How Eastern Bank Shifted Its Strategy to Compete with Online Lenders

HANNAH BATES: Welcome to HBR On Strategy, case studies and conversations with the world’s top business and management experts hand selected to help you unlock new ways of doing business. As technology disrupts the way businesses operate, how can existing businesses create innovation and change from within? Today, we bring you a conversation with Harvard Business School fellow Karen Mills, who studied how one 200-year-old regional bank in the U.S. used entrepreneurship to develop a completely automated small business lending product to meet a new type of competitor: online lenders. This episode breaks down Eastern Bank’s strategy for innovation from its early partnership with a FinTech entrepreneur to its eventual spinoff of Numerated, the online lending platform it developed in-house. This episode originally aired on Cold Call in December 2018. Here it is.

BRIAN KENNY: Bankers’ hours. Often said with a wink and a smile, it’s a punchline that depicts an entire industry’s largesse when it comes to customer service. It conjures up images of harried workers running to the bank to make their daily deposits before the gates are locked. Urban Dictionary defines bankers’ hours as working or being open for the shortest and most inconvenient amount of time, and also includes a long lunch break and every possible holiday off. The reputation was well-deserved historically, but in fairness, the scant hours were a byproduct of the reams of paperwork that had to be done in order to process loan applications and tally deposits and withdrawals. Technology and the internet have changed all of that. Today you’ll find banks open evenings and weekends with storefronts embedded in supermarkets and mall food courts. There are even banks that masquerade as high-end coffee shops with free Wi-Fi, all in an effort to draw customers in and create a convenient, hassle-free experience that keeps them coming back. But in a world where 82% of 18 to 24-year-old smartphone owners use mobile banking exclusively, expanding hours and serving lattes may not be a winning strategy. So what’s a bank to do? Today we’ll hear from Professor Karen Mills about her case entitled Eastern Bank: Innovating Through Eastern Labs. I’m your host Brian Kenny, and you’re listening to Cold Call.

Speaker 3: So, we’re all sitting there in the classroom.

Speaker 4: Professor walks in and.

Speaker 5: And they look up, and you know it’s coming.

Speaker 6: Oh, the dreaded cold call.

BRIAN KENNY: Karen Mills is a senior fellow at Harvard Business School and Harvard Kennedy School. Prior to that, she served in President Barack Obama’s cabinet as the Administrator of the U.S. Small Business Administration, and she’s about to release a new book called FinTech: Small Business and the American Dream. I think that comes out this spring, Karen, is that right?

KAREN MILLS: Yes, it’s coming out in March.

BRIAN KENNY: Terrific. We look forward to seeing that, but today we’re going to get into some of the ideas that you talk about in the book. So, thanks for joining us, this is your second time on Cold Call.

KAREN MILLS: I’m delighted to be back.

BRIAN KENNY: We’re glad to have you back. This case was terrific. It covered so many issues it was hard for me to figure out which to pick, so we don’t have to pick and choose, we can talk about all of them. But there was disruption in here, there are cultural clashes that happen in here, there is the surprising role of technology in banking, and we’ll get into all of that. Maybe you can start just by telling us how does the case begin? Who’s the protagonist and what’s on his mind?

KAREN MILLS: Well, Eastern Bank has a great set of characters, and it begins with Bob Rivers, who is the CEO of Eastern Bank. He has just come into that position, and Bob started as a bank teller and worked his way up. So, he is a traditional banker, he wears the dark suit and the white shirt, but he thinks like an innovator. When he comes to run Eastern Bank, it is a 200-year-old mutual. It was started in Salem, Massachusetts, really in the days of the witch trials, and it started as a community bank, and it keeps all of that community-mindedness. Under Bob, though, he realizes that innovation has come into banking, and what he says is we have to disrupt ourselves. We can’t just wait for the other forces to disrupt us. So he doesn’t know how to do it. He takes his chief information officer and they literally start walking around Kendall Square. They don’t know who to connect with, so they finally connect with one of the innovation groups, and they are asked, “Well, would you pay $20,000 to be a captain of innovation?” They say, “Of course.” And in that process, they meet the entire Boston FinTech community. Later, a few months later, it turns out that there’s a FinTech that fails in Boston, but there’s a very charismatic CEO named Dan O’Malley. So Bob Rivers picks up the phone and he calls his network from Kendall Square. He says, “Will you connect me to this person?” They get together and Bob convinces him to join the bank. Now, Dan is willing to join a bank because one of the reasons for his failure in his FinTech is it was not developed inside a bank. It didn’t understand how banks work. So Bob is the perfect host for this innovation. He wants to change. He sets up Eastern Labs, he puts it in the lobby of his bank in a glass box, and he says to them, “Go ahead, I’m going to give you $4 million a year,” which by the way, is 1% of the bank’s income, of the bank’s revenue.

BRIAN KENNY: Yeah, because the case mentioned Eastern Bank is the largest mutual bank, but compared to the Chase Manhattans of the world, this is a small outfit, yeah?

KAREN MILLS: It’s a regional bank. It had a leadership position since the recession in small business loans and SBA loans, and Bob wanted to retain that position. And he noticed that about 10% of his customers when he looked into their bank accounts, were actually getting loans from some of these new FinTechs and online lenders. So Dan goes in and he creates a new product. It turns out to be quite successful, an internally-developed, online lending product. Instead of weeks and months of paperwork, as you described in your introduction, this turns around an answer in 30 seconds and the money can be in your account in the next day.

BRIAN KENNY: I want to go back to Dan and Bob for a second, because as the case describes it, this is the odd couple. Bob dressing in his starch shirts and dark suits. Dan comes in in the jeans and a flannel shirt, so this is the beginnings of what we see as two cultures coming together and his move of putting Eastern labs in the center of the workspace in a glass bowl, as it were, that’s a pretty bold thing for Bob to do.

KAREN MILLS: Yes, and it has the repercussions that you would expect. One of the things that happens is that Dan wants to do what we call test and iterate. He wants to sort of see if his ideas are going to fly. So he says, “Let’s do a test where we take everybody who applies and we approve them,” and the traditional lender says to him, “Wait a minute. You want me to open my window and just throw tax guaranteed money out the window to just anybody?” And Dan says, “Yes. I want to see if my customer value proposition of a fast turnaround on this loan works.” And of course, they do it and it does work.

BRIAN KENNY: But everybody’s trying to do their job here, right? Because the question that the CFO at Eastern Banks asks, that’s a serious question. They are responsible. They have a fiduciary obligation to make sure that these funds are dispersed in a way that’s responsible and to people that can pay the loans back. So this has got to be a pretty unsettling proposition that Dan has made and that he’s asking the bank to do.

KAREN MILLS: Yes, and this is one of the reasons why innovation has come slowly to banks and to lending. This is a risk averse, highly regulated industry.

BRIAN KENNY: Yeah. I would love to hear how this case and maybe others that you discussed in the book look at this advent of FinTech and the questions that it raises more broadly about who owns the data and who’s making sure that people’s information is protected and who’s making sure that the government loans are backed and those kinds of things.

KAREN MILLS: FinTech, and particularly small business lending FinTech, is one of the most exciting transformation stories out there right now, because banking to small business turns out to be a really important part of the economy. Half the people who work in this country own or work for a small business, so it’s sort of an underappreciated economic driver. And when credit is not available to small businesses, as we saw in the great recession, we lose jobs. So it’s very important to have a well-functioning credit market. What happened in the recovery is that banks who had been very damaged, really pulled back from small business lending, particularly the smallest loans, maybe a 50 or $100,000 loan just wasn’t profitable for a bank, and the increase in regulatory burden made them turn away. And as they recovered, small businesses who wanted these small loans kept getting turned away. Enter the new online lenders. So in 2012, you had OnDeck and Kabbage and a whole series of new lenders who had these algorithms and sucked up all kinds of data that had never been used in underwriting. Now, you would’ve thought that David would then kill Goliath, that all the dinosaurs, i.e., the banks, would be disrupted. But of course, the story was not quite that simple. What happened was, the online lenders kind of stumbled because they hadn’t really anticipated all of the difficulty in getting customers, and they had very expensive capital. So the banks roared back in and they had their own customers and they had low-cost capital in the form of deposits. So back to the story of Eastern. Eastern is this 200-year-old dinosaur bank, and they create an innovative product that creates the same customer experience and they don’t have to go searching for customers. They can just email their customers and say, “You are pre-approved.” Now, they spun off this product into its own company, Numerated. Full disclosure, I’m an investor in Numerated. I’m also a venture capitalist. It has now an operation which is trying to sell that software to all the other community banks. So FinTechs had to step back and say, “Wait a minute, do we really have competitive advantage?” So that was phase one of the transformation.

Now we are in phase two where another set of competitors have come in. Think Amazon, PayPal Square, the new technology companies.

BRIAN KENNY: They know a lot about us, don’t they?

KAREN MILLS: They have the data. It turns out that the really transformative thing in FinTech is access to data in pipes, in APIs, that were never before available. So this API transition has really changed the game and it brings a whole set of new opportunities for banks and for FinTechs and for people who are going to provide the piping. There’s one company I love called Plaid that provides all this information and allows it to be used to assess your credit in minutes in much more robust ways.

BRIAN KENNY: So here we have a real understandable use application of big data, because we hear big data mentioned all the time, and it sounds like the FinTech organizations and the traditional banks kind of need each other, that there’s sort of a symbiotic relationship that’s forming here. Am I wrong in thinking that the better the FinTech companies get at mining the data and learning from it, the less they’ll need the banks? Are the banks working themselves out of a job here, I guess is my question.

KAREN MILLS: It’s a really great question, and this is kind of where the competitive battle is taking place. But you could also argue that the FinTechs are working their way out of a job. Because what happens when the banks, with their armies of technologists, when they get the right people inside, as Bob Rivers actually was able to do with Dan, and they create their own algorithms. Do they really need the FinTech companies? So now we come back to the question of who has the competitive advantage? Is it Amazon, which knows more than anybody else about its small business sellers? But if all this information is available in these open pipes, the advantage goes to the person who provides the best customer service and understands their small business client. So I make a prediction in the book, which I’m going to preview here.

BRIAN KENNY: Okay. All right. Listen carefully, folks.

KAREN MILLS: I think that there will be a new category of competitors which are online, small business banks focused on the products and services that small businesses need. Right now, if you think about small business banking, it’s really a weak cousin of consumer banking. And consumer banking is just much easier, because if you have five or 10 data points, you can tell whether a consumer should get a mortgage. Not so with small businesses. They suffer from two difficulties. The first is information opacity. It’s really hard to know if a small business is really actually making money, and sometimes they don’t even know themselves. And the second thing is heterogeneity. All the small businesses are different. So, if you’re very good at lending to restaurants, you might not be good at lending to steel suppliers. So how do you overcome that? And one of the things that I think might happen is that the online competitors will become specialized in different small business verticals and that all the information that they are sucking up will be able to be provided to small businesses as a cashflow dashboard. So we call this small business utopia. Imagine you’re a small business owner. Today you have to open QuickBooks, and then you open your Square account, and then you open your bank account, and then you open your TurboTax account, and you’re supposed to in your head create that Excel spreadsheet cashflow that tells you if you even need a bank loan. You’re going to run out of money. You’re supposed to do that mentally. Well, the technology exists today to bring all that information together in a way that is valuable to small businesses. That tells them “Next month, it’s going to be a time you’re building inventory and you probably need a working capital line. Press here, you are pre-approved for $10,000.” And that integration of the access to credit and the intelligence, I think will be the wave of the future.

BRIAN KENNY: So, you’ve got sort of an ecosystem forming where you’ve got the Amazons and others that have all the data, but their job then is to package that up in a way that the banks can access it easily. And then the bank’s job is to really enhance that customer relationship by packaging that information in a way that the business owner can make sense out of it and be able to anticipate what their needs are going to be.

KAREN MILLS: Well right now, I think it’s a free for all. In the UK, we see some challenger banks coming out with just this model of the small business online bank. So I would say it’s a drama and we don’t know the conclusion yet, but the players are lining up, and I would say this is one of the most interesting industry evolutions that you’re going to see with a technological transformation and a real disruption.

BRIAN KENNY: Let me ask you this. Because the case gets into the fact that even though Eastern and Bob and his team really invested in this and wanted it to be successful and it was, Numerated was the outcome of that, it wasn’t a tremendously profitable thing for the bank in terms of the overall portfolio of the bank and what Eastern Bank’s holdings were. The small business on the rise, I guess is the question.

KAREN MILLS: Well, small business is a critical part of the economy, and it is definitely a critical part of many banks’ business like Eastern. But one of the things we ask in the case is, was Eastern Labs a huge success or was it a $12 million, three-year mistake? And I think the students have a good time arguing both sides. Because on the one hand, Eastern Banks is now an innovator. It’s known for innovation. It’s creating a whole atmosphere where people learned how to test and iterate, and they have a successful online product. On the other hand, they spun off their technology and now it’s available to others, even including competitors to use, and they only own 25% of the new company, which is not maybe the best return on their $12 million. One of the reasons we teach Eastern Bank in the first year is it gives us a chance to talk about entrepreneurship. How you create innovation and change in a large organization. And we have some great people who have worked on that here at HBS. Michael Tushman we teach about, his ambidextrous organization and how on the one hand, you have to separate out the innovators from the traditional organization or the traditional organization will kill the innovation. But the trick is to have a successful transformation, you have to reintegrate that innovation back into the core business. And I would say from the case, they’re still working on that.

BRIAN KENNY: There could be a B case is what you’re telling me?

KAREN MILLS: Absolutely.

BRIAN KENNY: We’ll keep an eye out for that. Thank you so much, Karen, for joining us today.

KAREN MILLS: Thank you.

HANNAH BATES: That was Harvard Business School fellow Karen Mills in conversation with Brian Kenny on Cold Call. Mills is the author of FinTech: Small Business and the American Dream. We’ll be back next Wednesday with another hand-picked conversation about business strategy from the Harvard Business Review. If you found this episode helpful, share it with your friends and colleagues and follow our show on Apple Podcasts, Spotify, or wherever you get your podcasts. While you’re there, be sure to leave us a review. We’re a production of the Harvard Business Review. If you want more articles, case studies, books, and videos like this, find it all at HBR.org. This episode was produced by Anne Saini, and me, Hannah Bates. Ian Fox is our editor. Special thanks to Maureen Hoch, Adi Ignatius, Karen Player, Ramsey Khabbaz, Nicole Smith, and Bartholomew, and you, our listener. See you next week.