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Discover Financial Services Q2 2022 Earnings Call Transcript


Listen to Conference Call

Participants

Presentation

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 Instructions] Thank you.

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

Eric Wasserstrom
Head of Investor Relations at Discover Financial Services

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 Financials section of our Investor Relations website investorrelations.discover.com.

Our discussion today contains certain forward-looking statements that are subject to risks and uncertainties that may cause actual results to differ materially. Please refer to our notices regarding forward-looking statements that appear in our second quarter earnings press release and presentation.

Our call today will include remarks from our CEO, Roger Hochschild; and John Greene, our Chief Financial Officer. After we conclude our formal comments, there will be time for a question-and-answer session. During the Q&A session, you will be permitted to ask one question followed by one follow-up question. After your follow-up question, please return to the queue.

Now, it's my pleasure to turn the call over to Roger.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

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. For the second quarter, we reported net income of $1.1 billion after-tax, or $3.96 per share. Our operating metrics in the second 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. 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 BANCOMAT, 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. 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. 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-back rewards and no-fee products, created 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. 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. 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.

We also maintain 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 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. 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 key aspects of our financial results in more detail.

John T. Greene
Executive Vice President and Chief Financial Officer at Discover Financial Services

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 $1.1 billion, which was 35% lower year-over-year. However, I'd like to call out two items. The first is that in the second quarter of last year, we had a $729 million unrealized gain on our equity investments compared to a $42 million loss this quarter. Adjusting for these, our earnings would have been $4.07 per share in the current quarter. Second, the provision for credit losses increased from the prior year, due to a $110 million reserve build in the current quarter compared to a $321 million reserve release in the prior year. The current quarter reserve build was primarily driven by higher loan receivables. Excluding the impact of these two items, our profit before tax and reserves would have been up 38% year-over-year.

Moving to Slide 6. Net interest income was up $311 million, 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. We continue to expect that the normalization in payment rate will be modest this year and will continue through the back half of 2023.

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. Increases in our savings balances offset the run-off 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 million, or 19%. This was driven by higher net discount and interchange revenue, which was up $51 million, or 15%, reflecting strong sales and favorable sales mix, partially offset by higher rewards.

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 200 basis points and 300 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. Our standard 5% category aligning with customer needs included gas this quarter. Second, the substantial growth in new accounts over the past year increased the cost of our cashback 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 basis points to 4 basis points of annual rewards cost increases. Loan fee income was up $37 million, or 35%, primarily driven by an increase in late fee instances.

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 million, or 45%, as we continue to invest for growth in our card and consumer banking products. We grew new card accounts by 39% from last year's second quarter. 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. Net charge-offs remain 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 million from the prior year and up $61 million sequentially. In the card portfolio, the net charge-off rate increased 17 basis points sequentially, or $50 million.

Looking at our receivables, we are not seeing evidence of emerging credit stress at this point. Our delinquencies are virtually unchanged from the first quarter. 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 loans by $110 million, 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. 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 example, 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.

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 600 -- $601 million of common stock during the quarter and declared a quarterly common dividend of $0.60 per share.

Concluding on Slide 12. As we look into the back half of this year, our prospectus 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 second quarter support our confidence in this outlook. 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 first quarter level of 10.85%. Our expectations for expenses remain at mid-single-digit growth versus last year. We still expect marketing cost to come in above 2019 levels with non-marketing expenses to increase by low-single-digits.

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.

In summary, loan growth accelerated as we benefited from robust sales and strong account acquisition. Credit performance remained solid, reflecting our disciplined approach to underwriting and credit management. We manage 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&A.


Questions and Answers

Operator

Thank you. [Operator Instructions] Thank you. Our first question will come from Moshe Orenbuch with Credit Suisse. Your line is now open.

Moshe Orenbuch
Analyst at Credit Suisse Group

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 you 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. Thanks so much.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Sure, Moshe, thanks for the question. I would say the competitive environment remains intense with the consumer staying strong. We are seeing strong levels of marketing for most of our prime competitors, 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 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.

Moshe Orenbuch
Analyst at Credit Suisse Group

Great. Thanks. And just as a follow-up, on this -- 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 is -- you've got the issue that you've got from a compliance standpoint. You talked about how that could impact you from an origination standpoint, and if that does, how long that could last?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. 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.

Moshe Orenbuch
Analyst at Credit Suisse Group

Thanks very much.

Operator

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

Bill Carcache
Analyst at Wolfe Research

Thank you. Good morning, Roger and John. You guys certainly have historically remained profitable through the cycle with risk-adjusted yields remaining quite strong, even in a deep recession like we saw in '08. And it makes sense that you're continuing to invest here against the backdrop that we're in. But could you maybe frame for us what it would take to curb your appetite for investing for growth? And maybe just -- what it would take for you to have a pullback?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. Thanks for the question. So there are 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. 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 on 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 look to.

Bill Carcache
Analyst at Wolfe Research

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

John T. Greene
Executive Vice President and Chief Financial Officer at Discover Financial Services

Yeah. Hey, Bill. I'll take that one. Good question. We spent plenty of time thinking about it. So inflation on to itself is not correlated to loan losses based on all the historical data we've looked at. 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 is still about 11.3 million job openings right now versus 6 million people looking for jobs. Spending remains robust and credit is performing very, very well.

So as we look at those factors, 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, you know 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.

Bill Carcache
Analyst at Wolfe Research

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.

Sanjay Sakhrani
Analyst at KBW

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 excess capital and stress capital buffers and such? I mean should we infer that the size and scope of damages could be pretty significant?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

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 our share repurchase program. It's not just potential financial exposure. And I would say, you know, returning our shareholders' capital in the form of the repurchase has been a big focus for management and the Board, and we'll continue to do, and that's why John said, you know, we hope to get back to the repurchase program as soon as we are able.

Sanjay Sakhrani
Analyst at KBW

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

John T. Greene
Executive Vice President and Chief Financial Officer at Discover Financial Services

Yeah. Thanks, Sanjay. So the NIM guidance gave a range benchmarking of the 10.85%, and we 5 basis points to 15 basis point range of upside from that. Based on the Fed actions to date, we are tracking towards the upper end of that guidance range at this point. So that's a positive. We are seeing deposit cost increase and that's a function of two 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. But I would say, the -- first part of the year, we had a very, very low beta. I would expect that to normalize as the funding environment migrates.

Sanjay Sakhrani
Analyst at KBW

Okay. Great. Thank you.

Operator

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

Rick Shane
Analyst at J.P. Morgan

Good morning, guys, and thanks for taking my questions. 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, is there is something that you guys might see that suggests that this is more of a secular change than a cyclical change?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. Thanks, Rick. So, yeah, it's hard to call 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, but also that cash that folks used to expand, 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, you know, it's hard to call right now. We're about 500 basis points higher than the pre-pandemic level. If I were asked to give a range, I would say, maybe 100 basis points to 200 basis points of that could be a permanent change, and then the rest has to do with the strength of the portfolio and the strength of the consumers.

Rick Shane
Analyst at J.P. Morgan

Got it. Yeah, 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.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. Thanks for the question, Rick. And anything else?

Rick Shane
Analyst at J.P. Morgan

That's it. Thank you, guys.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

You got it.

Operator

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

Ryan Nash
Analyst at The Goldman Sachs Group

Hey. Good morning, John. Good morning, Roger.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Good morning.

Ryan Nash
Analyst at The Goldman Sachs Group

So, John, maybe a question on the allowance. If I look, I recognize, you know, 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 sevens versus high sixes. [Phonetic] So can you maybe just give us 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 healthier consumers are like, you know, what could that do to both losses in the allowance over time? Thanks.

John T. Greene
Executive Vice President and Chief Financial Officer at Discover Financial Services

Sure. So as I mentioned in my previous comments, we look at number of different scenarios, but I can give you a couple of data points here. In terms of unemployment, it range from a low of 3.3% at the end of 2022 to peak of 5.8%. And then as we look for '23, 3.5% to just about 5.5%. We're seeing a level of GDP growth slowing. We haven't baked in a full recession, but certainly, GDP does reduce and is near zero in one of the scenarios we ran. And the employment situation is still as robust, and we certainly consider that as well.

So as we look out into '23, we're going to evaluate what the macro conditions are and the impact on life loan losses. But for me, it is the portfolio performance is really, really strong, job market, really, really strong. Uncertainty on the broad macros and we conservatively model those. So overall, I feel like we're 100% consistent with how we've reserved in the past. We've taken that through the cycle underwriting approach, that has benefited through into the portfolio. And we've been conservative in our process to ensure that our reserves are fairly stated under GAAP.

Ryan Nash
Analyst at The Goldman Sachs Group

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 the investigation, I guess maybe just talk about [Technical Issues] to spend the buyback. And I know that you're limited in what you can say, but any sense for the timing of how long an investigation like this could take? Thanks.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. I am to your point, limited what I could say. We can't really give you anything to expect in timing other than, you know, you know our views on capital, and so as soon as we can, we hope to restart the buyback.

Ryan Nash
Analyst at The Goldman Sachs Group

I figured that try. Thanks.

Operator

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

Mark Devries
Analyst at Barclays

Yeah. Thanks. Just one more question 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 of this year, or could you accelerate repurchases?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

We'll look at that, Mark. Certainly, we have that broad authorization for the Board for over five quarters. It's $4.2 billion to $4.3 billion 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. And you know 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.

Mark Devries
Analyst at Barclays

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

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Good question. I think while valuations have pulled back, I'm not sure there any bargains yet. But you know 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 we have a good business development effort that's always out there, but I wouldn't necessarily expect something.

Mark Devries
Analyst at Barclays

Okay. Got it. Thank you.

Operator

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

John Pancari
Analyst at Evercore ISI

Good morning.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Good morning.

John T. Greene
Executive Vice President and Chief Financial Officer at Discover Financial Services

Good morning, John.

John Pancari
Analyst at Evercore ISI

And just -- sorry. Back to the still alone issue, just -- I know you've given all that you can comment on, but there's also -- in the public, you know, we know that there is also a consent order related to this with the CFPB. It looks like 2020 and I believe it's even tied to a consent order for 2015. Did that impact it? Did that influence the suspension? And was there something new that developed that caused the internal investigation?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

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.

John Pancari
Analyst at Evercore ISI

Okay, all right. Thank you. Thanks for helping there. And then separately, just on the -- this is sort of related to it, but we're around the expenses. 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 getting back to your earlier comment that there is unlikely to be an expense impact?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. 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 distribute 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 so we consider it as part of the cost of our operation and we're trying to make it as efficient as we can.

John Pancari
Analyst at Evercore ISI

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 incremental in the lower FICO bands, or any color around the modest increase in delinquencies that you saw?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. 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, and some of that could be are some of the work we've done in terms of analytics and optimize time to contact and collection strategies, and some of it could be just customer performance. So there is 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.

John Pancari
Analyst at Evercore ISI

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.

Betsy Graseck
Analyst at Morgan Stanley

Hi. Good morning.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Good morning, Betsy.

Betsy Graseck
Analyst at Morgan Stanley

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 a fair conclusion?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

I wouldn't necessarily link those two. I mean I think what we can say is that we do 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.

Betsy Graseck
Analyst at Morgan Stanley

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

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. 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.

Betsy Graseck
Analyst at Morgan Stanley

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 will 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 I'm 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? Thanks.

John T. Greene
Executive Vice President and Chief Financial Officer at Discover Financial Services

Yeah. The overall interchange has largely been a function of a 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, and obviously, we don't spend a lot of time discussing that. 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. It was one of the 5% categories in the quarter, everybody knows about inflation at the pump. 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 basis points to 4 basis points of inflation there. So interchange in the aggregate, super strong interchange rate, very, very solid rewards coming in at expectations.

Betsy Graseck
Analyst at Morgan Stanley

Got it. Yeah. And that was the follow-up, so appreciate it. Thank you.

Operator

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

Meng Jiao
Analyst at Deutsche Bank Aktiengesellschaft

Hey, good morning, guys, and thanks for taking my question. John, you mentioned I think sales growth above 18% through the end of second quarter. I want to see if that was sort of holding through the first three weeks of the third quarter. And then are you -- are there any specific verticals you call out in terms of sales volume?

John T. Greene
Executive Vice President and Chief Financial Officer at Discover Financial Services

Yeah. 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. We're seeing travel increase. Obviously, we're seeing petroleum increase and everyday categories have increased. The one thing that we did see through the first half is home improvement spend actually decreased versus everyday spend. So it's still positive year-over-year, but not increasing at the same rate as every day spend in other retail.

Meng Jiao
Analyst at Deutsche Bank Aktiengesellschaft

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.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. We're seeing a little bit of it. We believe that in terms of gas that there is -- 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 substitutions or decrease in consumptions will likely happen.

Meng Jiao
Analyst at Deutsche Bank Aktiengesellschaft

Okay. Great. Thank you, guys.

Operator

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

Kevin Barker
Analyst at Piper Sandler Companies

Great. Thanks for taking my questions. Just one last follow-up on the standalone side. You had -- your charge offs ticked up, although they're fairly low, still in -- 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-offs may have ticked higher just in this particular quarter, given credit metrics have been extraordinarily good within that portfolio?

John T. Greene
Executive Vice President and Chief Financial Officer at Discover Financial Services

Yeah. 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.

Kevin Barker
Analyst at Piper Sandler Companies

Okay. And then in regards to the outlook for NIM, I 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 a low 10%, just given the deposit costs are likely to remain fairly elevated as we go into next year, or maybe even continue to move higher, just given the sort of the curve moving higher combined with maybe a flattening of the long on the long end? Is there anything you're seeing there that would cause NIM to maybe start to soften as we move into the beginning of next year?

John T. Greene
Executive Vice President and Chief Financial Officer at Discover Financial Services

Yeah. Yeah, good question. So I would say this, so my expectation is that NIM will peak this year, and there a number of factors impacting it. Certainly, you mentioned deposit costs, that's going to create some impact. 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.

Kevin Barker
Analyst at Piper Sandler Companies

Okay. Thank you, John.

Operator

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

Mihir Bhatia
Analyst at Bank of America

Good morning, and thank you for taking my question. Maybe I'll start with just on the contemplative 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 account growth is coming from? And the reason I ask is, we've seen a few aggressive offers around cashback introduced in recent months, that's historically been your bailiwick. So I was curious if you are seeing any kind of impact from some of those offers out in the market.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. There are different competitors who will do different offers. We tend to try and be more consistent and sustainable. So we like the double cash back to the first year has worked very well for us. So someone will be $300, $500, you'll see different issuers doing very long-term balance transfers. 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're -- we -- like our long-term focus and approach, and it has served us well in a variety of competitive environments.

Mihir Bhatia
Analyst at Bank of America

Okay. Thank you. And then -- sorry, and I don't mean to beat a dead horse here, but one last one -- from 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 spend buybacks just solely driven by you internally and DFS and the Board?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. The decision was made by Discover.

Mihir Bhatia
Analyst at Bank of America

Thank you.

Operator

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

Dominick Gabriele
Analyst at Oppenheimer

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? Thanks. I also have a follow-up.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. I mean it's -- a bit of a different answer for the portfolio, but for new accounts. But I'd say, for our new accounts, virtually all of it is one-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 are seeing with their other cards.

Dominick Gabriele
Analyst at Oppenheimer

Okay, great. Thanks for that. And then I would 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 fourth quarter of 2023? You know, given our analysis, we see that that's the rough timing where some of these macro dominos might fall into place with possibly higher unemployment-related net charge-offs. So how does the waiting work? And from a timing perspective, when you think an event may actually begin to occur and affects either your growth algorithm or your loss algorithm? Anything you can provide on that would be really great. Thank you.

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. I would say, we tend to look out roughly four to five years, but it is not as sensitive in terms of whether it's in 18 months or two years or two and a half years. If you think about this is a long-term product and the cash flows 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.

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.

Dominick Gabriele
Analyst at Oppenheimer

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.

Bob Napoli
Analyst at William Blair

Thank you, and good morning, everybody. Really solid fundamental results great to see. Just the network -- leveraging the network, so you know partnerships, when you know you have the Ariba, Sezzle. But just having this global payments network and just any update you can on the -- your efforts to leverage that network. I know a Ariba B2B payments, is there anything else on the table there? I mean, that continues to grow nicely, but any just any thoughts there that make the network payments portion of the business a larger part of the company?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. A 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 to 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 and 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.

Bob Napoli
Analyst at William Blair

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 on cashback debit and the importance to your business over the next five years or potential benefits from that?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. I think 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're 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 we're putting on.

Bob Napoli
Analyst at William Blair

Thank you.

Operator

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

Donald Fandetti
Analyst at Wells Fargo & Company

Hey, 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 in pricing and leverage perspective, and also the same question in terms of brokered CDs?

John T. Greene
Executive Vice President and Chief Financial Officer at Discover Financial Services

Yeah. A great question. So I'm going to kind of break it into 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 hitting that low rate environment, the all-in rates on some of those transactions were unbelievable. We were down at 71 basis points. So it took me personally a little bit to come to terms with something in the twos or threes 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 a super-efficient, secured and important funding source.

The rest of the funding stack continues to be stable. The broker CDs that you mentioned, you know, their 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.

Donald Fandetti
Analyst at Wells Fargo & Company

Thanks, John.

Operator

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

Arren Cyganovich
Analyst at Smith Barney Citigroup

Thanks. And the stronger loan growth that you've seen recently, an increase in 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 in acquiring new accounts?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. Arren, 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 provides some more energy for growth. We haven't anticipated that. The drivers of growth have been kind of the strong sales performance, the new accounts that we put on the books in the later part of '20 and into '21 and into this year, and customers putting our card top of wallet. So we've been really pleased and feel like the balance of kind of risk versus opportunity in terms of additional growth is probably more on the opportunity side at this point.

Arren Cyganovich
Analyst at Smith Barney Citigroup

Okay. Thanks. And then secondly, the internal investigation obviously, that's internal. Have you discussed this with the regulators already? Are they involved? I just want to know if there is another leg so to speak to drop with respect in this?

Roger C. Hochschild
Chief Executive Officer and President at Discover Financial Services

Yeah. That's something I can't comment on. I would say though, in terms of internal, just to reinforce it is independent from the Board. But I can't comment on our discussions with regulators.

Arren Cyganovich
Analyst at Smith Barney Citigroup

Okay. Thank you.

Operator

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

Eric Wasserstrom
Head of Investor Relations at Discover Financial Services

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

[Operator Closing Remarks]

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