NBFIs: Risks and Opportunities From Nonbanks in the Financial System

How prepared are commercial banks for the risks stemming from nonbank financial institutions (NBFIs), and does the ascension of these firms provide opportunities for aspiring and early-career risk managers?

The International Monetary Fund’s (IMF) latest Global Financial Stability Report states that NBFIs (also known as “shadow banks”) now represent nearly 50% of global financial assets – but they face little if any oversight from banking regulators.

To help learn how financial risk managers (FRMs) in the field view the risks related to NBFIs, the GARP Benchmarking Initiative (GBI) recently surveyed nearly 500 FRM-Certified practitioners worldwide. While the responses will be more fully analyzed in GBI’s upcoming “Risk Snapshot” webcast, we can see from the raw data that risk managers recognize a wide range of potential exposures from NBFIs. 

Risk managers, for the most part, do not believe their firms are well prepared to handle these exposures. But while NBFI risks are worrisome, it’s also true that they will yield more risk management jobs across different sectors.

The Risks of NBFIs

Michael B. Imerman is an Assistant Professor of Teaching in Finance and Director of the Master of Finance program at the Paul Merage School of Business, UC Irvine. He has researched and consulted for numerous NBFIs over the years — particularly financial technology companies ("fintechs") — and sees several risk factors surrounding the growth of the sector, beginning with the fact that there’s no formal risk framework in place for banks to deal with these entities. Banks and regulators, he says, need to establish protocols and procedures for evaluating the risks related to NBFIs.

Noting that credit risk was the leading concern expressed in the GBI survey, Imerman would like to see the development of better methodologies for evaluating credit risk and counterparty risk when dealing with NBFIs. “Since they have become increasingly active in credit markets and lending, to the extent that they’re either counterparties in derivative transactions or lending transactions, being able to evaluate their likelihood to default on an obligation is going to be critical as they continue to grow and occupy more of the transactions in the global financial system.”

Some of those transactions originate from two types of NBFIs that are important to the modern economy: private equity (PE) and venture capital (VC). Lamentably, Imerman cautions, PE and VC are “largely unregulated” and have no formal risk function. “This must change,” he says. “I'd like to see more work done in educating the alternative investment and private market communities on risk management practices.”

Investors have increasingly looked to private markets for opportunities, taking advantage of the low interest rate environment that existed until recently. But Imerman warns these opportunities come with risks, and he worries that few PE and VC firms even have a CRO.

Opportunities for Risk Managers

Imerman tells his students that when there’s an area of the financial industry that's not well understood and represents possible novel risks — like NBFIs — it creates massive opportunities for risk managers. This includes entry-level professionals right out of college or graduate school, mid-level managers, and all the way up to the executive and C-suite levels.

Some of Imerman’s students have been placed in risk functions within fintech companies in recent years, and he hopes to see an increase in these spots as fintechs begin to take the risk function more seriously. This should create more opportunities for early-career risk managers.

Jobs may also be found at marketplace lenders — formerly known as peer-to-peer lenders. Imerman says these NBFIs have been proactive in ramping up risk management hires, leading to many entry-level positions. But he admits to frustration with some other NBFIs, particularly crypto-related firms, for failing to embrace a robust risk function.

Professor Michael B. Imerman, UC Irvine

Even reluctant NBFIs are likely to build out their risk departments, eventually. However, Imerman fears that, for many, the motivation to act will only come from another FTX-style collapse.

Hedge funds and insurers, with their well-established risk management track records, are among the other types of NBFIs that offer hope to aspiring and early-career risk professionals. “It's not something you hear students talk about, because it's not well-publicized that there are career opportunities on the buy side in risk management,” Imerman notes. The buy side is often associated with portfolio management, he elaborates, “but established risk management tracks within these organizations go from entry-level risk analyst all the way up to CRO, especially at the asset managers.”

Data analysts may also benefit from the rise of shadow banks. The lack or opacity of NBFI data is viewed as the biggest challenge related to NBFIs, according to the GBI survey. The regulated financial sector, Imerman notes, has a good amount of transparent data that can be analyzed using traditional statistical measures, thanks to standardized disclosures and financial reporting requirements. But among shadow banks, he says, “the scarcity of data means that risk analysts must get more creative. And that's a tremendous opportunity for risk professionals with a strong data analytics background.”

Last year’s crypto winter, including the collapse of FTX, may ultimately open even more risk management jobs at both conventional banks and NBFIs. “The losses associated with those types of events do make their way into the traditional financial system. That was part of what happened to banks catering to the tech community such as Signature Bank and Silvergate Bank, and even Silicon Valley Bank and First Republic,” Imerman opines.

He anticipates increasing engagement between risk managers and their regulators, since these new risks encourage both groups to produce solutions. Along the way, risk professionals should see opportunities at banks, NBFIs and regulators.

Indeed, Imerman hopes that all three groups will decide to bolster their risk function proactively rather than waiting for the next crisis. “The risk community functions best when it has the policies and procedures and protocols in place, rather than waiting for something to go wrong. It's better to think ahead, expect the worst, and hope for the best,” he counsels.

Tod Ginnis is a content specialist at GARP. He is the author of a GARP blog that is aimed at early-career risk managers and professionals aspiring to earn their Financial Risk Manager (FRM) Certification.