Discover Financial Services Q2 2022 Earnings Call Transcript

Quartr
Provided by Quartr
July 20, 2022

Key Takeaways

  • Q2 net income of $1.1 billion ($3.96 per share) with 13% year-over-year loan growth and solid prime credit metrics.
  • Expanded global payments acceptance via an Italy network alliance and won J.D. Power awards for top mobile card and checking satisfaction.
  • Inflation and Fed rate hikes have improved net interest spread on its moderately asset-sensitive balance sheet, while credit performance remains stable despite recession risks.
  • Temporarily suspended its share repurchase program amid an internal review of student-loan servicing and related compliance issues.
  • Raised full-year guidance to low-teens loan growth, projected 5–15 bps NIM upside, mid-single-digit expense growth, and net charge-offs of 1.9–2.1%.
AI Generated. May Contain Errors.
Earnings Conference Call
Discover Financial Services Q2 2022
00:00 / 00:00

There are 17 speakers on the call.

Operator

Good morning. My name is Katie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter 2022 Discover Financial Services Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session.

Operator

Thank you. I would now turn the call over to Mr. Eric Wasserstrom, Head of Investor Relations. Please go ahead.

Speaker 1

Thank you, Katie, and welcome everyone to this morning's call. I'll begin on Slide 2 of our earnings presentation, which you can find in the Financial section of our Investor Relations website, investorrelations. Discover.com. Our discussion today contains certain forward looking statements that are subject to and uncertainties that may cause actual results to differ materially. Please refer to our notices regarding forward looking statements that appear in our Q2 earnings press release and presentation.

Speaker 1

Our call today will include remarks from our CEO, Roger Hochschild and John Green, our Chief Financial Officer. After we conclude our formal comments, there will be time for a question and answer Now it's my pleasure to turn the call over to Roger.

Speaker 2

Thanks, Eric, and thanks to our listeners for joining today's call. I'm very pleased with our results this quarter. We generated robust revenue growth and strong earnings, while advancing several strategic initiatives. This solid performance reflects the strength of our integrated digital banking and payments model and our focus on managing the business while investing for growth amidst an increasingly fluid macroeconomic backdrop. Let's turn to the summary on Slide 3.

Speaker 2

For the Q2, we reported net income of $1,100,000,000 after tax or $3.96 per share. Our operating metrics in the 2nd quarter remained very strong. Loan growth increased by 13% from the prior year, driven by a combination of higher sales and strong new account growth. And our asset quality remains solid across all products, reflecting our focus on prime lending and our approach to underwriting and credit management. We also advanced several strategic priorities in the quarter.

Speaker 2

In our Payment Services segment, we continue to expand our global acceptance through new partnerships. In June, we announced a network alliance in Italy with BancoMent, one of Europe's largest payment networks. This should provide our customers with access to merchants in Italy through BancoMat's extensive acquirer relationships. This partnership represents a significant advancement in our acceptance across Western Europe and we remain committed to expanding our international merchant coverage. In our digital banking segment, our combination of industry leading customer service and compelling products continues to differentiate us in the marketplace.

Speaker 2

We were recently awarded the highest ranking in customer satisfaction by J. D. Power among mobile credit card apps and websites. We also achieved J. D.

Speaker 2

Power's top customer satisfaction in checking accounts for Direct Retail Banks. This recognition underscores our customer service model, which combined with our compelling cash rewards and no fee products create a value proposition that we believe others will struggle to match. For this reason, we're confident that we are well positioned to generate substantial growth and shareholder value over the long term. Notwithstanding our strong performance, we continue to closely monitor today's evolving economic environment. Slide 4 provides some views on the current macro conditions.

Speaker 2

Measures of inflation remain persistently high and the Federal Reserve has signaled its intent to address this through restrictive monetary policy. Our business model has somewhat of a natural hedge against inflation as higher expenses are largely offset by the contribution inflation makes to our sales volumes. And because our balance sheet is moderately asset sensitive, rate hikes improve our outlook for spread income despite driving higher funding costs. Perhaps more significantly, tighter monetary policy may have raised the risk of an economic recession, But behavior and trends from our consumer loan portfolio currently do not suggest that a downturn is imminent. Our credit metrics remain strong and sales are robust even as our customers maintain high payment rates.

Speaker 2

Similarly, most labor market measures indicate employment conditions remain broadly supportive of consumer financial health and credit performance. Nonetheless, Should there be changes in macroeconomic conditions, we will make the appropriate adjustments. Our through the cycle underwriting considers all stages of a credit cycle, including downturns. And our history of conservative credit management positions us well for any future periods of economic stress. Our actions during the recent pandemic are a good example of how nimbly we can respond to changing circumstances.

Speaker 2

We also maintained a strong balance sheet and capital position. Our current level of common equity Tier 1 is 14.2%, well above our internal target and regulatory minimums. And as John will detail, our reserves capture our estimate of losses over the expected life of our loan portfolio. This brings me to one topic about which I want to make you aware. As we addressed in our press release, we are temporarily suspending our share repurchase program in light of an internal investigation being conducted by a Board appointed independent special committee.

Speaker 2

This investigation concerns our student loan servicing practices and related compliance matters. And while we cannot comment further at this time, I can say this matter was contemplated as John reaffirms our expense guidance for the year. In summary, while macroeconomic conditions remain somewhat uncertain, We continue to advance our strategic goals and are benefiting from the combination of strong sales and receivables growth, expanding margin and slowly normalizing credit. These trends give us confidence in our outlook over the forecast horizon, while our reserves and high level of capital position us to withstand a range of macroeconomic environments. I'll now turn the call over to John to review specs of our financial results in more detail.

Speaker 3

Thank you, Roger, and good morning, everyone. I'll start with our financial summary results on Slide 5. As Roger indicated, we reported net income of $1,100,000,000 which was 35% lower year over year. However, I'd like to call out 2 items. The first is that in the Q2 of last year, we had a $729,000,000 unrealized gain equity investments compared to a $42,000,000 loss this quarter.

Speaker 3

Adjusting for these, our earnings would have been $4.07 per share in the current quarter. 2nd, the provision for credit losses increased from the prior year due to $110,000,000 reserve build in the current quarter compared to a $321,000,000 reserve released in the prior year. The current quarter reserve build was primarily driven by higher loan receivables. Excluding the impacts of these two items, Our profit before tax and reserves would have been up 38% year over year. Moving to Slide 6.

Speaker 3

Net interest income was up $311,000,000 or 14% driven by higher average receivables and improved net interest margin. NIM was 10.94%, up 26 basis points from the prior year and 9 basis points sequentially. On both a year over year and sequential basis, the increase in net interest margin reflects the higher prime rate and favorable funding mix, partially offset by increased promotional balances and higher funding costs. Receivable growth was driven by card, which increased 15% year over year from strong sales and robust new account growth last year and into this year. In the quarter, the payment rate increased 40 basis points and remains more than 500 basis points above the pre pandemic level.

Speaker 3

We continue to expect that the normalization in payment rate will be modest this year and will continue through the back half of twenty twenty three. Organic student loans increased 4%, reflecting solid growth in originations. Personal loans were up 4%, reflecting a return to growth. We view this as a validation of our approach to marketing, underwriting and pricing of this product over the past several quarters, and we believe we are competitively positioned to grow, particularly relative to some non bank originators. In terms of funding mix, our customer deposit balances were flat year over year and up 1% sequentially.

Speaker 3

Increases in our savings balances offset the runoff in higher cost CDs. Our strong asset growth may cause deposits to vary as a proportion of our funding mix, but we continue to target 70% to 80% deposit funding over the medium term. Looking at other revenue on Slide 7. Excluding the impacts of equity investments detailed earlier, non interest income increased $105,000,000 or 19%. This was driven by higher net discount interchange revenue, which was up $51,000,000 or 15%, reflecting strong sales and favorable sales mix, partially offset by higher rewards.

Speaker 3

Sales were up 18% year over year with growth across most categories. For the first half of the year, Our sales growth was 20%. We estimate that inflation contributed between 203 100 basis points to this figure. Strong sales also drove higher rewards expense compared to the prior year. Our rewards rate increased 6 basis points year over year, reflecting two factors.

Speaker 3

Our standard 5% category aligning with customer needs included gas this quarter. 2nd, the substantial growth in new accounts over the past year increased the cost of our cash back match. However, on a sequential basis, the reward rate was up 1 basis point and up 3 basis points through the first half of the year. This is consistent with our expectations of 2 to 4 basis points of annual rewards cost increases. Loan fee income was up $37,000,000 to 35%, primarily driven by an increase in late fee instances.

Speaker 3

Moving to expenses on Slide 8. Total operating expenses were flat year over year and up 8% from the prior quarter. Compensation costs were up slightly year over year, primarily due to increased headcount and higher average salaries. Like many organizations, we are seeing salary and wage pressure, which will likely continue through the balance of this year and into next year. Marketing expenses increased $79,000,000 or 45% as we continue to invest for growth in our card and consumer banking products.

Speaker 3

We grew new card accounts by 39% from last year's Q2. This speaks to the strength of our brand, the relevance of our value proposition and the benefits of our investments in targeting analytics. As Roger discussed, we closely track economic and competitive conditions and we remain disciplined about our through the cycle approach to underwriting. This approach contributes to our confidence about investing in brand and acquisition. Moving to credit performance on Slide 9.

Speaker 3

Net charge offs remained low and were in line with expectations for continued credit normalization. Total net charge offs were 1.8%, 32 basis points lower than the prior year and up 19 basis points from the prior quarter. Total net charge off dollars were down $27,000,000 from the prior year and up $61,000,000 sequentially. In the card portfolio, the net charge off rate increased 17 basis points sequentially for $50,000,000 Looking at our receivables, we are not seeing evidence of emerging credit stress at this point. Our delinquencies are virtually unchanged from the Q1.

Speaker 3

And while we expect some increases in delinquencies over the back half, This is consistent with our outlook for steady credit normalization into 2023. Turning to the discussion of our allowance on Slide 10. This past quarter, we increased our allowance by 110,000,000 largely due to higher receivable balances. Our reserve rate continued to decline, however, dropping 31 basis points to 6.8%. As a reminder, our reserves are based on our expectation of life of loan losses.

Speaker 3

On the macroeconomic view, We believe the balance of risk has shifted to include the potential for an economic slowdown resulting from Fed policy actions. For us, The most significant driver of loss is changes to employment conditions. As Roger mentioned, current labor the current labor market conditions remain healthy. And as examples, the number of job openings still exceeds the number of unemployed people and the unemployment rate remains low, but unemployment claims have started to creep up. As part of our reserving process, we consider the prospects of higher unemployment and a range of macroeconomic scenarios.

Speaker 3

Looking at Slide 11. Our common equity Tier 1 for the period was 14.2%, well above our 10.5% target. The strength of our capital position is underscored by the recent CCAR's regulatory stress test. Based on the CCAR's results, Our preliminary stress capital buffer should decrease by 110 basis points, which effectively lowers our minimum required CET1 ratio to 7%, the lowest possible ratio. We repurchased $601,000,000 of common stock during the quarter and declared a quarterly common dividend of $0.60 per share.

Speaker 3

Concluding on Slide 12. As we look into the back half of this year, our perspectives for 2022 remains favorable. We are improving some elements of our expectations. We are revising our view on loan growth to low teens. Continued strong sales and new account acquisitions through the 2nd quarter support our confidence in this outlook.

Speaker 3

There is no change to our view on NIM. We continue to see 5 basis points to 15 basis points of upside for the full year relative to the Q1 level of 10.85%. Our expectations for expenses remain at mid single digit growth versus last year. We still We are improving our credit outlook. We now expect net charge offs to be between 1.9% and 2.1% for the full year, and we intend to return to share repurchases at an appropriate time in the future.

Speaker 3

In summary, Loan growth accelerated as we benefited from robust sales and strong account acquisition. Credit performance remains solid, reflecting our disciplined approach to underwriting and credit management. We managed operating expenses while investing in new account acquisition, brand and digital capabilities and our balance sheet and capital position are strong. The results demonstrate the resiliency of our integrated digital Banking and Payments model, and I'm confident that we are well positioned for continued profitable growth through a range of economic conditions. With that, I'll turn the call back to our operator, Katie, to open the line for Q and A.

Operator

Thank you. We remind you to please pick up your handset for optimal sound quality. We will pause for just a moment to allow questions to queue. Thank you. Our first question will come from Moshe Orenbuch with Credit Suisse.

Operator

Your line is now open.

Speaker 4

Great. Thanks and really strong results in terms of accounts and loan growth. And maybe, Roger, could you just Talk a little more detail about kind of as you see the competitive environment, you're adding a lot of accounts. I know you've talked about how kind of originate them with a through the cycle approach. But just talk a little bit about both how you see the competitive environment and how you see What's your any kind of tweaks you are making because of the current environment and talk about that in terms of the outlook?

Speaker 4

Thanks so much.

Speaker 2

Sure, Moshe. Thanks for the question. I would say the competitive environment remains intense. With the consumers Staying strong. We are seeing strong levels of marketing from most of our prime competitors.

Speaker 2

But I think our differentiated value proposition is succeeding well in the marketplace across all of our products. From a credit standpoint, I would say we're roughly back to where we were pre pandemic. But keep in mind that's sort of a late cycle approach that we had towards the end of 2019. So we think we remain conservative on credit, but the differentiation from the brand and the product are really working well to drive growth even in this competitive environment.

Speaker 4

Great. Thanks. And just as a follow-up on the student loan side, given that this is the key quarter coming up in terms of originations. Last quarter, you talked a little bit about how you expected to have some advantages versus market funded players. Obviously, there's you've got the issue that you've got from a compliance standpoint.

Speaker 4

You talked about how that could impact From origination standpoint and if that does, how long that could last?

Speaker 2

Yes. We are moving forward with our plans For peak season. Again, what has been a wildcard over the last couple of years has been sort of overall number of kids going back to school and their demands for funding. So I think that the market size is always a bit uncertain, but we feel good about how Prepared we are as we move into the peak origination months.

Speaker 4

Thanks very much.

Operator

Thank you. Our next question will come from Bill Carcache with Wolfe Research. Your line is now open.

Speaker 5

Thank you. Good morning, Roger and John. You guys certainly have Historically, remain profitable through the cycle with risk adjusted yields Remaining quite strong even in a deep recession like US908. And it makes sense that you're continuing to invest here against the backup that we're in. But Could you maybe frame for us what it would take to curb your appetite for investing for growth?

Speaker 5

And maybe just what it would take So you don't have a pullback.

Speaker 2

Yes. Thanks for the question. So there are a whole series of things we carefully monitor in terms of the health of our customers and portfolio and that goes into our appetite for growth. I would say probably the things we watch most carefully externally are the job market and rising unemployment. And so we have a finely tuned playbook in terms of how we'll adjust originations.

Speaker 2

But we continue to originate throughout the cycle. And so even during the financial crisis that you referred to, we kept up a certain level of account production even as we became more conservative in credit. And our underwriting always uses a through the cycle approach as we think about the profitability of accounts we're booking. So those are some of the things we'd look to.

Speaker 5

Thank you. And if I may follow-up on that, maybe could you also frame how you're thinking about the risk that The strength that we're seeing in the consumer and labor markets is in and of itself inflationary and could leave the Fed to have to do more. And since we know that monetary policy operates with long and variable lags. The increases in unemployment that follow those Fed hikes tend to be quite lagged, and so those effects could take some time to show up. Maybe could you just speak to that dynamic, how that feeds, if that feeds in any way into your reserving models?

Speaker 5

Yes, we haven't had a significant inflation cycle in a long time. And so there are some concerns that current underwriting models may not be picking that up. Would love to hear your thoughts on that. Thank you.

Speaker 3

Yes. Hey, Bill, I'll take that one. Good question. We spent plenty of time thinking about it. So Inflation, unto itself is not correlated to loan losses based on all the historical data we've looked at.

Speaker 3

Now certainly, we've seen some changes in consumer behavior, so we'll keep an eye on it. But typically, It would be unemployment or changes in employment levels overall. I have a particular view that As we try or the Fed tries to deal with the inflation situation, Certainly, it's going to be quite a period of time before the job market is Directly impacted in a significant way. So unemployment remains super low, so 3.5%. There's still about 11,300,000 job openings right now versus 6,000,000 people looking for jobs.

Speaker 3

Spending remains robust and credits performing very, very well. So as we look at those We're going to keep an eye and see if there's any material changes on that. But in terms of reserving at this point, That life of loan approach that we take looking at broad macros as well as portfolio performance Gave us confidence in the reserving levels we chose and the corresponding reduction in the reserve rate. So We'll keep an eye on it and update it quarterly.

Speaker 5

That's very helpful. Thank you, Roger and John. Appreciate it.

Operator

Thank you. Our next question will come from Sanjay Sakhrani with KBW. Your line is now open.

Speaker 6

Thanks. Good morning. I guess my first question is on the share repurchase suspension. Obviously, that decision was probably not something that was taken lightly. Could you just talk about the thought process in making that decision given all the positive news on your Capital and stress capital buffers and such.

Speaker 6

I mean, should we infer that the size and scope of damages could be pretty significant?

Speaker 2

Thanks for the question Sanjay. I think I tried to address that when I said our expense guidance that John reaffirmed includes our views on this matter. So there are many factors that go into a share repurchase program. It's not just potential financial exposure. So and I would say returning our shareholders' capital in the form of the repurchase has been a focus for management and the Board and we'll continue to do and that's why John said, we hope to get back to the repurchase program as soon as we are able.

Speaker 7

Okay.

Speaker 6

And then I guess a question for John just on NIM. Lee, I think like the Fed's posture has moved towards more rate hikes. I'm just curious, Your NIM expectation is sort of unchanged, but maybe you could just talk about what went into that and if you're seeing any changes in deposit betas?

Speaker 3

Yes. Thanks Sanjay. So the NIM guidance gave a range benchmarking off the 10.85 and we said 5 to 15 basis points range of upside from that. Based on the Fed actions to date, we're tracking towards the upper end of that guidance range at this point. So that's a positive.

Speaker 3

We are seeing deposit costs increase and that's a function of 2 things, the competitive environment and then also the fact that we had a record loan growth in the quarter at 13%. So the funding mix, as I said in my prepared remarks, That will likely change in the back half of the year and we're going to continue to focus on that 70%, 80%. So Competitively, we're not going to lead certainly in terms of deposit pricing, but we're going to respond to ensure We remain very competitive and have a proposition, a strong value proposition for our customers. So How that translates into betas? It's hard to call right now.

Speaker 3

But I would say, the 1st part of the year, we had a very, very low beta. I would expect that to normalize as the funding environment Migrate.

Speaker 7

Okay, great. Thank you.

Operator

Thank you. Our next question will come from Rick Shane with JPMorgan. Your line is now open.

Speaker 8

Good morning, guys. Thanks for taking my question. When we look back at some of the changes over the years like the promulgation of the Card Act, there were impacts that people thought would be cyclical that became secular in terms of loss rates, in terms of yields. I'm wondering when we look at payment rates today. If there's something that you guys might see that suggests that this is more of a secular change than a cyclical change?

Speaker 3

Yes. Thanks, Rick. So, yes, it's hard to call it right now, but we do have some preliminary data that shows that the decrease in the use of cash and The touchless transactions you may do at Starbucks or other institutions where folks previously would use cash, A lot of that's gone away. So it's creating a higher level of transactions through our card. Good thing for us from an interchange perspective.

Speaker 3

But also that cash that folks used to expend, I believe there is some portion of it that is now going to pay down balances, which is increasing the payment rate. Now How much is that? It's hard to call right now. We're about 500 basis points higher than the pre pandemic level. If I were to ask to give a range, I would say maybe 100 basis points to 200 basis points of that could be a permanent change.

Speaker 3

And then the rest has to do with the strength of the portfolio and the strength of the consumers. Got

Speaker 8

it. Yes, it's helpful. And I agree with that conclusion. It just feels like On a day to day basis, we're all using less cash and I'm wondering if that's just driving more and more creating more and more transactors for you guys.

Speaker 3

Yes. Thanks for the question. Rick, anything else?

Speaker 8

That's it. Thank you, guys.

Speaker 3

You got it.

Operator

Thank you. Our next question will come from Ryan Nash with Goldman Sachs. Your line is now open.

Speaker 9

Hey, good morning, John. Good morning, Roger. Good morning. So, John, maybe a question on the allowance. If I look, I recognize that obviously this is a life of loan count, but when I look at the level of reserve today, you're only modestly below where you were at March of 2020, call it low 7s versus high 6s.

Speaker 7

So can you maybe just give us

Speaker 9

a little bit more color in terms of what's assumed in the reserve in terms of scenarios? And if we see a modest downturn, just given how healthy your consumers are, like what could that do to both losses in the allowance over time? Thanks.

Speaker 3

Sure. So as I mentioned in my previous comments, we looked at number of different scenarios, but I can give you a couple of data points here. In terms of unemployment, It ranged from a low of 3.3 at the end of 2022 to peak of 5.8. And then as we look for 23.5 to just about 5.5. We're seeing a level of GDP growth slowing.

Speaker 3

We haven't baked in a full recession, but certainly GDP does reduce and It was robust and we certainly considered that as well. So as we look out into 2023. We're going to evaluate what the macro conditions are and the impact on life of loan losses. But For me, the portfolio performance really, really strong, job market really, really strong, uncertainty on the broad macros and we conservatively modeled those. So Overall, I feel like we're 100% consistent with how we've reserved in the past.

Speaker 3

We've taken that through the cycle underwriting approach that has benefits through into the portfolio and we've been in our process to ensure that our reserves are fairly stated under GAAP.

Speaker 9

Got it. And Maybe Roger, maybe a follow-up to Sanjay's question. I guess, given that it doesn't sound like you're expecting much in terms of costs from this investigation. I guess maybe just talk about what you're seeing in the buyback and I know that you're limited in what you could say, but Any sense for the timing of how long an investigation like this could take? Thanks.

Speaker 2

Yes. No, I am to your point What I can say, we can't really give you anything to expect in timing other than our views on capital. And so As soon as we can, we hope to restart the buyback.

Speaker 9

I figured I'd try. Thanks.

Operator

Thank you. Our next question will come from Mark DeVries with Barclays. Your line is now open.

Speaker 10

Yes, thanks. Just one more On the buybacks, when you are able to resume, should we expect the cadence to kind of mirror what you did in the first half this year or could you accelerate repurchases.

Speaker 3

We'll look at that, Mark. Certainly, We have that broad authorization for the Board for over 5 quarters. It's $4,200,000,000 to $4,300,000,000 of repurchases. So depending on the pause, we'll see what we can do because Certainly, we're over regulatory minimums. We're certainly over our internal target.

Speaker 3

And as we've said previously, we're committed to stepping the CET1 ratio down to 10.5. So we'll do what we can do.

Speaker 10

Okay, great. And then maybe a question for Roger. I mean just Given kind of the pullback we've seen in FinTech valuations, is there anything that looks interesting here to deploy that capital inorganically?

Speaker 2

Good question. I think, while valuations have pulled back, I'm not sure there are any bargains yet. But for us, we've tended not to focus on partnerships and potential investments as opposed to acquisitions and a lot of capabilities given our great technology team, we feel like we can build ourselves. So yes, we have a good business development effort that was out there, but I wouldn't necessarily expect something.

Speaker 10

Okay. Got it. Thank you.

Operator

Thank you. Our next question will come from John Pancari with Evercore ISI. I, your line is now open.

Speaker 11

Good morning. Good morning. Good morning, John. Just sorry, Back to the student loan issue. Just I know you've given all that you can comment on, but there's also in the public, we know that there's also a Send order related to this with the CFPB, it looks like 2020 and I believe it's even tied to a consent order from 2015.

Speaker 11

Did that impact did that influence the suspension? And was there something new that develops that caused the internal investigation.

Speaker 2

I guess the only thing I can say is both the consent order and the investigation are in the area of student loan servicing. But beyond that, there really isn't anything else I can add at this time.

Speaker 11

Okay. All right. Thank you. Thanks for helping there. And then separately, just on the this is sort of related to it, but more around the expenses.

Speaker 11

I know you indicated that the investigation is already contemplated into the expense guide, and I appreciate that color. Does that mean that there were potential expense offsets that would help keep the expense guide unchanged or that getting back to your earlier comment that there This is unlikely to be an expense impact.

Speaker 3

Yes. So John, the way I would think about it is, We're continuing to kind of run and manage our business and try to be disciplined in the way we distributed expense dollars and spend expense dollars. Certainly, there's puts and takes in every single expense line and We've continued to have our foot on the gas in terms of new account acquisition and Media, which contributed to the marketing increases. The rest of it is we consider it as part of the cost of our operation and we're trying to make it as efficient as we can.

Speaker 11

Okay. Thanks for that. If I could just ask one more on the credit side. I know the delinquencies edged up a little bit year over year for 2Q. Did you see any pressure in rental in the lower FICO bands or any color around the modest increase in delinquencies that you saw?

Speaker 3

Yes. So what we're seeing is the lower FICO bands normalizing. So and you would expect those to normalize more quickly than the higher FICO bands. And frankly, we consider that when we do our underwriting. Interestingly, what we've seen is early stage delinquencies across the board have Corrected in later stage buckets more quickly than we see it in the past.

Speaker 3

And some of that could be our Some of the work we've done in terms of analytics that can optimize time to contact and collection strategies and some of it could be just customer performance. So there's really no takeaways from the portfolio Other than it continues to perform very, very well and gave us a degree of comfort as we reduce the overall reserve rate.

Speaker 11

Got it. Okay. Thanks for taking my questions.

Operator

Thank you. Our next question will come from Betsy Graseck with Morgan Stanley. Your line is now open.

Speaker 12

Hi, good morning.

Speaker 2

Good morning, Betsy.

Speaker 12

Just on the investigation one for me here. You did mention that It is embedded in your full year guide on expenses. And I'm wondering if we should take that to mean that you expect the review will be finalized by the end of this year. Is that fair conclusion.

Speaker 2

I wouldn't necessarily link those 2. I mean, I think what we can say is that we did not See anything that would change our view that non marketing expenses this year would grow in the low single digits. And we did indicate that we would hope to have it concluded, but it's done by an independent committee that reports to the Board.

Speaker 12

Right. And the buyback restarting is a function of the investigation concluding, is that fair rather than like a particular CET1 level.

Speaker 2

Yes. The termination of the buyback has nothing to do with our capital levels. It does not necessarily require the investigation to be fully complete for us to resume. There are many complex factors that go into it.

Speaker 12

Okay. So it's a bit open ended on our end thinking about when to put it back in the model. I realize you understand that, so I suppose there'll be a wide range of opinions after this call on that. Just on the business, can we talk a little bit about the interchange rate? The gross interchange rate has been really strong in recent quarters and wondering if there's anything in particular driving that, are there increases in competitors that you're matching or is there something else going on?

Speaker 12

Thanks.

Speaker 3

Yes. The overall interchange has largely been a function of the robust sales volume. So we're up Our sales were up 20% through the first half of the year, 18% through the end of the second quarter. So that's driving overall interchange. Now mix does come into play in terms of The interchange rate, obviously, we don't spend a lot of time discussing that.

Speaker 3

But overall, the solid business performance is driving interchange. And then Maybe your follow on might be rewards. We did see a spike in rewards, which to me wasn't a bad thing whatsoever. What happened was gas was 1 of the 5% categories in the quarter. Everybody knows about inflation at the pump.

Speaker 3

So we had a larger percentage of customers maxing out on that 5 category which drove the rate up. But overall The rate is we expect 2 to 4 basis points of inflation there. So interchange In the aggregate, super strong interchange rate, very, very solid rewards coming in at expectations.

Speaker 12

Got it. Yes. And that was the follow-up. So appreciate it. Thank you.

Operator

Thank you. Our next question will come from Ming Zhao with Deutsche Bank. Your line is now open.

Speaker 13

John, you mentioned, I think sales growth was up 18% through the end of Q2. I wanted to see if that was sort of holding through the 1st 3 weeks of Q3? And Are you are there any specific verticals you'd call out in terms of sales volume?

Speaker 3

Yes. So it is holding. So Through Monday, it was up 17%. So again, incredibly robust. Those figures actually Have surprised me a little bit to the upside, which is nice.

Speaker 3

We're seeing travel increase. Obviously, we're seeing petroleum increase and the everyday categories Have increased. The one thing that we did see through the first half is home improvement spend actually decrease versus everyday spend. So it's still positive year over year, but not increasing at

Speaker 4

the

Speaker 3

same rate as everyday spend and other retail.

Speaker 13

Okay. Got it. That makes sense. And then I guess secondly, Are you guys sort of seeing any change in consumer behavior in regards to the inflationary environment in terms of sort of Any substitution effects or anything that any color there would be helpful.

Speaker 3

Yes. We're seeing a little bit of it. We believe that in terms of gas that there's Certainly, it's significantly up year over year, but call it the volume of transactions Indicate a certain level of substitution or decrease in consumption levels. And then across the other categories, Nothing discernible at this point, but we do expect in the second half of this year with the high rate of inflation that consumers are going to make some choices and or decrease in consumptions will likely happen.

Speaker 13

Okay, great. Thank you, guys.

Operator

Thank you. Our next question will come from Kevin Barker with Piper Sandler. Your line is now open.

Speaker 14

Great. Thanks for taking my questions. Just one last follow-up on the student loan side. You had The charge offs ticked up, although they're fairly low still on student loans, but it is still higher than what we've seen from a quarterly run rate basis for the last few years. Is there anything related there to the investigation on why the charge May have ticked higher just in this particular quarter given credit metrics have been extraordinarily good within that portfolio.

Speaker 2

Yes. No, those aren't linked. And actually, I would view it as sort of a one time move and we feel very good about the credit in our student loan portfolio.

Speaker 14

Okay. And then in regards The outlook for NIM, appreciate everything for this year. But as you look out further out, just given the yield curve today, Would you expect some reversion back to your longer term NIM down to the low 10% Just given deposit costs are likely to remain fairly elevated as we go into next year or maybe even continue to move higher, just given The short end of the curve moving higher combined with maybe a flattening on the long end. Is there anything you're seeing there that would Because NIM to maybe start to soften as we move into the beginning of next year.

Speaker 3

Yes, good question. So I would say this. So my expectations is that NIM will peak this year. And there are number of factors impacting it. Certainly, you mentioned deposit costs That's going to kind of create some impact.

Speaker 3

We're going to have impacts on credit, which will impact it. But fundamentally, our funding mix has changed, which will I believe will drive improved net interest margin versus historical levels.

Speaker 14

Okay. Thank you, Joe.

Operator

Thank you. Our next question will come from mehr Bhatia with Bank of America. Your line is now open.

Speaker 7

Good morning and thank you for taking my question. Maybe I'll start with just on the competitive intensity a little bit. You're staying quite disciplined on rewards and operating costs even as you drive growth. Could you talk a little bit about where your And the reason I ask is we've seen a few aggressive offers around cash back introduced in recent months. That's historically been your bailiwick.

Speaker 7

So I was curious if you are seeing any kind of impact from some of those offers out in the market?

Speaker 2

Yes. There are different competitors who do different offers. We tend to try and be more consistent and sustainable. So we like the double cash back for the 1st year has worked very well for us. So yes, someone will be $300 $500 you'll see different issuers doing very long term balance transfers.

Speaker 2

We just don't think that's really driving sustainable growth. And a lot of that promotional activity can drive sort of new accounts, but not necessarily long term relationships. So we like our long term focus and approach, and it has served us well in a variety of competitive environments.

Speaker 7

Okay. Thank you. And then, sorry, and I don't mean to beat a dead horse here, but One last one for me, just one question on the buyback suspension. Is that something that regulators require or encourage you to do While you get your arms around the servicing issues or was the decision to suspend buybacks just solely driven by you internally at DFS and the Board?

Speaker 2

Yes, the decision was made by Discover.

Speaker 7

Thank you.

Operator

Thank you. Our next question will come from Dominique Gabrielli with Oppenheimer. Your line is now open.

Speaker 15

Hey, great. Thanks so much for taking my questions. I just I was wondering how do you monitor want versus needs based loan growth as the consumer might feel some pressure both on an individual and a portfolio level. How do you monitor that? Is there some internal data that perhaps we don't have access to that help you understand good borrowing behavior versus bad borrowing behavior outside of delinquency trends?

Speaker 15

Thanks.

Speaker 14

I just have a follow-up.

Speaker 2

Yes. I mean, it's a bit of a different answer for the portfolio, but for new accounts. But I would say for our new accounts, virtually all of it is want based, Right. We're not accepting anyone who doesn't have significant availability on other credit cards outside of potentially our secured card where some of those people we represent their first card. So it really is about want and having a better value proposition than they're seeing with their other cards.

Speaker 15

Okay, great. Thanks for that. And then I was just curious, how long out does your through the cycle loss expectation look out for changes in economic overlays. So does it include today, let's say through the Q4 of 2023. Given our analysis, we see that that's the rough timing where some of these macro dominoes Might fall into place with possibly higher unemployment related net charge offs.

Speaker 15

So how does the waiting work and From a timing perspective of when you think an event may actually begin to occur and affect either your growth algorithm or your loss algorithm. Anything you can provide on that would be really great. Thank you.

Speaker 2

Yes. I would say we tend to Roughly 4 to 5 years. But it is not as sensitive in terms of whether it's in 18 months or 2 years or 2.5 years. If you think about this is a long term product and the cash flow is associated with a credit card. And if you're not careful, you can find yourself whipping around your new account criteria every week based on sort of the latest change in economic forecast.

Speaker 2

So while we can react quickly, If it's far enough out, you're not going to see sort of continuous adjustment for that. And then for the portfolio, It's much more driven by account level dynamics. We're really looking at the risk of individual accounts.

Speaker 15

Excellent. Thanks so much for all the help.

Operator

Thank you. Our next question will come from Bob Napoli with William Blair. Your line is now open.

Speaker 16

Thank you and good morning everybody. Really solid fundamental results, Great to see. Just the network, leveraging the network partnerships,

Speaker 2

And I

Speaker 16

know you have the Ariba, Sezzle, but just having this global payments network and just any update you can on Your efforts to leverage that network. I know Ariba, B2B payments, is there anything else on The table there, I mean, that continues to grow nicely. But just any thoughts there to make the network payments portion of the business a larger part of the company.

Speaker 2

Yes, great question. So I did talk about one of our latest network to network deals. So we continue to invest and expand Acceptance and some of those deals too also generate volume and more cross border volume for us. We remain in a wide range of discussions with different FinTech players truly around the world, but we tend not to comment on deals. I would point out too though, we see a lot of value from the network, not just in the payment services segment, but for the differentiation capabilities it gives our card issuing business and in particular the support it provides for rewards on debit, which is a real differentiator in the marketplace.

Speaker 16

Thank you. My follow-up was, I guess, rewards on debit. It seems like a pretty Good opportunity for Discover. Any updated information you can give us cash back debit and the importance to your business over the next 5 years or potential benefits from that?

Speaker 2

Yes. I think it long term it will be really exciting and a great benefit for the business and provide another entry point into the franchise versus most of our customers now coming from the credit card. We continue to be deliberate In terms of how we grow that, we want to make sure that we're really solid operationally, that we have the right fraud prevention, in place. But it's a business we were going to scale for the long term. And again, really excited about some of the early signs we're seeing in terms of cost per account and the usage from some of the customers

Speaker 4

we're putting on. Thank you.

Operator

Thank you. Our next question will come from Don Fidetti with Wells Fargo. Your line is now open.

Speaker 3

Yes. John, I was wondering on the funding side, if you could talk a little bit about the ABS market. I know you've been A bit more active and so other card issuers. Are you pleased with sort of the post pandemic from a depth and pricing and leverage perspective? And also the same question in terms of brokered CDs.

Speaker 3

Yes, great question. So, I'm going to kind of break it into kind of Two categories. So very pleased with the team's execution when we go into the ABS market. I feel like the offerings are solid and the execution has been very, very good. The other side of the coin is when we were in that low rate environment, The all in rates on some of those transactions were unbelievable.

Speaker 3

We were down at 71 basis points. So it took me personally a little bit to come to terms with something in the 2s or 3s right now. But that's a function of where we are and relative to What we're driving in terms of top line yield, it's still super efficient, secured and an important funding source. The rest of the funding stack continues to be stable. The broker CDs that you mentioned.

Speaker 3

They're pricing higher than our online deposits And we're trying to get the right balance in terms of ensuring we're competitive that we're not a market leader in terms of pricing deposit pricing decisions, but also not having to kind of lean into more expensive funding sources. But We'll continue to evolve there and make sure we're making good efficient choices for the franchise.

Speaker 7

Thanks, Joe.

Operator

Thank you. Our next question will come from Arren Cyganovich. Your line is now open.

Speaker 14

Thanks. The stronger loan growth that you've seen recently in increasing your guidance for the full year, How much of normalizing of payment rates is included in that versus just the continued momentum that you're having acquiring new accounts?

Speaker 3

Yes, Erin, thanks for the question. Very little. So we modeled out a sustained high payment rate normalization back in through 2023. And frankly, if the payment rate should reduce, That would provide some more energy for growth. We haven't anticipated that.

Speaker 3

The drivers of growth have been That is a strong sales performance, the new accounts that we put on the books in the later part of 2020 and into 2021 and into this year. And customers putting our card top of wallet. So we've been really pleased and You like the balance of kind of risk versus opportunity in terms of additional growth is probably more on the

Speaker 14

internal. Have you discussed this with the regulators already? Are they involved? I just want to know if there's another leg, so to speak, to drop with respect to this?

Speaker 2

Yes. That's something I can't comment on. I would say In terms of internal, just to reinforce it is independent from the Board, but I can't comment on our discussions with regulators. Okay.

Speaker 7

Thank you.

Operator

Thank you. This concludes today's Q and A. I would now like to turn the program back over to Mr. Wasserstrom for any additional or closing remarks.

Speaker 1

Well, thank you all for joining us. The IR team is available all day. So please reach us with any additional questions and have a great day.

Operator

Thank you, ladies and gentlemen. This concludes today's event. You may now disconnect.

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