When thinking about investing in the financial sector, it's easy to only consider the big banks that often get the headlines. However, limiting investment choices to these large-cap institutions would be a mistake, as there are hundreds of smaller, regional banks that often fly under the radar.

One of those is Live Oak Bancshares (LOB -0.75%), a regional bank based in North Carolina that specializes in lending to small businesses. After a tough 2022 that dragged the stock down 65%, Live Oak is up 20% so far in 2023.

How the rest of this year turns out may have a lot to do with Live Oak's biggest risk. Let's take a closer look.

Taking a conservative approach

While Live Oak is not the only bank that provides loans to small businesses, it does have a unique strategy for doing so. First, most of the loans are partially guaranteed by the U.S. Small Business Administration, which limits some default risk right off the bat because the loans are backed by the U.S. government. 

Secondly, Live Oak lends mainly to businesses in specific industries it knows very well. By developing industry-specific knowledge and fostering relationships with its customers, Live Oak believes it can limit risk.

Lastly, Live Oak has no physical branches and operates its entire business online. This eliminates a lot of expenses, allowing the bank to run more efficiently.

Live Oak's efficiency ratio (a measure of how well a bank controls noninterest expenses) was 55.6% in 2022. By comparison, Bank of America (BAC -1.31%), a large bank with many branches, posted an efficiency ratio of 64.7% last year.

The biggest risk

While Live Oak does its best to limit risk, lending to small businesses is inherently risky because so many of them end up going out of business. To prepare for this, banks keep money in reserve, called loan loss provisions, to cover loans that it doesn't expect to be paid back. 

Despite only having $1.4 million of charge-offs in Q4 2022 (bank-speak for loans that are written off because they won't be paid back by customers), Live Oak boosted its provisions for loan losses to $20 million, a 400% increase from the year-ago quarter.

This cautious approach is a smart move that could help insulate the company against its biggest risk: a recession. Should the economy enter a prolonged downturn, it's likely more small businesses would go out of business. For a company with significant exposure to small businesses, preparing for the worst is essential.

Fortunately, Live Oak's customers are optimistic about 2023. Nearly 25% of Live Oak customers plan to borrow money in the next 12 months, and 60% believe it's a good time to expand. These are just snapshots, but management feels the conversations they're having with customers don't make it feel like a recession is looming. 

Is Live Oak a buy?

The large increase in provisions for loan losses made Live Oak's Q4 2022 results look worse than they were. The company increased its total loans and leases, total assets, and total deposits by 19%, 20%, and 25% respectively. Net interest margin, which is simply the difference between the interest it pays and the interest it collects, was 3.76%, wider than the industry average. 

Before 2022, Live Oak was a winning investment. From its initial public offering in 2015 through the end of 2021, the company outpaced the market by more than 200%. There are still recession concerns for the business, but Live Oak has a lot of upsides and a track record of success. With its share price down almost 50% from its most recent high, the risk-reward from here is compelling.