(Editor's Note: Market participants' need for transparency on the full scope of credit risk will expand as the financial system innovates—with increasing interplay and interconnection between public and private markets. Systemic Risk is a new commentary series from S&P Global Ratings, providing perspective on key contagion and stability risks across sectors, asset classes, and the credit spectrum. Read our latest research on private credit's characteristics, the dynamics of U.S. banks' loans to nonbank financial institutions, and the global state of play for this bank-nonbank nexus.)

S&P Global Ratings sees lending to NBFIs, which is dominated by large and regional banks, as both an evolving opportunity and risk for U.S. banks.

As traditional lenders continue increasing their loans to nonbanks across a variety of sectors at speed and scale, this activity is facilitating expansion outside of the banking sector—even as other parts of banks' balance sheets have grown slowly. We believe most banks' NBFI exposures to nonbank business, mortgage, and consumer lenders and private equity and credit funds are conducted through collateralized facilities like warehouses and subscription lines.

Such lending, which NBFIs depend on substantially, has allowed banks to profit from the long-term growth of nonbank credit in an asset class that frequently can be structured to carry lower bank regulatory capital requirements than other types of loans. NBFI loans add to banks' net interest income and often lead to investment banking fees related to securitization.

In our view, the fast pace of bank-nonbank interconnection growth (which has caught the attention of U.S. regulators) opens the possibility for poor underwriting and credit losses, particularly if the valuation and quality of the assets held by NBFIs were to decline amid a future economic downturn. The Federal Reserve, in addition to its supervisory stress test this year, said it will conduct an exploratory analysis to examine certain risks that NBFIs pose to banks.

Lending to NBFIs could also add to the competitive pressures that U.S. banks face from their nontraditional counterparts--as well as intensify systemic risk, particularly if potential problems that arise at NBFIs ricochet back on their bank lenders.

To be sure, we believe rated banks that are active in the space have well-managed the associated credit risk to date, most notably through collateral requirements, lending covenants, and good diversification by borrower and underlying asset class. Based on current levels, we do not see a high risk that loans to NBFIs will result in material asset quality issues for rated banks.

Bank Loans To NBFIs Have Surged With The Growth Of Private Markets, Mirroring An Expansion In The Overall Sector

More than doubling the amount reported in 2019 and accounting for approximately 8% of total loans, Federal Deposit Insurance Corp. (FDIC)-insured banks reported that "loans to nondepository financial institutions" increased to more than $1 trillion at year-end 2024. A portion of that increase related to a regulatory reporting change made at the end of last year that broadened the definition of such loans.

Yet even prior to that definitional change, loans to nonbanks had grown roughly 15% on average at annual rates from 2015-2023—well above the low- to mid-single-digit growth rates for total loans.

The growth of these loans correlates with the expansion of the NBFI system, as well as in private credit, that has been developing since the global financial crisis as a proliferation of business development companies (BDCs), private equity and credit funds, and fintech players have targeted credit assets. Several insurance companies, who borrow from banks, have also teamed with asset managers in search of credit assets.

Banks remain major players as credit providers to the economy, but their growth has been restrained by heightened regulation, regulatory capital requirements, liquidity pressures, and uncertain economic conditions, among other factors. NBFIs have found opportunities to offer new lending solutions to borrowers, often taking on risks or extending credit in structures banks generally avoid.

Large And Regional Banks Hold Most Loans To NBFIs

The global systemically important banks (GSIBs) have accounted for the majority of NBFI loans in the U.S. banking system. For instance, such loans made up 17% of Wells Fargo's total loans and equated to almost 100% of its tier 1 capital, as of Sept. 30, 2024. Regional banks such as First Citizens Bancshares, Truist Financial Corp, The PNC Financial Services Group, BMO Financial Corp., and Capital One Financial Corp. are also meaningful players. Most community banks in the banking system report little to no exposure to these types of loans.

New Disclosures At Year-End 2024 Show Exposures To Nonbanks Active In Mortgage, Business, And Consumer Lending As Well As Private Equity

Given the growth of nonbank lending, regulators have required banks to report more granularity on their nonbank exposures in public regulatory filings, starting with year-end 2024 data.

Banks with at least $10 billion in assets segment their nonbank exposures by: mortgage credit intermediaries (e.g., residential and commercial mortgage originators and servicers and real estate investment trusts); business credit intermediaries (e.g., equipment lessors and business development companies); private equity funds (e.g., capital call or subscription facilities); consumer credit intermediaries (e.g., auto lenders); and other (e.g., insurance companies or holding companies of other depository institutions).

Based on these disclosures, we estimate that banks' exposures to mortgage credit intermediaries, business credit intermediaries, and private equity funds were roughly evenly split—accounting for approximately 23% of exposures, respectively. Consumer credit intermediaries made up a smaller piece, at about 10%, followed by other uncategorized loans at 22% of the total.

Banks Have Deployed Specific Strategies To Limit Their NBFI Risk

Data that we have collected from rated U.S. banks indicates that they have managed the risk on NBFI exposure through good diversification, collateral requirements, conservative covenants, short durations, and other structuring strategies.

We believe many NBFI borrowers depend heavily on such financing to operate their businesses, meaning they often prioritize staying in compliance with the terms of the facilities. Additionally, data we have collected from rated banks suggests that these traditional players have low levels of criticized and nonperforming NBFI exposures, with most non-investment grade exposures well-collateralized.

In asset-based finance (which we believe makes up a substantial portion of the loans to business, consumer, and mortgage credit intermediaries), banks extend warehouse financing to NBFIs to facilitate the origination of loans that ultimately can be securitized, typically by the bank lender.

For example, the bank may provide warehouse funding for a residential mortgage finance company to originate mortgages—whereby the entity ultimately pools and securitizes those mortgages, with the new securitization funding paying down the warehouse. Through that arrangement, the bank earns net interest income on the warehouse, followed by fees for acting as the investment bank on the securitization.

We believe banks often structure these warehouses with an aim to securitize the underlying assets at investment-grade ratings. They extend financing at haircuts expected to meet or exceed the collateralization that rating agencies typically require on investment-grade rated securitization tranches. They also consider the diversification and performance of the underlying assets that likely will be needed to achieve investment-grade ratings on these securitizations.

Warehouse lending can be operationally intensive, with the bank lender collecting frequent data on both the performance of the assets and the condition of the borrower. Banks often also manage the risk on warehouses by:

• Setting limits on the underlying mix of assets in a given warehouse and across all warehouses;
• Imposing requirements related to the borrower's financial position, including on leverage, tangible net worth, liquidity, profitability, or debt service;
• Placing requirements related to the performance of the underlying assets, such as the level of delinquencies, nonperforming assets, and charge-offs; and
• Putting in place a back-up servicer that could step in to service the underlying assets in a warehouse should the primary servicer be unable to.

If a borrower breaches or is in danger of breaching such requirements, the borrower typically would be forced into remediation or negotiation with the bank. For instance, if delinquent loans financed in a warehouse breached a threshold, the borrower likely would have to buy the loans out of the facility or replace them with performing loans.

Subscription Facilities Are A Key Area In Nonbank Lending, Including For Private Capital Funds

Some banks have sharply increased loans and lending facilities known as subscription or capital call facilities to private equity, venture capital, secondary buyout, and private credit funds over the last decade. The new year-end 2024 disclosures suggest that those facilities may equate to almost a quarter of banks' NBFI exposures.

In private capital funds, limited partners (LPs) commit to send capital to the fund's general partner (GP) when the latter calls on that capital to finance investments. As the sponsor, the GP initially leaves such capital commitments undrawn as it seeks investment opportunities and subsequently calls on the capital as it makes investments into the fund during the investment phase. Funds typically borrow from banks via subscription facilities to bridge the timing difference between when the sponsor makes an investment and when LP investors send capital.

Undrawn capital commitments from a fund's investors serve as the primary source of collateral, allowing the bank to exercise capital calls from the fund's investors if the fund defaults on the subscription facility. In some instances, banks have recourse to the underlying investments in the fund via a dual pledge, which they would take possession of if the sponsor fails to meet repayment and the fund's investors default on their capital commitments.

In our view, banks have experienced very low defaults on such exposures historically for several reasons. Most notably, the funds banks lend to typically have relatively creditworthy institutional investors that rarely default on capital commitments, allowing the sponsor to use the funds advanced from the investors to repay the subscription facilities. Furthermore, if an LP fails to meet a capital commitment, it could lose the ability to invest in successor funds of that particular asset manager and, in some cases, any capital it previously invested in the fund.

In addition, the sponsor can take steps to meet repayment on subscription facilities even if an investor fails to meet a capital commitment. For instance, it may sell the commitment of the defaulted investor to another investor, seek additional capital from existing LPs (including through overcall provisions), or sell assets in the fund. Sponsors are also often incentivized to meet repayment for reputational reasons.

On top of requiring the collateral of capital commitments, banks use other measures to manage risk on these exposures, including relying on granular diversified pools and structuring subscription facilities to have maturities of a year or less.

The strength of the sponsor and the LP pool is also crucial. A sponsor with a well-known reputation, ability to raise capital from a variety of investors, and a solid investment track record is less likely to default on a subscription facility. A sponsor with capital commitments from large institutional investors, such as pension funds and insurance companies, is also ess likely to default.

Banks may also extend net asset value (NAV) facilities to funds, which are collateralized by the fund's underlying assets rather than capital commitments. We believe rated banks have less exposure to NAV facilities than subscription facilities. While funds typically initially rely on subscription facilities at the early stage of their lifecycle, they may also add leverage through NAV facilities as they mature and build up their asset bases. NAV facilities may be used for liquidity, general risk management, and returning proceeds to LPs, among a plethora of additional purposes.

Despite Conservative Underwriting, Defaults Still Occur On NBFI Loans And Counterparties Can Be Risky

While banks limit the risk on NBFI lending with collateral and structuring, losses can occur. We view the rapid growth of banks' NBFI lending as an indicator of risk.

For instance, the subscription and NAV facilities banks have extended to funds could be tested in a period that brings declining asset valuations and elevated credit losses on fund investments. Furthermore, we believe that increased use of these facilities has added to the funds' leverage, perhaps weakening the resiliency of some.

Meanwhile, counterparty risks can be material in warehouse lending. Counterparties, such as subprime consumer lenders, can be small, lack diversification, or participate in risky lending areas.

Additionally, the potential for idiosyncratic and unexpected events (such as a pandemic) or company-specific challenges (including fraud and poor management) that bank lenders may lack protections for also pose risk—leading to sharper-than-expected declines in collateral values that lead to losses.

Banks Often Structure NBFI Exposures As Securitizations For Favorable Capital Treatment

By structuring their NBFI exposures as securitizations, banks can achieve low-risk weightings and highly leverage such assets.

To do so, a special purpose entity (SPE) is formed. The bank then provides funding to the SPE, which purchases loans from the borrower. The borrower effectively provides the equity to the SPE. Through this arrangement, the bank often can risk weight its senior exposure to the SPE at 20%, assuming sufficient collateral is in place. Alternatively, if the bank lends directly to the borrower, the risk weight would likely be 100% under standardized capital rules in the U.S.

Put simply, the bank can leverage the NBFI exposure 5x as much by structuring as a securitization. At a 20% risk weighting, the bank essentially only has to hold $2 of tier 1 capital for every $100 of NBFI exposure, assuming a 10% tier 1 ratio.

While the implementation of the final set of Basel 3 capital standards could alter this treatment, uncertainty over when and how the U.S. implements those standards remains.

Banks' Expansion In NBFI Lending And Their Interconnection Could Add To Systemic Risk

While banks face increasing competitive challenges from nonbanks, they also are increasing their interlinkages with them. FDIC data showed not only $1 trillion of bank loans to nonbanks, but also another roughly $770 billion of unfunded commitments.

A future economic downturn could place pressure on the asset quality of those exposures with potential weak performance of nonbanks affecting banks. Banks could also be put in a difficult position of having to restructure nonbank loans or take possession of and liquidate collateral.

In our view, that will make it crucial for banks to carefully structure, diversify, and monitor nonbank exposures—particularly if they continue to grow quickly in this area.

Related Research

• Systemic Risk: Global Bank-Nonbank Nexus Could Amplify And Propagate Market Shocks, Feb. 18, 2025
• Systemic Risk: U.S. Banks' $1 Trillion In Loans To Nonbanks, Like Private Credit, Creates Risks And Rewards, Feb. 18, 2025
• Systemic Risk: Private Credit's Characteristics Can Both Exacerbate And Mitigate Challenges Amid Market Evolution, Feb. 18, 2025
• Systemic Risk: Global Nonbank Financial Institutions Press Ahead, Feb. 18, 2025
• Systemic Risk: Global Banking Regulation At A Crossroads, Feb. 18, 2025