Is This Any Way to Run a Bank?

The first thing you notice when you walk into the main lobby at Live Oak Bank in Wilmington, North Carolina, is how casually dressed most of its staff are. Anyone adhering to the conventional baby boomer standards of business casual would be overdressed here. Most of the employees are millennials, and the standard-issue uniform on one hot and humid day in early June consists of shorts, a polo shirt and sandals.

The lobby serves as the bank’s one branch as well as its headquarters, but there’s no counter or even a high-tech kiosk, just someone sitting at the reception desk who doubles as a teller. Live Oak services, on average, between two and six deposit transactions a day at this branch, but raises 99.99 percent of its deposits digitally. Its physical location merely serves to comply with the federal requirement that every chartered bank have at least one branch.

When Live Oak CEO James S. “Chip” Mahan III founded the company in 2008, he did so unapologetically on the principle that his employees came first, his customers second and shareholders third. This is not because he is anti-shareholder, but because he knows what every dairy farmer knows-that happy cows produce better-tasting milk than unhappy ones. Examples of this philosophy abound throughout the company. A fleet of three corporate jets allows its lenders to make West Coast trips and get home that same night. A heavily subsidized employee cafeteria called The Grove serves restaurant-quality food throughout much of the day. There is also a 200-square-foot fitness center that will be replaced later this year by a 20,000-square-foot fitness center, built on to the side of a new 600-car multi-level parking garage. Live Oak pays 100 percent of its 560 employees’ health insurance costs and does a full match on their 401(k) deductions up to the 6 percent legal limit. Two adjacent dog parks allow employees to bring their canines to work. And if you need to take a break, you can take a walk around the lake on its 22-acre campus.

Is this any way to run a bank?

Yes, if what you’re running is at its core a financial technology company with a bank charter. The charter allows Live Oak to raise insured deposits, and it’s regulated just like any other bank, but just about everything else is pure fintech, right down to the dress code.

Live Oak is in fact an example of how banking and the world of fintech are beginning to converge. Banks need to become nimbler and more innovative, while many young fintech companies that compete directly with banks need to pay more attention to regulatory compliance. “I would submit to you that Live Oak Bank is a fintech-we just happen to be a fintech that uses our balance sheet,” says Live Oak President Neil Underwood. “Banks are gravitating toward fintechs and fintechs toward traditional banks.”

Live Oak is the second ranked bank in Bank Director’s 2018 Bank Performance Scorecard for the $1 billion to $5 billion asset category. (The Bank Performance Scorecard is a ranking of the 300 largest publicly traded U.S. banks, broken into three asset-size categories, and the banks are ranked on five metrics that measure profitability, capital strength and asset quality. For a full explanation of the Scorecard, please see page 14.) When all 300 banks are ranked against each other, $3.6 billion asset Live Oak is the third best performing public bank in the country, based on last year’s financial data.

Live Oak saw a strong 25.8 percent increase in loans and leases last year compared to 2016, and a lot of that production now stays on its balance sheet. Early on, Live Oak sold a lot of its loans to create an income stream that helped finance its operation, but that has changed. “They’re shifting from a model where they were generating a lot of gain on sale income to a model that has more recurring income,” says Sandler O’Neill + Partners analyst Aaron Deer. “It’s becoming a stronger bank with the wherewithal to ride through the [economic cycle] with less vulnerability.”

Its 2017 earnings were augmented by a $68 million gain in the fourth quarter, when it was required to value its share of a joint venture with First Data Corp., named Apiture, which is developing a next generation online and mobile banking platform. While investors typically place more value on operating earnings than one-time investment gains, one could argue that technology development is a core business at Live Oak. It is certainly part of its corporate DNA.

“These guys have been putting up phenomenal numbers from the very beginning, both in terms of growth and profitability,” says Deer.

The bank is unusual for more than just its shorts-and-sandals dress code. Live Oak focuses exclusively on small business loans guaranteed by the Small Business Administration-which accounted for about 70 percent of its originations last year-and the U.S. Department of Agriculture. Indeed, it is now the largest small business lender in the country, having displaced megabank Wells Fargo & Co. last year. It is also a force to be reckoned with in the fintech space, punching well above its weight both in its use of technology throughout the company and in its development of technology as a partner and investor.

Live Oak has funded over $8 billion in small business loans over the last 10 years, mostly SBA 7(a) loans, and since 2013 has grown its portfolio at a compound annual growth rate of 40 percent. By his calculation, the 67-year-old Mahan, a native Kentuckian who is something of an iconoclast despite having spent his entire career in banking, is just getting started.

“It’s my view that maybe we’re on the second pitch in the first inning here,” says Mahan. “I see no reason why we can’t grow this to a $100 billion bank.”

Mahan’s first job in banking was with Wachovia Bank & Trust Co. in Winston-Salem, North Carolina, where he spent a year in the credit department and nine years as a lender. But he clearly is an entrepreneur in a banker’s body. He became chairman and CEO of Lexington, Kentucky-based Citizens Union National Bank & Trust Co. in 1984, after having worked there for several years. Two years later, he formed an investment group that bought the bank and later sold it to Banc One Corp. He subsequently started Cardinal Bancshares in 1987, grew it to $800 million in assets and took it public in 1992. Up until then Mahan had played in banking’s conventional space, but his next move would be pure maverick. In 1995, he founded Security First Network Bank, the world’s first internet bank, which was sold three years later to Royal Bank of Canada when it failed to gain traction with customers. Mahan was on to something. He was just a decade or so too soon.

Through the latter part of his career, Mahan also has shown a deep appreciation for the defining competitive difference that technology can make in banking. Security First had a software division, and when the banking operation was sold to RBC, the software business was spun off as a separate company and renamed S1 Corp. Mahan ran that company as chairman and CEO until 2006, but quit after the board turned down his offer to take the company private when it was under pressure from an activist investor. Mahan was also instrumental in the formation of nCino, a fintech company that sells a cloud-based automated lending platform that was originally developed in-house at Live Oak and was spun off in 2012. The nCino platform is used by 150 banks and credit unions, including Live Oak.

In addition to Apiture, other fintech adventures that Mahan has embarked upon include Live Oak’s venture capital subsidiary, Canapi, which has made several investments in fintech companies, including Payrailz, an AI-driven payments solution, Greenlight Financial Technology, a debit card designed to be used by older children, and Finxact, a cloud-based core operating system.

With Live Oak, Mahan brought together several elements that separate it from most commercial banks, beginning with its culture. One of the company’s founding principles is that it doesn’t pay its lenders commissions, unlike most of its competitors, because it doesn’t want them putting their interests ahead of the customers’. The company also has what is jokingly referred to as a socialistic bonus plan where every employee, except for a few senior executive officers who are excluded from the plan, receives the same percentage of their salary based on the attainment of shared corporate goals. “We’re not successful because of our technology,” says David Lucht, a senior vice president and one of the company’s founders. “We’re successful because of the culture.”

That’s not to say that Live Oak’s technology doesn’t give it a powerful advantage in the marketplace. Its automated platform enables it to underwrite a small business loan faster and cheaper than other lenders that still rely on manually intensive underwriting and administrative processes.

Another departure from convention is Live Oak’s narrow product focus. The Live Oak formula is to identify one of the 1,100 approved industries in the SBA’s guaranteed loan program that has an inherently good risk profile and dig deeply into that business-or vertical in its vernacular-to understand everything about it. The bank then hires a domain expert who knows the industry in question extremely well, gives them the title of general manager and puts them in charge with P&L responsibility for the vertical.

The company currently serves 20 verticals, ranging from veterinarians (its first vertical) and poultry producers to solar panel leasing and automotive after-market products. Although focusing so narrowly on a small number of industries in a single market like SBA loans might seem like a risky thing to do, Live Oak is quite conservative in its selection of verticals and the pace at which it adds new ones.

Because Live Oak raises the vast majority of its deposits through its online and mobile banking platforms, it is highly reliant on technology in this activity as well, and in May was awarded the top ranking in Bank Rate Monitor’s ease of use category. Mahan admits that Live Oak also pays “at the top of the scale” for its funding, and he defends this by arguing that branch banks have a much higher cost of deposits when all of their overhead, including “branches, tellers, heat, light, utility, taxes, compliance,” is factored in. Recently, Mahan asked the bank’s data scientists to look at a group of well-managed branch banks and estimate their all-in cost of funds. The number they came back with was 276 basis points. “So, we’re raising money at 170 basis points with 15 people, and we added a half a billion dollars in deposits in Q1,” he says. “If I wanted to turn it up, I could do a billion dollars in Q2.”

Still, funding your bank almost entirely with hot money in the consumer deposit market could be viewed as a liquidity risk in a recession if depositors retreat to large national banks which they perceive to be safer. Mahan has plans to alter Live Oak’s deposit profile over time. Asked if Live Oak would some day become an online consumer bank with a suite of checking and savings products, Underwood points to Aspiration, a fintech company that currently offers a checking account paying 1 percent interest, along with mutual funds and IRAs, through its mobile and online channels. Aspiration is not a bank. Its checking account is white-labeled by Radius Bank, and its mutual funds and IRAs are provided by UBS Asset Management and Emerald Asset Management, which connect with Aspiration through application programing interfaces, or APIs, which give these outside firms access to their systems and customers. Underwood says there’s no reason why Live Oak can’t do the same thing.

Underwood wants to be a “fintech-friendly bank” that works with fintechs like Aspiration to provide them with deposit products. “There’s no reason why we, as a bank, shouldn’t be as nimble as a fintech and go direct to the consumer in that way,” he says. “The benefit to us is lower cost for the ownership of technology and non-interest bearing deposits.”

But to make that strategy work effectively, the bank needs a core processing system that is easy for third-party developers to connect to, and that’s where Finxact comes in. The Finxact core will be an open system, or what Underwood describes as a “headless core” that does nothing but monitor accounts. Users will be free to work with best-of-breed developers on solutions like online and mobile banking, statement generators and the like. And because Finxact will be cloud based, the cost to users will be much less than the current core providers. Mahan says that Live Oak will move to the Finxact core in July of this year.

The core processing market is currently dominated by three very large companies, and they won’t give up market share easily, but Mahan is a hard man to bet against. “Somebody’s got to do it, and it may as well be us,” he says.