John Greene
Chief Financial Officer at Discover Financial Services
Thank you, Roger, and good morning, everyone. I'll start with our financial summary results on Slide 4. There were three important trends in the quarter: strong asset growth, net interest margin expansion, and modest credit normalization. The strength in asset growth, combined with a NIM rate improvement increased revenue by 8% sequentially and 25% year-over-year. Asset growth resulted in an increase in our reserves under CECL of $304 million, but our reserve coverage ratio declined slightly. So while our reported net income was down 8% year-over-year, adjusting for the reserve change, our net income would have been 28% higher on a year-over-year basis.
Let's review the details starting on Slide 5. Net interest income was up $438 million year-over-year or 18%, driven by higher average receivables and improved net interest margin. We achieved a record-high NIM rate of 11.05%, up 25 basis points from the prior year and 11 basis points sequentially. On both a year-over-year and sequential basis, the increase in net interest margin primarily reflects the higher prime rate, partially offset by higher funding costs and increased promotional and balance transfers.
Receivable growth was driven by card, which increased 19% year-over-year, reflecting continued strong sales and the contribution from new accounts growth last year and into this year. Sales growth was 15% in the period, a deceleration from the 20% growth we experienced in the first half of the year.
As anticipated, the sales decline was partially mitigated by a decrease in the payment rate, which fell 70 basis points in the quarter. Nonetheless, it remains more than 400 basis points over 2019 levels. We expect the payment rate to continue to decline through the back half of 2023, which should help support receivable growth.
Turning to our non-card products, organic student loans increased 4% as a result of peak season originations. Personal loans were up 11%, the growth reflects our disciplined approach to marketing, underwriting, and pricing of this product, which we believe has created an attractive competitive position for us in the market, particularly relative to some non-bank originators.
In terms of funding mix, our customer deposit balances were up 4% year-over-year and 2% sequentially. So far, deposit pricing has been in line with what we expected in a rising rate environment. As we mentioned last quarter, our strong asset growth has caused deposits to various proportions of our funding mix, but we continue to target 70% to 80% deposit funding over the medium term. We also issued $2 billion of card ABS fixed notes in the quarter and booked $5 billion of broker deposits. We maintain broad access to a variety of funding sources, enabling us to confidently fund our asset growth.
Looking at other revenue on Slide 6. Non-interest income increased $264 million or 71%. This was partially due to a $157 million loss on our equity investments in the prior year quarter compared to a $4 million loss this quarter. Adjusting for these, our non-interest income was up 19%. This was driven by higher net discount and interchange revenue, which was up $47 million or 16%, reflecting strong sales and a favorable sales mix, partially offset by higher rewards costs.
Similar to last quarter, we estimate that inflation contributed between 200 basis points and 250 basis points of sales growth in the period. The strong sales also drove higher reward expenses. Consistent with the prior quarter, our rewards rate increased 3 basis points year-over-year, driven by substantial growth in new accounts, increasing the cost of our cash-back program. Year-to-date, our rewards rate is up 2 basis points, consistent with our expectation of 2 basis points to 4 basis points of annual reward rate inflation.
Moving to expenses on Slide 7. Total operating expenses were up $198 million or 17% year-over-year and up 13% from the prior quarter. Compensation costs were up primarily due to increased headcount. Our servicing organization is a key component of our value proposition. We expect to grow this as our accounts and assets expand. This will contribute to an increase in salary and wages through the end of this year and into next year.
Marketing expenses increased $66 million or 31% as we continue to invest for growth in our card and consumer banking products. We grew new card accounts by 22% from last year's third quarter. Professional fees increased $43 million or 22% as a result of investments in technology and increased consulting costs. We also had additional fraud costs in the consumer bank, driven by increased volumes as well as some legal expenses elevating our other expense category in the quarter.
Moving to credit performance on Slide 8. Total net charge-offs were 1.71% or 25 basis points higher than the prior year, but down 9 basis points from the prior quarter. Total net charge-off dollars were up $114 million from the prior year and only up $10 million sequentially. In the card portfolio, the net charge-off rate of 1.92% was 27 basis points higher than the prior year and 9 basis points lower sequentially.
Similar to our commentary from last quarter, we are not seeing evidence of emerging credit stress beyond normally expected normalization. Delinquencies among our lower prime segment have been normalized, but in the upper prime delinquencies and charge-offs remain below pre-pandemic levels. This is consistent with our baseline expectation that credit will continue to normalize over the next several quarters' absence of a change in macro conditions.
Turning to the discussion of our allowance on Slide 9. This past quarter, we increased our allowance by $304 million due to higher receivable balances. Our reserve rate modestly declined to 6.7%. For us, changes through -- to employment conditions pose the most significant risk to loss levels. As part of our reserving process, we have considered the prospects of higher unemployment among a range of macroeconomic scenarios which is reflected in our reserve balance.
Looking at Slide 10. Our common equity Tier 1 for the period was 13.9%. The strong asset growth was a primary driver of the approximate 30 basis point decline from the prior period. Our long-term target remains 10.5%. In terms of capital return, we declared a quarterly common dividend of $0.60 per share and repurchased $212 million of common stock in the period before we decided to temporarily suspend our buyback activity.
Concluding on Slide 11. As we look at the last quarter of the year, our prospects for 2022 remain favorable, and we are once again improving elements of our expectations. We are revising our view on loan growth to high teens, continued strong sales, new account acquisitions through the third quarter and some recent improvements in the payment rates to support our confidence in the outlook.
In terms of NIM, we expect the full year to be mildly above the high end of our expected range with sequential margin improvement in the fourth quarter based on rate hikes that happened in late September. We are revising our expense outlook to be up high single digits versus the prior year, driven by increased marketing and compensation costs. In line with previous communications, we still expect marketing costs to come in above 2019 levels as we've discussed.
We expect to add headcount, which will elevate salary and wages as well as benefit expenses. Excluding these two categories, expenses are expected to increase by low single digits. We now expect net charge-offs to be between 1.8% and 1.9% for the full year, driven by lower-than-expected credit losses through this point in the year. Our temporary pause on share repurchases remains in place, but we hope to resume share repurchases before year-end.
In summary, receivable growth accelerated as we continue to benefit from elevated sales, strong new account acquisitions, and improvements in the payment rate. NIM continues to benefit from prime rate increases. Funding costs are consistent with expectations and credit performance is slowly normalizing, reflecting our disciplined approach to underwriting and credit management. These results demonstrate the resiliency of our integrated digital banking and payments model. Our earnings power, coupled with our strong balance sheet and capital position, keeps us 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.
