How the Banking Landscape Has Changed

In this podcast, Motley Fool senior analyst Bill Mann caught up with Chip Mahan, CEO of Live Oak Bancshares. They discussed:

• The breakdown of communication between regulators and Silicon Valley Bank.
• How Live Oak Bank is differentiating itself from larger institutions.
• Why traditional banks may face margin issues in the "not-too-distant future."

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on June 11, 2023.

Chip Mahan: But you've got an industry here that has spent since 1950 building branches. Heat, light, utility, taxes, tellers, CSRs to gather what they consider to be low-cost deposits that'll never be moved and sticky. And then make loans to the butcher, the baker, the candlestick maker. I think those days are over.

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Mary Long: I'm Mary Long and that's Chip Mahan, CEO of Live Oak Bank, a digital bank that focuses on small businesses and niche industries. Bill Mann caught up with Mahan to discuss how the banking landscape has changed over the past few months and decades, the golden rule of taking market share, and why Mahan believes we're in a seminal moment for the banking industry.

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Bill Mann: I thought we would just start at the top because I think it will be the thing that people will be most interested in. What is the lending environment for you all right now? I know there was a point in time in which borrowers had the upper hand in terms of their relationship with lenders. But have you seen a really dramatic shift in risk appetites that's gone along with the rate changes?

Chip Mahan: I think we're seeing this daily ... and so what is "this"? I think gradually, but ever so predictably, the credit guys are beginning to run these banks. They're worried about recession. We had March 9. They're worried about liquidity. They're worried about regulatory actions and increased capital ratios. They're worried about "too big to fail," and all those guys got all these cheap deposits. So I think when that happens, then the credit guys end up running the bank. We absolutely, absolutely love it. We're going to do the same thing that we've always done.

As you know, we're a different bank. You can argue that our capital account is roughly three times what is necessary because of the weird bank that we run into government-guaranteed paper. So we are in the market all day, every day. I just returned from Florida just a minute ago looking at a recreational vehicle park, which most banks wouldn't touch, but we seem to really like that space, so we're all ahead full, brother.

Bill Mann: You've perhaps already started to answer this question, but just in terms of setting the table, going back to what happened in early March with the meltdown at Silicon Valley Bank. What is your take on how your fellow bankers have been reacting to the headlines and to the changes of realities, from a customer basis as well as from a capital basis?

Chip Mahan: You know, it's unfortunate because we know those people. These are banks that were extremely well-respected, that had NPS ratios that were off the charts, that had a long track record of growing earnings organically. It was Jimmy Stewart and "[It's] a Wonderful Life," driven by social media.

That said, let's drop back and analyze the facts. The average bank, Bill, in this country has 44% of its deposits uninsured. If you go back to when the FDIC was created in 1933, that average from 1933 until today is 60%. Now FDIC insurance in 1933 was like $1,000,  and you and I remember when they bumped it from $100,000 to $250,000. How does that relate to Live Oak Bank? Our average uninsured depositors were 18% -- and in the abundance of caution, we immediately went out and had four times -- $4 for every dollar of uninsured deposits -- sitting in a checking account at Live Oak Bank if any of our customers wanted the money. So I think we've been through that. Now the question is, what are we going to do about that in the future? Are we going to ask every human being to analyze every financial statement of every bank to see how safe and sound you are at Live Oak Bank, when their accountant says "You need to move your money to JPMorgan Chase"?

Bill Mann: I'm so glad to hear you say this because it was an argument that I was making in terms of making sure that the depositors were held harmless. It's not something that a healthy banking system should expect of depositors, I wouldn't think.

Chip Mahan: Well, there are a number of companies out there that make it rather easy -- I wouldn't say really easy, but rather easy for you, Bill Mann, if you have $5 million and you want to put it at Live Oak Bank, that we can get you insured deposits through a network of other banks. There are several companies that do that. But do I think that the Hill is going to make any changes to that, and get together between the right and the left? I just don't think they're going to change that deposit insurance right now.

Bill Mann: As an outsider, I've described some of what happened at Silicon Valley Bank as being a breakdown of communication from their state banking regulators. From my own past in being in an asset-management business, we had constant conversations with our regulators that never saw the light of day, but just in terms of our own capital adequacy, in terms of our own risk appetite. What is your view about what happened there? How a bank that was a white-shoe bank like Silicon Valley ended up where it did so quickly? What broke down?

Chip Mahan: Well, everything happened quickly. In a matter of two years, they went from a $100 billion bank to a $200 billion bank to a $300 billion bank. And yes, it is true that TikTok and other folks overseas had a billion dollars of uninsured deposits, non-interest-bearing, at the bank. But what is the management team going to do? This was not a credit crisis. They put it in, albeit, longer-term securities, but who could have predicted interest rates to rise 5.5% in the last 12 to 15 months? Then they basically said we're going to sell that at a loss, we're going to raise capital. Then all of a sudden, social media took over and $43 billion went out of that bank that afternoon. As Greg Baker said when he testified before Congress, it was a million dollars a second. No one could have predicted that.

Bill Mann: On some levels, a banker's job is to bend your headlights around corners and make sure that a lot of your risks are not aligned in ways that may have been unanticipated. When in a steady state, in times of crisis, sometimes correlations go to 1. But I do wonder where the California banking regulators were, late 2022 saying, "Perhaps this might be a good time for you to raise a little capital."

Chip Mahan: Well, that and the Fed too. A bank that size is going to have to deal with the Fed on almost a daily basis.

Bill Mann: Yeah. Well, let's talk about Live Oak for a little bit. You had mentioned in the past there are certain franchises where Live Oak has a knowledge advantage regarding lending. One we've talked about before was veterinary clinics. Is this a good time to continue your lift-out or is this more of a devil-you-know environment in terms of your borrowers?

Chip Mahan: I would say that we are all-ahead offensively on three fronts. As we probably talked last time, the SBA allows you to lend to 1,100 industries. We're in 35.

Bill Mann: You've got some more left, is what you're saying.

Chip Mahan: Well, you can look at me and say, "Why are you in only 35 industries after 15 years, Mahan? Come on!"

Bill Mann: [laughs] Just one a month pal, come on!

Chip Mahan: I think that's it. I think our theory there is to understand those industries deeply. Usually, we hire a domain expert to advise our credit team that has actually run one of those businesses. Then what is a natural progression is now that we're not just a start-up bank, but we're a $10 billion bank, if you know and understand how those industries operate, why don't you make a non-SBA loan? So we are going upmarket with larger loans in those industries. Then about five years ago, we started hiring people from other banks in other towns. So that now totals about 33 separate towns where we have lenders that have relationships with business brokers and acquisitions, and those are all SBA lenders.

So would I like to be in 100 of the top cities in the United States? Absolutely, right? We're seeing growth both across other industries, so 35 should go to whatever, more conventional loans in those industries that we understand, and more SBA lenders in the top 100 cities. Are we reasonably confident that we can continue what we've done here for 15 years, which is grow this business organically in good times and bad, in excess of 15% per year? The answer is yes.

Bill Mann: Perhaps this is as naive a question as I can come up with, but how did you go about assessing the 35 that you are in? Is it a matter of making sure that you've got subject-level expertise on the lending side first, or was it a matter of targeting ones that have a certain credit profile that you think you could do business with?

Chip Mahan: Well, it's almost "don't be a dumbass." If the SBA has the data, then go get the data from the SBA over the past 35 years of how every bank in the country did in lending to veterinarians, funeral homes, independent pharmacies, and go cherry-pick the best of the best. Then find your expert to advise the credit department as to what the rules are, and then wrap that in a bunch of technology, because we have learned one thing over 15 years, relative to our customers. They want to know two things. Am I approved? And when are you going to give me the money? If we can go faster in an industry that is hung up with excuses, and not necessarily taking care of the customer and treating every customer like the only customer, then we can distinguish ourselves, and I think that's what we've done.

Bill Mann: How would you go about assessing a new industry to move into? Will it be the same process? You start with SBA and you begin to make some assumptions based on the lending profile and the credit profiles from what has happened in the past?

Chip Mahan: Well, again, we get the data -- charge-offs, defaults, all of that. Or when we're in the field and we find something interesting. So we were in the self-storage lending business for the longest time. Then we learned a little bit about recreational vehicle parks and the fact that they're always full, and it's really a zoning issue. So if we can get in there at a modest loan-to-value ratio and drive break-even at 50% occupancy, then now you have project financing with a government guarantee. We like that.

Bill Mann: One of Live Oak's primary tag lines is that you are or want to be America's best small business bank. Is it that you're claiming to be, I believe, or that you would like to be?

Chip Mahan: Here's the way I look at that. I mean, that's a great question. I think we're gaining on becoming the best small business lending bank. And we've waited 15 years to be a complete bank on the deposit side. You're familiar with our investment in the creation of Finxact?

Bill Mann: Yes.

Chip Mahan: We started that company in 2016 and fundamentally sold it to Fiserv for close to a billion dollars. We're the first bank to use that next-generation core in the marketplace. So can we take that technology and fundamentally create a bespoke bank for every industry that we're in? That's called embedded banking. You can't do that on an old core, with 40-year-old technology. You can only do it in a situation like this. Can we tightly integrate banking, payments, loans, and deposits, to practice management software, to financial forecasting, to payroll, to whatever you make your mind on or whatever other next-generation code that small business is operating? And the really good news about this is we have 6,000 loan customers. There are 2.2 million customers out there with revenues between $2 million and $5 million, which is our target set. If you ask any other banker about what is a small business to them, it is highly likely that 80-plus% are going to say anybody with revenues over $10 million. So we believe that that subset, particularly with the larger banks -- larger banks being defined as the top 50. The top 50 banks in this country have 80% market share -- 80%. I don't think they do a very good job with the $1 million revenue business. So if we can wrap the deposit side of the business -- which, by the way, their deposits in this sub-segment are five times their loans. So if we can continue to be the best of the best on the lending side, and now, some say, well, we've been an overnight success -- well, it took us 15 years to be an "overnight success" in the deposit business. I think if we can do that, we can achieve our dream.

Bill Mann: Chip, some of the fear in the marketplace has pushed -- or at least has made it a reasonable outcome for a lot of business customers -- to move their borrowing to the bigger banks, though. I think that that is a reasonable presumption for customers to make. How are you getting past that trend that's happened over the last few months?

Chip Mahan: I really don't care. When I think about our folks and I think about whatever service... I'll give you a quick example. My wife works out every morning. This guy trains a bunch of these old ladies. He said, "I saw that Live Oak is paying 4% on a savings account. So I called them. Somebody answered the phone. Then I called them a second day, and in 12 seconds, somebody answered the phone again. Then I called them again on something else the third day, so three days in a row." Now, you can pick whatever one of those big banks that you're thinking of -- call them and see who you talk to and how long it takes.

It's real simple. Treat folks the way you want to be treated. I think with that advantage and how we operate this business, we can take market share from those big guys. I'm not worried a bit about them. It's a target-rich environment, Bill.

Bill Mann: Chip, as my last question to you, I'm going to give you the opportunity to speak on behalf of Live Oak Bank and then also for small banks in general. A lot of investors who we talked with following the recent turmoil have said maybe the best move for them is just to swear off banks as an investment, to put them into the "too hard" pile. What would you say to these people? And then furthermore, we all know anyone who's ever known a banker has heard a banker describe a competitor as being a well-run bank or the opposite. How would you go about describing to the average investor how to find well-run banks to invest in?

Chip Mahan: This may sound uncharacteristically self-serving, but I do believe this is a seminal moment in the banking business. We went through the "Jimmy Stewart situation" -- Silicon Valley Bank goes down at precisely the point in time interest rates have risen at the highest rate in 45 years. We as an industry, applaud low deposit betas. You're familiar with a deposit beta. How can I think, as a normal bank, not to pay market rates on deposits? If you look at the average money market or savings account rate of the larger banks United States today, it may be 50 basis points.

Bill Mann: That's the amount they're paying?

Chip Mahan: That's what they're paying. On a one-off basis, maybe they'll have a conversation with you if you have more money with them. But you've got an industry here that has spent since 1950 building branches. Heat, light, utility, taxes, tellers, CSRs to gather what they consider to be low-cost deposits that'll never be moved and sticky. And then make loans to the butcher, the candlestick maker. I think those days are over. I think when you can pick up your cellphone before you sign off on this call and close your account at JPMorgan Chase -- I'll just pick on the most famous bank in the United States...

Bill Mann: Sure. You're not going to cause a run at JPMorgan, it's OK, that's probably a good target.

Chip Mahan: It's highly unlikely that Jamie Dimon is going to call and fuss at me. [laughs]

Bill Mann: "Mahan, what are you doing!?"

Chip Mahan: Even if all you had in the world was $10,000 and you could pick up 4% or $400. If that person found $400 in the couch, they're going to do it. We are all now about ones and zeros. When we have the technology, and you treat every customer like the only customer, and pay them a market rate, and then you can lend that out and achieve a spread. I think that the normal and customary bank with branch infrastructure is going to have margin problems in the not-too-distant future.

Now if you're a community bank, to your point, and you've done business with that person forever in a smaller town, those deposits may be a bit stickier. But, I like where we are because we've been operating this business without branches, without that overhead, paying a fair rate, both on the deposit side at a fair rate to our customers and achieving a 4% spread. If we can continue to do that with everything else we've talked about, we can grow this business 15% year over year. And that's what we're going to do.

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Mary Long: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy stocks based solely on what you hear. I'm Mary Long, thanks for listening. We'll see you tomorrow.