The Silent Risks Between Banks And Nbfis

(MENAFN- ING)

While banks have faced tighter regulation since the global financial crisis, Non‐Bank Financial Intermediaries have expanded rapidly under lighter regulatory oversight, now even exceeding banks in size. As the sector becomes more complex and interconnected, a severe shock within NBFIs could increasingly spill over into the wider financial system, creating a new type of risk for the 'traditional' banking sector.

In this piece, we look at the recent evolution and structural vulnerabilities of NBFIs before examining the direct channels through which such risks could spill over to banks.

Non-Bank Financial Intermediaries explained

Before diving into the development of the sector, let's define what we mean by Non-Bank Financial Intermediaries (NBFIs). The term NBFI is used to describe a large variety of institutions. We define them here as financial corporations other than banks. Most NBFIs take in cash, just as banks do, and deploy it in various securities and derivatives.

Currently, there is no universally agreed-upon way to classify the different types of NBFIs. Therefore, the sector is often split to account for differences in regulation and risks. In this piece, we mainly differentiate between four sub-sectors.

The first two, insurance companies and pension funds, are subject to a broad range of regulations. The latter two, investment funds and other financial intermediaries (OFIs), comprise a wide variety of financial institutions that are subject to less regulatory oversight. The graph below gives a non-exhaustive view of the different types of funds and entities included in each sub-sector.

Non-exhaustive NBFI sector split

Part of the complexity in understanding and analysing the NBFI sector stems from the various ways of looking at it. This adds to the significant lack of data available and its overall low quality. The difficulty in identifying and estimating risks within the sector has brought a lot of attention as it has significantly grown over the last decade.

While the broad consensus points to the well-being of the banking and corporate sector, we consider that non-banks could be seen as the largest known unknown in the financial system.

NBFIs continue to expand to more than 50% of global financial assets

After a brief dip in 2022, the NBFI sector resumed its strong expansion in 2023-24, reaching 51% of global financial assets by the end of 2024.

According to the Financial Stability Board, 2024 marked the second‐largest annual increase on record, with assets rising by 9.4% year‐on‐year. This reflects investors' increasing risk appetite in an environment with stronger asset prices and lower policy rates. By comparison, global banking sector's assets grew just 4.7% over the same period, underscoring the faster pace of NBFI growth.

Historical evolution of the NBFI sector globally

On average, NBFIs represent just over 32% of total financial assets in advanced economies globally, but major pockets of concentration exist, including in the EU. While in many European countries banks still hold the largest share of the jurisdiction's financial assets, in the Netherlands, Ireland and Luxembourg we see a significant predominance of NBFIs.

Composition of the financial system shows predominance of NBFIs in some countries

At the global level, the role of NBFIs in providing credit to non-financial corporates (NFCs) also continues to increase, showing the importance of NBFIs in funding the real economy. The FSB highlights that the share of global OFIs' assets directed towards NFCs grew by 1.33 percentage points YoY in 2024. The increase is also noticeable in the insurance and pension fund sectors, which respectively show an increase of 0.5 and over 1 percentage point YoY.

Despite the recent growth of the NBFI sector, the latest data highlights that its composition remains relatively stable year-on-year. However, over the past five years, the share of insurance companies and pension funds has decreased gradually. This coincides with the growth of OFIs, which saw the largest increase in 2024 YoY at over 11%. The same year, both insurance companies and pension funds grew by about 6%.

Naturally, as OFIs comprise many types of entities, we also note growth differences within the sub-sector. Investment funds (excluding money market funds and hedge funds) are the largest contributor to the recent increase, with 14.5% growth YoY. The graph below shows the composition of the OFI sub-sector over the years.

Despite recent growth, the composition of NBFI sector remains stable YoY

Looking more specifically at the composition of the EU financial sector, data points to a relative increase in the share of investment funds and OFIs over the last quarter of 2024. Indeed, at the end of that year, OFIs made up 17% of the EU financial sector's assets. Taken together, EU investment funds and OFIs totalled €50.7tr at the end of 2024, up €3.3tr YoY. The bulk of this growth stems from a stark increase in investment funds' assets under management (AuM), reflecting equity funds' AuM growth, which is mainly driven by US equity valuations.

Again, while these numbers give an understanding of the trend for the largest NBFI sub-sector, there is a significant lack of granularity in the available data, especially in the evolution of specific entities within the OFI and IF segments. What is known is that equity funds make the largest share of the sector in the Union (at 27%), followed by bond funds and mixed funds.

Composition of the European NBFI sector

As shown in the graph above, 4% of European OFIs are composed of private market entities. These private finance entities aim to provide funds to companies, mostly unlisted ones, via debt and equity investments. The segment aggregates private equity (the largest subsector), private credit, as well as real estate and infrastructure firms.

Over the past five years, private markets have grown in the EU to reach €900bn in 2024. The sector's inherent opacity, combined with the rapid growth, has raised concerns. Read more on this in our piece focusing on private markets here.

NBFI's main vulnerabilities

The NBFI sector comprises a large variety of financial institutions whose activities are exposed to various kinds and degrees of risks. This is especially true as a large part of the sector faces lighter regulatory oversight, which restricts the availability and quality of data. This directly limits the understanding of inherent risks and exposures to the rest of the financial system.

The three main risk factors the NBFI sector faces include financial leverage, liquidity risk and interconnectedness.

1. Stable, but for some, high financial leverage

The past few years' low-interest-rate environment, as well as asset price volatility, has incentivised investors to use financial leverage to boost returns. While you can argue that the build-up of leverage creates vulnerabilities, estimating the level of debt for NBFIs has proved difficult for authorities and market participants due to the complexity of the sector and the lack of data.

The FSB estimates, however, that financial leverage has been stable year-on-year across all types of NBFIs. Nonetheless, disparities within the sector remain, with some entities such as broker-dealers, structured finance vehicles and real estate funds showing the highest debt-to-asset ratios. If a shock occurs and impacts asset values or drives interest rates abruptly higher, NBFIs may be forced to de-lever, amplifying the initial price decline. High leverage remains a key vulnerability and a major“known unknown” that could deepen a market correction with wider implications.

Historical evolution of leverage for global OFIs

2. Liquidity risks in pockets of the NBFI sector

Liquidity risks can come in different shapes and forms. The first one consists of liquidity mismatches, which remain an important structural vulnerability for NBFIs, more specifically for investment funds. The bulk of EU investment funds are open-ended, allowing frequent redemption options. The structure may expose some funds to a sudden increase in redemptions in times of market volatility, resulting in potential liquidity stress.

However, here again, even within investment funds, entities engage in various degrees of liquidity and maturity transformation. As shown below, real estate funds show the highest degree of liquidity transformation as they invest in inherently illiquid assets.

European investment funds' liquidity transformation

Liquidity risks can also emerge from the use of derivatives. A derivative position may expose financial entities to a sudden and significant liquidity demand during a shock. This can trigger fire asset sales and exacerbate market stresses, triggering procyclical behaviours. Within the wide variety of NBFIs, central counterparties (CCP) could also pose a risk here. A sudden large or system-wide market move may result in substantial margin calls, posing a risk for the CCP liquidity position, which, in a worst-case scenario, could cascade further in the financial system.

Liability-Driven Investment (LDI) funds have recently shown vulnerability to fire‐sale dynamics and spillover risks through liquidity pressures in recent years. Some countries, such as Luxembourg and Ireland, have taken regulatory steps to mitigate liquidity vulnerabilities for these types of funds. Both the Central Bank of Ireland and the Luxembourgish 'Commission de Surveillance du Secteur Financier' therefore implemented liquidity buffer requirements back in 2024.

However, aside from these examples, regulation tackling liquidity risks in the NBFI sector remains limited and focused on specific types of entities. The broader liquidity risks thus remain a structural vulnerability for NBFIs.

3. Growing interconnectedness

Compared to both financial leverage and liquidity risks, NBFIs' interconnection has continued to increase over the past two years. This is true both when looking at links within the sector and with the broader financial system.

The graph below depicts the aggregated linkages between the large NBFIs groups. The data shows that both insurance companies and pension funds are exposed to various types of NBFIs, with, for example, claims to OFIs representing respectively 14% and 23% of their total financial assets. For both sectors, these exposures are larger than they are for banks and non-financial corporates.

In addition, interconnection between the different types of OFIs also exists, with various degrees depending on the entities, but it remains difficult to assess.

Aggregated linkages between NBFIs globally

The rapid growth of the NBFI sector has been accompanied by growing interconnections with banks. These links could broaden and propagate a shock in the sector and subsequently to the real economy. The interconnection between NBFIs and the banking sector takes several forms. There are direct links arising from bilateral transactions such as loans, deposits, repos and derivatives. The growing concentration of assets that are held by both NBFIs and banks instead poses more of an indirect link between the two.

At the global level, the FSB estimates that banks' funding from OFIs is around 5% of bank assets, while the exposure reaches 4%. However, there are significant national variations.

Banks interconnectedness with NBFIs has grown globally since 2023 after several years of decline Channels linking NBFIs to European banks

The sustained growth of NBFIs is significantly increasing their interconnectedness with banks. European banks are now exposed to the NBFI sector on both sides of their balance sheet. We therefore see some channels through which the development in the NBFI sector could have a more direct impact on the banking sector. These include a weakening in the credit quality of the banks' NBFI exposures or sudden liquidity stress in NBFIs leading to substantial deposit outflows in banks.

Some channels may be more indirect. Some banks and NBFIs are active with the same counterparties. A realised, larger risk in one of these counterparties could therefore impact a bank both directly and via a weakening in the position of the NBFI. In instances where the NBFI reduces its exposure in times of stress, the bank counterparty may see more pressure to pick up the slack and see higher use of credit limits, for example. Lastly, while NBFIs are clients to banks, they may also be seen as competitors, with some supported by lighter regulation than banks.

Channel 1: weakness in loan quality

One main channel through which a large-scale shock in the NBFI sector could directly impact banks is via a weakening in non-bank credit quality. Weaker loan quality would reflect as higher impairments, directly pressuring banks' earnings. Large enough, they could eat into banks' capital positions and eventually reflect as higher funding costs once financial markets start pricing in a higher perceived risk. Negative credit risk migration would push risk-weighted assets (RWA) higher, a negative for capital metrics.

European banks have a total of €1.75tr in exposures to financial corporations other than credit institutions or NBFIs, based on the EBA data. Of these exposures, the bulk (about 83%) is in the form of lending and the rest as debt securities issued by these NBFIs.

In the following charts, we have included banking sectors that have above €20bn in total non-bank exposures.

European bank exposures in non-bank financials

Of the €1.46tr in NBFI lending, the largest exposures are in German (30% of total) and French (20%) banks. Country-wise, the five most active jurisdictions in the NBFI sector are Germany, France, the Netherlands, Italy and Spain, carrying an aggregated 85% of the European total.

Banks increased their lending into NBFIs by some €95bn by the end of 2Q25, from €1.36tr since the end of 2024, led by the Netherlands (€32bn), France (€20bn) and Germany (€19bn).

The largest exposures to debt securities issued by NBFIs are in France (€88bn), followed by Germany (€66bn) and Italy (€57bn). However, French names have a stronger diversification, and as such their NBFI exposures account only for some 7% of total lending and debt securities, while for German names, the NBFI sector accounts for a clearly higher share of some 17% of the total.

In countries like Greece, Denmark, Italy and the Netherlands, banks run with a larger than 10% NBFI exposure as of their total lending and debt securities. Of the smaller countries, Lithuania, Luxembourg and Latvia also have above 10% exposures here.

European bank lending books are diversified across segments, with NBFIs just one of them

Obviously, only running with a large NBFI exposure doesn't necessarily tell much of the risk profile of the bank yet, as the underlying sector consists of a wide range of different types of financial counterparties with differing risk profiles. Unfortunately, the data sample gives very limited further idea of the more subtle split of the exposures. A higher exposure is likely to make the bank more exposed to potential market turbulence in case of problems in the wider NBFI sector.

While we can see several risk factors in the sector, currently the bank lending to NBFIs is (for the most part) performing with limited non-performing lines. For the larger countries, the average non-performing exposure (NPE) ratios for NBFI exposures were in the range of 0.1-1.3%. The €7.2bn in non-bank NPEs are covered by €3.5bn in allowances, on top of which banks run with an additional €2.1bn in allowances for performing exposures and have €2.2bn in collateral and financial guarantees on top.

The largest stock of NBFI NPEs are in French banks at €2.7bn followed by €2bn in German banks. France and Belgium were running with the highest NPE ratios for NBFI exposures at 1.3% and 1.2%, both still at benign levels, with coverage at 52% and 39% for NPEs respectively (or at 67% and 84% including collateral and financial guarantees). Of the large countries, the NPEs corresponded to a limited 0.6% in Germany, with NPE coverage at 38% (or 69% with collateral and guarantees). When also including impairments on performing exposures, coverage for these countries would rise to above 100%.

Overall, the NPEs have remained in check as of 1H25, with banks in only three countries reporting a higher NPE ratio for the NBFI sector from the year-end: Norway, Denmark and Austria.

Bank lending to NBFIs has so far remained rather healthy with strong coverage ratios overall

We consider that some scrutiny is of the essence when it comes to NBFIs. Currently, though, for European banks, it is rather the other segments that are leading in terms of non-performing exposures. Non-performing loans (NPL) ratios are higher for non-financial corporates and, for most, also for households than for the NBFI sector.

It is not NBFIs that lead in problem loans but either household or corporate lending

Channel 2: a risk to bank liquidity and funding stability

NBFIs contribute to the funding of European banks, among others, via deposits and repos. If the NBFI sector experienced sudden liquidity stress, it could trigger corresponding deposit outflows from banks, putting pressure on their liquidity and funding profiles.

The chart below shows the share of funding different NBFI entities provide to banks. For European banks, outside insurance companies, the use of NBFI financing varies a lot across countries. For example, in France, banks rely to a larger degree on money market funds, while in Ireland structured finance vehicles provide the bulk of NBFI funding.

Luxembourg is the EU Member State with the highest share of bank funding stemming from NBFIs, making nearly 24% of the sector's total assets. While the share is high, it is good to note that any systemic consequences are likely to be limited by the relatively limited total size of the country's banking sector.

Different types of NBFIs provide funding to banks

NBFIs have deposited closer to €2.47tr in European banks with 44% of this in overnight deposits, based on EBA data. If the NBFI sector were, for some reason, to suddenly withdraw a more substantial part of this, it could obviously have clear consequences for bank funding and liquidity profiles.

NBFIs deposits correspond to some 14% of the overall total deposit bases and 10% of total overnight deposits. They comprise just below 9% of the aggregated bank balance sheet total, or just below the aggregate liabilities. The substantial size means that weakness in this sector acts as a risk factor also for banks as a whole.

The largest NBFI deposit base is clearly in French banks at €1.01tr, corresponding to some 18% of total deposits. German banks housed €527bn of non-bank deposits (21% of total deposits) and Spanish ones €233bn (9% of total deposits). The largest relative deposit exposures are in smaller countries such as in Liechtenstein (36% of deposits), Luxembourg (22% of deposits) and Estonia (21% of deposits).

NBFI deposits have become an important bank funding source

Within European banks, it is mainly the large names that are more active in the NBFI sector. The ECB shows that the bulk of short-term liabilities from NBFIs are concentrated at the level of a handful of individual institutions with systematically important banks (SIB) showing the largest exposures, followed by universal and diversified banks.

NBFIs contribute both via deposits and repos to the funding palette of systemic banks, while for the smaller banks the bulk of NBFI funding exposure is in the form of deposits. Although the absolute exposures are larger in systemic and universal and diversified banks, the relative share of total assets is more noteworthy in the case of asset managers and custodian banks, as well as investment and wholesale banks. This makes the latter two groups more exposed to potential funding risks coming from NBFI sector, in our view.

Some NBFI entities have business models that are based on a large use of leverage. The ECB has pointed towards commercial real estate funds, hedge funds and risky trading among those with higher risk profiles. At the EU level, about 26% of the lending to NBFIs involves highly leveraged firms. Most of the higher risk exposure is concentrated in the largest banks, with hedge funds, in particular, among the larger exposures.

The larger European banks are more active in the NBFI sector Conclusion

The NBFI sector's growth in both size and complexity implies greater links with banks. Interconnections with the rest of the financial sector is one of the three main structural vulnerabilities NBFIs are facing, alongside liquidity and financial leverage risks. However, while the latter two stabilised over the past years, interconnectedness keeps increasing.

Greater overlap between the two sectors may pose problems if the wider NBFI sector faced a sudden shock that, in turn, impacted banks directly via their exposures. This is especially true as banks are linked to NBFIs via both sides of their balance sheet.

The largest NBFI exposures are in German and French banks. Of the two, for German names the relative share is clearly higher as French names benefit from stronger diversification. On the funding side, it is French banks that rely a bit more on NBFIs in their funding mix than their German counterparts. Overall, mainly the larger systemic banks are active in NBFIs and, as such, they are also the ones that would be more exposed in case of trouble in the sector.

We identify several channels through which NBFI developments could impact European banks. These include, in particular, weaker NBFI loan quality and sudden NBFI deposit outflows from banks. Concentration of risks with the same counterparties may exaggerate credit risks of these counterparties for banks. Lighter-regulated NBFIs may also impact the competitive landscape for some products where both sectors are active.

We consider that these direct risks to banks remain in check, at least for now. Banks are also likely to benefit from the increased ties between the two sectors, offering growth opportunities. That being said, some scrutiny is of the essence when it comes to NBFIs especially as more granular and frequent information is necessary to paint a complete picture of the risks and developments of the sector.

For the time being, the NBFIs remain a large unknown, casting a shadow on the relative well-being of the financial and corporate sector.

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