely to blame, but thankfully—there are some companies willing to do the heavy lifting.
The imaginatively named non-bank financial institutions, which are companies that offer select banking services without a banking licence, are these heavy lifters. Non-banking financial institutions play a critical role in the financial space, from widening the accessibility of financial services to increasing competition across the banking sector.
In this article, we discuss what a non-banking financial institution is, including examples of such institutions and how they differ from licensed banks.
What is a Non-Bank Financial Institution?
A non-bank financial institution is any financial company that offers banking services without holding an official banking licence. Non-banks tend to offer services such as lending, currency exchange, underwriting, and more. However, unlike their banking compatriots, they cannot accept traditional deposits.
Some of the most common services that non-banks offer are similar to those from:
- Lenders (mortgage, market, P2P, etc.)
- Investment banks
- Insurance companies
- Hedge funds
- Currency exchanges
- Financial consultants
- Money transmission companies
- Venture capitalists
Even companies like casinos and pawn shops can fall under the umbrella of non-bank financial institutions, as they offer financial services without accepting demand deposits.
Banking vs. Non-Banking Financial Institutions: What’s the Difference?
The key difference between a bank and a non-bank is whether or not an institution has a banking licence.
In the U.S., banking licences are distributed by the government and require an institution to be regulated by both federal and state authorities. As a result of this lack of conventional regulation, non-bank financial institutions tend to have greater flexibility in how they operate their business.
For example, a licensed bank must face stricter regulatory requirements when loaning money, as this money comes from deposits from the bank’s customers.
Non-banks are not subject to these requirements, making them more capable of offering loan and credit-building services to ‘riskier’ borrowers. These types of institutions rely on fundraising efforts and borrowing from licensed banks, rather than on the funds deposited by customers.
How Many Types of Non-Banking Financial Institutions Exist?
It can be difficult to quantify the total number or types of non-banking financial institutions worldwide, as many companies can fall under the non-bank umbrella.
According to The World Bank, a non-bank typically falls into one of five categories:
- Risk Pooling Institutions: A risk pooling institution underwrites economic risks that are associated with specific types of loss, such as death and property damage. These companies accept premium payments that form a pool of funds used to offer economic protection and support in the event that a customer experiences a qualified loss. The most common form of risk pooling institution is an insurer.
- Contractual Savings Institutions: Contractual saving institutions include most investment funds, pensions, and mutual funds. These types of institutions act as fiduciaries, making them legally bound to act in the best interests of clients. Mutual funds and private pension plans are the two most popular examples of contractual savings institutions.
- Market Makers: A market maker is a broker-dealer institution that creates quotes for buying and selling assets such as stocks or bonds. These types of institutions make a profit off of bid-offer spreads—which is the difference between the price that people are willing to pay for an asset and the price that asset holders are willing to sell at—based on the difference between the buying and selling quotes. By doing so, a market maker can provide greater liquidity and depth within a market.
- Specialized Sectoral Financiers: Specialized sectoral financiers are institutions that offer a limited range of financial services to a specific sector. Equipment leasing companies are one of the top examples of a specialized sectoral financier. These types of companies own the equipment, allowing them to include this in a collateral agreement, as well as receive preferential tax treatment for equipment investments.
- Financial Service Providers: Financial service providers is a term that encompasses many of the non-bank financial institutions that do not fall into any of the aforementioned categories. These institutions can include brokers, management consultants, and advisors. Typically, a financial service provider will charge a fee for customers to receive their services, though some offer transaction-based services that require the liquidation of existing assets.
What is the Role of Non-Banking Financial Institutions?
Non-banking financial institutions are critical in the financial industry in three primary ways:
- They Offer Greater Access to Banking Services: Above all else, non-bank financial institutions provide consumers and businesses with alternatives to traditional banking services. These institutions help to supplement the financial services of banks, making such services more widely accessible and available to both individuals and firms.
- They Boost Competition in the Banking Business: Non-banking institutions boost the levels of competition in the banking industry, particularly when it comes to offering specialized and targeted financial services. According to the FDIC, competition in the banking industry is crucial for increasing economic growth. However, it is important to note that an increase in competition can also increase the risk of financial instability via an increase in risk-taking.
- They Protect the Economy Against Financial Shock: Non-banking institutions help national and international economies to bolster themselves against economic uncertainty by creating a more multifaceted financial system. In turn, financial systems have a greater ability to both respond to and recover from economic shocks.
From a consumer perspective, non-banking financial institutions increase financial and economic opportunities for historically unbanked populations.
The FDIC reports that some of the most popular non-banking services include online payment services such as Venmo and PayPal, with 46.4% of all U.S. households using a non-bank online payment service in 2021 alone.
Real-World Examples of Non-Bank Financial Institutions
What do non-bank financial institutions look like in the real world?
Well, odds are you know more than a few of them—widely-used non-banks include digital wallet providers such as PayPal. PayPal is legally considered a money transmitter and financial services provider, which falls under the Money Services Business (MSB) umbrella.
On PayPal, users can benefit from a variety of digital payment services, including peer-to-peer payments and the ability to apply for PayPal’s credit card.
However, contrary to what some might believe, PayPal is not a bank. It does not accept demand deposits, it simply custodies funds and allows users to transfer or spend them—and to get money into PayPal, you’ll still need to add funds to PayPal using a debit card, credit card, confirmed bank account, or PayPal CASH.
Another example is Klarna. Klarna is a payments company, they provide buy-now-pay-later service to consumers globally. While Klarna doesn’t have a banking license, and doesn’t provide traditional lending services, they do work with a range of retailers to bring alternative funding options to their users. The service they provide is considered an unregulated credit agreement, and while they do have to conform to certain regulations, they don’t need to conform to the same regulations traditional banks do.
Competition vs. Collaboration: A Look at Non-Bank & Bank Partnerships
As we can see with both the PayPal and Klarna examples above, non-banks are not necessarily built to compete with traditional banks—but many of them ultimately do, even if they use the services of one or multiple traditional banks while doing so.
Non-banks often work in concert with banks to expand access to various products like credit or investing without diminishing the role traditional banks still play.
In fact, licensed banks which offer services and partnerships to non-banks have been some of the biggest benefactors in the fintech revolution. Fintechs have helped non-banks identify opportunities in the market, increase the amount of money they have in the bank (literally), and indirectly become investors in the success of possible competitors—after all, so long as non-banks use traditional banking services, some banks will stand to benefit.
Of course, the lack of regulation surrounding non-banks is not without risks as well. Major strides toward non-banking reform have been taken over the past decade in the wake of the 2008 financial crisis. As recently as August 2022, the Consumer Financial Protection Bureau announced its plans to examine non-banks and subject more of these institutions to official supervision.
Greater regulation and supervision can help to fortify the non-banking sector, helping to eliminate more of the risks that can cause instability in the economy.
Former Federal Reserve Vice Chair Stanley Fischer qualified that investigation:
“ — we know that we will never be able to identify in advance all the threats to stability that are out there, and that it is therefore all the more critical to maintain and strengthen the robustness of our financial institutions, and of the financial system as a whole.”
Final Thoughts: How Sila Money Supports Non-Bank Fintechs
Banking is big business, but so too are the non-banks—and if prior user growth, venture money, and regulatory inquiries are any indication, the nonbank solutions are here to stay.
It’s easy to see why, too: the COVID-19 pandemic brought about a financial upheaval unlike any other, a massive opportunity for the public to reconsider where it’s putting its money to work, spending on, or borrowing from.
For non-bank fintechs striving to build better financial services, Sila offers a robust money API which combines industry-leading technology with pre-approved fintech marketplace partnerships and deep industry knowledge and expertise.
Sila innovates on top of ACH, providing features for:
- Payments: At Sila, we aim to modernize ACH to enable instant, same-day payments. Plus, we leverage bank partnerships to offer in-app direct deposit switching.
- Identity: With Sila’s ID verification and anti-fraud solutions, you can launch a secure platform with ease. Our identity features include individual and business onboarding, as well as industry-leading KYC solutions.
- Wallets: The Sila Wallet API links U.S. bank accounts to verified entities using proprietary ledger technology. Plus, proprietary blockchain-based financial programming tools are currently under development at Sila to help our clients take advantage of the newest technologies.
- Accounts: Sila’s Virtual Accounts offer flexibility for programmers, as well as excellent functionality and access to a variety of payment methods. Moreover, Sila is an official Plaid Auth partner, making bank account linking a breeze.