How this bank keeps small-business clients away from online lenders

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In the spring of 2014, Dan O'Malley, a former Capital One executive, joined Eastern Bank in Boston, where one of his first tasks was investigating the emerging threat of online business lenders.

Upstarts such as OnDeck and Kabbage had been getting a lot of attention offering quick-turnaround loans to small-business borrowers — not only in the industry, but from the mainstream press. On the surface, any danger to the 200-year-old Eastern seemed nebulous, as its business loans were growing at a healthy clip. But O'Malley, a data scientist by trade, took a deep dive into the bank's transaction records anyway. What he found was a shocker: About 5% of Eastern's small-business customers at the time were making regular payments to online lenders.

These weren't customers with spotty repayment histories; they included doctors with private practices and sterling credit scores, said O'Malley, the chief development officer at the $10 billion-asset Eastern and head of Eastern Labs, its innovation unit.

O'Malley and his team reached out to Eastern customers who had borrowed from online lenders and learned that many just needed fast infusions of cash — something they didn't think the bank could provide. O'Malley also began surveying Eastern's markets, asking business owners whether they would consider taking out a small-dollar loan if it were available immediately and online. The response was an overwhelming "yes."

So Eastern joined the fray. After building and then testing an online lending platform within its own customer base, the bank formally rolled out its "Express Business Loan" product this past spring. Using a high-tech approach to underwriting, the bank is offering business loans of up to $100,000 that it can approve within minutes and fund the same day.

Eastern has even bigger plans for the coming year. It plans to license its technology to other small and regional banks that have been struggling to figure out how to deal with the online lending trend. This will help Eastern defray the cost of developing the technology. (The bank would not disclose the cost, except to say that it was millions of dollars.)

Eastern already has licensing agreements with two banks — which O'Malley declined to name — and has more deals in the works. The banks will pay a flat fee, as well as a variable charge based on loan volume.

As part of the contract, the banks get access to assorted digital tools from Eastern, including an engine that powers automatic loan decisions, a variety of marketing modules and a dashboard to track performance.

But most important, O'Malley said, such partnerships will help smaller banks compete with not just established players such as OnDeck and Kabbage, but also the larger banks that are muscling into the market.

While community banks have ties to Main Street businesses that give them a competitive advantage, they are at risk of losing some of their best customers unless they upgrade their lending technology, he said.

"We're wildly committed to making our partners a lot of money," O'Malley said.

O'Malley, a former credit card executive, views the dynamics in online business lending as being similar to the credit card market in the early 1990s. Getting a credit card used to be time-consuming and cumbersome. But once high-tech approaches made marketing and approving applications easier, big banks began offering cards on a national scale and quickly took control of the market.

"If you've watched the credit card industry grow up, you've seen this problem before," O'Malley said.

"We're wildly committed to making our partners a lot of money." — Dan O'Malley of Eastern Bank

Recent moves by big banks into online small-business lending underscore O'Malley's concerns. This past spring Wells Fargo began offering online small-business loans of up to $35,000 and one of its selling points is speed. It advertises that applicants who get approved for a FastFlex loan will receive their funds as soon as the next business day. JPMorgan Chase also rolled out its offering last year through a white-label agreement with OnDeck, while Regions Financial has been making online loans to businesses in a partnership with Fundation Group since 2015.

A big question is whether there is enough demand to go around. Last year, business loans of $1 million or less accounted for 21% of all loans made by banks, compared with 40% two decades ago, according to research from Karen Mills, a professor at Harvard Business School and former head of the U.S. Small Business Administration.

Experts cite a mix of reasons for the decline, the biggest being a reluctance among small-business owners to expand or buy new real estate. Additionally, businesses that posted a loss during the economic downturn may not have the track record of revenue growth that's necessary to get a bank loan.

Another factor is that the crisis accelerated the decades-long decline in new business formation. Businesses less than one year old accounted for 8% of all employer firms in 2013, compared with 10% in 2007 and 17% in 1977.

"During the recession and after the recession, demand has not been strong," said John Barlow, chief executive of Barlow Research Associates, a market research firm for commercial banking.

Still, when it comes to small-dollar loans — such as those under $100,000 that businesses often use to finance new equipment or pay vendors — research suggests that demand for credit has exceeded what banks are willing to provide. For instance, only 45% of businesses with fewer than 500 employees received the full funding amount they requested from their banks, a 2015 small-business survey from the Federal Reserve found.

That could help explain why total business loans made by nonbank online lenders increased more than 68% in 2015 from a year earlier, to $7.9 billion, according to a report from Morgan Stanley. By 2020, the market for online business loans could exceed $200 billion, the report said.

Eastern explored the idea of partnering with nonbank online lenders before it decided to build its own platform from scratch, but O'Malley said the bank ultimately was not comfortable with their credit policies and quality controls. "We didn't think that they were ready to partner with a bank, in the way that a bank lends," O'Malley said.

Most of the upstart lenders were established in the wake of the crisis, and haven't yet "been through the gauntlet" of a market downturn, he added. Recent trouble in the marketplace lending sector — including OnDeck's struggles to obtain funding, as a result of rising delinquencies — seem to validate those concerns.

Often the lenders also use complex algorithms to make credit decisions — a sticking point for bank executives who wanted to clearly understand the criteria used to underwrite local business loans. "Banks need a credit policy — especially in business lending — where they can explain it to a regulator," O'Malley said.

"I think there's a huge opportunity to build new technology that's going to shape the next era of financial services." — Dan O'Malley of Eastern Bank

In place of a complex algorithm, Eastern developed a scorecard that includes a select number of variables, including a business owner's credit score, annual revenue and industry characteristics. Though community bankers like to pride themselves on relationship-based lending, O'Malley insists that most credit decisions for small-dollar loans are black-and-white assessments of an underlying business model. It makes sense to automate the process.

"It's not the strength of someone's grip and the glint in their eye," O'Malley said. "Where relationship and temperament comes into play is in more complicated loans."

In total, Eastern approves between 60% and 70% of online loan applications for borrowers who are already Eastern customers, O'Malley said. The approval rate is slightly lower for applicants who are new to the bank.

Eastern declined to specify how much lending volume is coming from online, but O'Malley said the number of applications increased fourfold last year, when compared with the initial rollout to its existing customer base the previous year.

Pricing the loans has been a challenge. Initially Eastern charged between 3% and 5%, a rate that turned out to be too low. "Frankly, we weren't making much money," O'Malley said.

In the past few months, Eastern has improved its yield by doubling the interest rate to between 6% and 10% — still cheaper than most credit cards.

As for licensing the platform to other banks, O'Malley so far has drummed up interest mostly by speaking at industry events. He talks about the need for banks to invest in technology and collaborate. "In the course of doing that, we've had banks say, 'Hey, this is pretty interesting,' " O'Malley said.

Still, many community and regional bankers don't feel any sense of urgency to offer loans online.

In a series of recent interviews, several bankers said that while they are interested in upgrading technology to underwrite or deliver documents more efficiently, they are skeptical about the need to be as speedy as online competitors, particularly if that requires using technology, and perhaps nontraditional data, to make fast decisions about credit.

"I think we all jumped on that worry wagon a couple years ago," Anne Strange, executive vice president of wholesale banking strategies at the $28 billion-asset First Horizon in Memphis, Tenn., said in discussing the rise of online business lenders.

Taking the time to connect a business owner with the right product is more important to the bank than speed, Strange said.

"Will [we] ever be as fast? Maybe not. But we look for opportunities to help the client get from point A to point B," and customers appreciate that, she said.

First Horizon does not partner with any online lenders, which Strange attributes partly to its underwriting division setting a high bar for partnerships with outside firms.

Other bankers said they are keeping an eye on competition from online business lenders while exploring their options.

"We are actually in the throes of researching" online lending products, said Scott Sanborn, a senior vice president at the $2 billion-asset HarborOne in Brockton, Mass. "We've talked with some very large providers in the market."

Sanborn praised Eastern's loan product as an "intriguing" fintech approach. But he also downplayed the importance of speed in small-business lending.

"We haven't found our timing to be a competitive advantage or disadvantage," Sanborn said.

Other community banks are working on their own innovative approaches to expand into online small-business lending. Live Oak Bancshares in Wilmington, N.C., last year began offering a same-day business loan of up to $350,000. The $2 billion-asset bank has no immediate plans to license its lending technology to other banks; however, it is laying the groundwork to offer its loan through third parties in the coming years, such as through a white-label partnership with equipment distributors.

As O'Malley looks ahead, he says he's concerned about adding enough staff to meet the demand he expects for the licensing agreements in the coming year. But he is nonetheless excited.

"I think there's a huge opportunity to build new technology that's going to shape the next era of financial services," O'Malley said.

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