Discover Financial Services - Q3 2022
October 25, 2022
Transcript
Operator (participant)
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 third quarter 2022 Discover Financial Services earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. If you would like to ask a question at that time, please press star one on your telephone keypad. If you should need operator assistance, please press star zero. 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)
Thank you, Katie, and good morning, everyone. Welcome to today'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 risks and uncertainties that may cause actual results to differ materially. Please refer to our notices regarding forward-looking statements that appear in our third quarter's earnings release, 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 Hochschild (CEO)
Thanks, Eric, and thanks to our listeners for joining today's call. I'm very pleased with our results this quarter. Against a fluid macroeconomic backdrop, we generate strong financial performance while continuing to advance our strategic priorities. Let's start with a summary on Slide 3. For the third quarter, we reported net income of $1 billion after tax or $3.54 per share. Over the past three months, as Fed policy has become more restrictive, it has made fears of a recession more acute. Against this backdrop, the key narratives of the third quarter results are the strength of our balance sheet and the quality of our earnings. Our increase in revenues this year has been largely driven by our strong receivables growth with loans up 17% year-over-year.
This growth was driven largely by elevated sales volume and the increased number of new accounts we've added since mid-2021. We continue to use a through the cycle approach to underwriting, which considers all stages of a credit cycle, including downturns. As part of our conservative credit management, we marginally tightened our new account underwriting criteria this quarter. Given these factors, we consider our growth to be consistent with current macroeconomic conditions. Naturally, discussion of a recession elicits concerns about credit quality, but the credit performance of our loan portfolio at this stage does not suggest anything other than gradual normalization. Nonetheless, a late cycle environment requires a particular awareness of changing conditions and underscores the importance of our strong financial condition. We also continue to advance our strategic priorities.
As a few examples, in August, we expanded our global presence with the signing of Woori Card, one of the largest issuers in South Korea. The extension of this relationship as well as the number of new network partnerships we've announced this year highlight our focus on expanding our international presence. We continue to demonstrate the value of our network and our growing relationships with fintech partners. As an example, we announced in October that we will facilitate payments for TYDEi's new healthcare vendor management system, which will digitize and streamline payments in an industry where legacy purchasing is still primarily manual. Finally, this summer, we announced the opening of our new advanced analytics resource center at our downtown Chicago location.
The first cohort of 75 individuals, which we selected from over 1,000 applicants, has already started, and we intend to grow the program with an additional cohort in 2023. This follows the grand opening of our customer care center in the South Side neighborhood of Chatham earlier this year and underscores our commitment to bring additional jobs to Chicago while supporting great customer experiences. I'll now turn the call over to John to review our results in more detail.
John Greene (CFO)
Thank you, Roger, and good morning, everyone. I'll start with our financial summary results on Slide 4. There are 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 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. 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 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 vary as a portion of our funding mix, but we continue to target 70%-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 $167 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 favorable sales mix, partially offset by higher rewards costs. Similar to last quarter, we estimate that inflation contributed between 200 and 250 basis points of sales growth in the period. The strong sales also drove higher reward expense. 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 cashback program.
Year-to-date, our rewards rate is up 2 basis points, consistent with our expectation of 2-4 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 head count. 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 expense, 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 normal expected normalization. Delinquencies among our lower prime segment have been normalized, but in 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 absent 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 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 and 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 points 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 rate 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 expense. 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 expectation, 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.
Operator (participant)
Thank you, sir. At this time, if you would like to ask a question, please press star one on your telephone keypad. If you wish to remove yourself from the queue, you may also do so by pressing star two. We remind you to please pick up your handset for optimal sound quality. We'll take our first question from Ryan Nash with Goldman Sachs. Your line is now open.
Ryan Nash (Managing Director)
Hey, good morning, guys.
John Greene (CFO)
Morning.
Roger Hochschild (CEO)
Morning.
Ryan Nash (Managing Director)
Maybe to start on the net interest margin. You know, John, you commented that it implies another uptick. Given the rate hikes that we saw at the end of the quarter, can you maybe just talk about where we go from here on the margin? I think last quarter you talked about it potentially peaking out. I'm just curious, do you think you can continue to hold the line around these levels? Maybe, you know, what is incorporated within that in terms of deposit betas and the like?
John Greene (CFO)
Great. Okay. Thanks for the question, Ryan. There's a lot there. Let me start with kind of the fundamentals that we're seeing. The liability side of the balance sheet is certainly subjected to increases in deposit funding costs as a result of competitive actions and general needs across the market to attract some deposits. With that said, the 11%+ we delivered in the third quarter, we do expect some upside from that as a result of the Fed hikes in September. Certainly, sequentially into the fourth quarter, we'll see further improvement. Now, into the fourth quarter, we'll see improvement.
Beyond the fourth quarter, at this point, you know, we're gonna reserve any commentary. What I would say is, you know, we don't expect any specific, I'll say seismic changes to net interest margins in 2023 based on the stability of our funding base and current access to multiple sources of funds.
Ryan Nash (Managing Director)
Got it. Thanks for the color. Roger, maybe one for you. You mentioned, you know, you guys are marginally tightening on account acquisition. Can you maybe just give additional color regarding some of the changes you're making to underwriting and, you know, what do you think this might mean for growth over the intermediate term? Thanks.
Roger Hochschild (CEO)
Sure. I would start by saying in general, it remains a very good environment. We're seeing costs per account on the prime side below what we had last year. The value proposition is resonating well. For the new account space at the margin, we tightened some of those segments that will be most volatile in a downturn. Think, you know, the lower end of prime. You know, are ready to take further action on new accounts or the portfolio side. Again, I'd say overall, a very good environment, and that's part of why you're seeing such strong growth.
Ryan Nash (Managing Director)
Got it. Appreciate the call.
Operator (participant)
Thank you. Our next question will come from Moshe Orenbuch with Credit Suisse. Your line is now open.
Moshe Orenbuch (Managing Director)
Great. Thanks. I was hoping maybe you could talk, you know, a little bit of a different tack, maybe talk a little bit about the competitive environment and what you're seeing from, you know, from a credit standpoint and from a competitive marketing standpoint, you know, kind of in your two installment loan businesses, both in the personal loan business and the student loan business. Maybe talk about that and the outlook there for a moment.
Roger Hochschild (CEO)
Yeah. So it is hard, Moshe, to know what individual competitors are doing. I would say in general, most of them are much broader spectrum lenders than we are. My guess is we'd be seeing some stress at the lower ends of their books. For us, a rising rate environment creates a lot of focus on debt consolidation, which is the primary use of our personal loans. We're maintaining, you know, very disciplined credit criteria, but seeing strong originations in that segment.
Moshe Orenbuch (Managing Director)
Got it. Thanks. It is interesting. I mean, I think we've seen that for others that are at the higher end of the credit spectrum where the stress you're talking about we do see at the lower end. Follow-up question that I had is, you know, you talked about, you know, the hoping to restart the buyback, you know, by year-end or so, and a little bit, you know, growth kind of causing a 30 basis point downtick in your capital, but you're still well above. Just talk about, I guess, the appetite for that given, you know, and does the, you know, kind of macro environment, you know, figure into that? Just talk about the appetite for the buyback once that restarts. Thanks.
John Greene (CFO)
Yeah. Sure. Moshe, I'll take that. From an overall capital level, we are very well capitalized, right? We're 13% approaching 14% on a CET1. Our target is 10.5%. The credit book has been very stable. It's normalizing, but overall very stable. The capital allocation priorities for the firm remain in place. First is to invest in strong organic growth. Second would be a return of capital. Third, perhaps a bolt-on acquisition. If we're gonna do that, it'll likely be in the payment segment. Overall, those priorities didn't change.
You know, the suspension remains in place, but we're hopeful that buybacks will resume here in the fourth quarter.
Moshe Orenbuch (Managing Director)
Okay. Thank you.
Operator (participant)
Thank you. Our next question will come from Sanjay Sakhrani with KBW. Your line is now open.
Sanjay Sakhrani (Managing Director)
Thanks. Good morning. John, I want to just walk through the expense guide increase. You mentioned it's a blend of marketing and comp costs. Could you just parse apart what part is. You know, how much of each, sort of contributed to the increase? I'm just trying to flip the marketing comments to, you know, slightly pulling back the credit box. And then as far as, like, the headcount increases, was that related to the growth? I'm just trying to figure out what changed in terms of the comp costs.
John Greene (CFO)
Yes. Yeah, happy to help with that, Sanjay. Let me provide some context upfront here. Year-to-date total expenses are up 7%. Comp expense is up 5%. Excluding marketing, our expense base year-to-date is up 2%. Actually, really what I'll say first half of the year and into this quarter, some strong fundamentals. Now, we did have a significant growth in the asset base, which of course means that, you know, there are accounts that we're going to have to service.
You might have seen a press release that came out that indicated we were hiring about 2,000 servicing agents through the balance of this year and into next year, depending on the balance sheet and our customer value proposition and metrics. Overall, the strong growth and the strong acquisition has necessitated investments in our people. We'll continue to do that. We've also made specific investments in information technology, specifically around resources, advanced analytics in order to further position us to be able to grow profitably and then also enhance underwriting and customer targeting. We believe all those investments make perfect sense for the long term.
What you're seeing here in the third quarter is a culmination of what I'll say is a tough comp as a result of some turnover last year. Then us coming on with backfilling resources of what I'll say is salaried resources as well as the investments I talked about in terms of customer service. Hopefully that provides some context and color to your question.
Sanjay Sakhrani (Managing Director)
Okay. That's very helpful. I know we're trying to read between the lines in terms of the student loan servicing inquiry or investigation that's going on. Just to be clear, there's no change to how you guys are thinking about it relative to last quarter and as far as expenses are concerned? It seems like things are progressing as you expected it to, and it's just a matter of timing. Is that a correct statement?
John Greene (CFO)
Yeah. That is a correct statement. You know, no change. Obviously, you know, when we have some news to share, we're gonna share it. You know, the expense guidance we provided in the updates reflect those items I discussed on your previous question, and no specific changes related to expenses related to the buyback suspension.
Sanjay Sakhrani (Managing Director)
Okay. Great. Thank you.
Operator (participant)
Thank you. Our next question will come from John Hecht with Jefferies. Your line is now open.
John Hecht (Managing Director)
Good morning, guys. Actually, most of my questions have been asked, and I was gonna ask one about marketing, but maybe since you addressed the spend patterns, can you talk about, just 'cause it's a topic that we haven't really talked about in detail recently, your perspective on rewards and the competitive environment around rewards and what that means for the intermediate term?
Roger Hochschild (CEO)
Yeah. Sure. A lot of the most intense competition on rewards is in the super prime segment. You know, we've talked over the last year or two how we think some of the propositions issuers are putting out aren't necessarily sustainable in the long run. You know, as John mentioned, our rewards costs are moving up exactly as we forecast. We haven't felt the need to make any structural changes to our program. You know, as you can see from the growth in the new accounts, our value proposition competes very well in that prime revolver segment. While the market is always competitive, you know, we bring a differentiated value proposition that resonates well with consumers.
John Hecht (Managing Director)
Okay. Second question is maybe you're thinking about like the 2021 cohort, and I know it's probably early for the 2022 cohort, but what can you tell us in terms of how they're seasoning? You know, what utilization rates and kind of delinquency seasoning. Is it back to what it looked like in 2019, or is there something different that's worth pointing out with respect to more recent vintages?
Roger Hochschild (CEO)
Yeah. I would say more recent vintages are performing, yeah, exactly in line with our expectations, right? I mean, every vintage got distorted during the pandemic, so you sort of, you know, cut across the curves. Again, we feel very good about the performance.
John Hecht (Managing Director)
Okay. Thank you, guys.
Operator (participant)
Thank you. Our next question will come from John Pancari with Evercore. Your line is now open.
John Pancari (Senior Managing Director)
Morning.
John Greene (CFO)
Morning.
Roger Hochschild (CEO)
Morning.
John Pancari (Senior Managing Director)
On the efficiency ratio came in around 40% for the third quarter. Just given the commentary that you gave around the investments that you're making and your expense expectations, can you maybe help us think about how that could shape up for the fourth quarter and more importantly into 2023, how we could think about the trajectory there? Thanks.
John Greene (CFO)
Yeah. John, thanks for the question. You know, what we said in the past and what we've told our board and what we're targeting is an efficiency ratio in the high 30s. Through this year, you know, we've done a pretty good job in terms of being able to deliver that. You know, certainly the really strong growth and the great performance through the first half on the expense base, and then the third quarter reflects some investments. Despite those investments, still below forty. We're gonna continue to make investments where we see an opportunity to drive great returns for our shareholders.
As we approach 2023, you know, we are aware that the economic environment's a little tougher. We do feel like we have remaining tailwinds in terms of asset growth. We do have, you know, investments we're going to continue to make. I would say for 2023 specifically, we'll come out in January to give more specific details, but the overall commitments remain in place. You know, a commitment to positive operating leverage and efficiency ratio south of 40, and expense discipline while investing for growth.
John Pancari (Senior Managing Director)
Okay. Thank you. That's helpful. On the reserve front, just wanted to get your take on how you see that trajectory here. I know you allowed the reserve to bleed a bit in terms of the ratio this quarter. Now, you know, as you're seeing some of the normalization that you indicated and some of the pressure on delinquencies, how should we think about the reserve as you look here, particularly as you factor in the economic conditions and how the economy, you know, the impact on the economy plays out? Thanks.
John Greene (CFO)
Yeah. Great. Yeah. Thanks for that question. A little bit of context there. We put on about $5.5 billion-$5.6 billion worth of assets in the quarter. Our reserves increased by $304 million. As we look at the portfolio and the macro environment, you know, we're seeing the portfolio continuing to be very stable but normalizing. The macro environment, you know, indications of a recession are certainly increasing. Roger mentioned his comments about some mild tightening. In terms of expectation around reserves, we'll continue to take a look at the macros.
We'll run multiple scenarios and then make sure the balance sheet, the portfolio specifically continues to perform as anticipated and we'll make you know appropriate calls for reserves under GAAP. It's really tough to give any specific guidance on that other than you know we're gonna be mindful of the macros, continue to watch the portfolio, and that prime revolver targeting we do tends to add a high level of stability. A matter of fact, you know, one other point that may be useful, not specific to reserves, but rather charge-offs. You have to go all the way back to the second quarter of 2011 to see charge-offs that charge-off rate that is north of 4%.
You know, we're seeing great stability this year and we expect it to be stable next year as well.
Kevin Barker (Managing Director and Senior Equity Research Analyst)
Got it. Okay. Thanks for taking my question.
Operator (participant)
Thank you. Our next question will come from Betsy Graseck with Morgan Stanley. Your line is now open.
Betsy Graseck (Global Head of Banks and Diversified Finance Research)
Hi. Good morning.
John Greene (CFO)
Morning.
Betsy Graseck (Global Head of Banks and Diversified Finance Research)
I just wanted to see if I could get you to unpack your statement on no seismic changes in 2023. Maybe we could speak a little bit about how you're thinking, and I know you just detailed a little bit, but how you're thinking about how the loan yield should project. I know in the slide deck you called out that the loan yield was, you know, driven by prime obviously, but with a partial offset from higher promotional mix and the timing of pricing changes. Could you help us understand how that works, how much the promo mix and the timing impacted loan yields, and how you're thinking about that projecting as we, you know, continue to go through a Fed rate hike period here?
John Greene (CFO)
Okay. Yeah. There's a lot there and as you know, it's fairly complex, Betsy, but I'll do my best to create some transparency here. Let me start with the loan yield. You know, 80% of our book is floating rate on the asset side. As the Fed increases that creates the opportunity to move the contract rate up with the Fed changes. Correspondingly, if the Fed were to come down, you know, the contract rate would come down. What we're seeing there is in a rising rate environment, we still expect 3-5 basis points of yield improvement, so net interest margin yield improvement over a 12-month period.
You know, we saw significant increases in September that it looks like based on the forward curve, there's another maybe as much as 125 basis points of further Fed action this year. Then next year, depending on the economy, there could be a couple more or, you know, there'll be a pause. I don't think there will be much in the way of Fed rate reductions until maybe as late as 2024. What that means is we're going to get the benefit from the Fed rate increases into the portfolio. We're seeing deposit pricing continue to go up. You know, we haven't been a price leader on that. Certainly, we've been a follower to make sure we have a positive value proposition for our customer base.
You know, the next question would be around betas and what do you think about betas? I'm going to try to address that right now. As there's greater disparity between our rates from a deposit standpoint and the brick-and-mortar banks, it creates plenty of opportunity for us to market into those customers, and they'll find an attractive value proposition, which should help dampen the impact of further rate increases. We do think the combination of the Fed increases, us being able to manage the deposit book, but in a rising rate environment, stability from a credit standpoint, but normalization, which will create a bit of incremental interest reversals impacting net interest margin.
Ultimately the pricing decisions we're gonna make, you know, where we have that flexibility to make sure we're making good decisions for our customers and for our shareholders. Ultimately it nets out that we expect a relative stability over net interest margin through 2023.
Betsy Graseck (Global Head of Banks and Diversified Finance Research)
Okay. Got it. No, I appreciate that. Thanks. My follow-up has to do with the buyback discussion that we had earlier, and I know you mentioned that you're hopeful it can resume in Q4. Would you expect to put out an 8-K that indicates that you can now resume buybacks, or would we hear about buybacks only after you'd started? There's no obligation to put a notification into the market that you can resume. Thanks.
John Greene (CFO)
Correct. There isn't an obligation, but we would likely put an 8-K out.
Betsy Graseck (Global Head of Banks and Diversified Finance Research)
Okay. No obligation, but you would likely do it. Okay. Thanks.
John Greene (CFO)
Yes.
Operator (participant)
Thank you. Our next question will come from Robert Napoli with William Blair. Your line is now open.
Robert Napoli (Senior Director)
Yeah. Thank you. Good morning. Just following up. It was good to hear resuming the buybacks. I guess that would suggest that the review is behind you. Would you expect then to go towards your 10.5% target capital ratio? Over what timeframe would you like to do that? Or what kind of a buffer do you want above that 10.5%?
John Greene (CFO)
Yeah. Hey, Robert, thanks for the question. I just wanna be very specific about something you said. Our comments have consistently been here on this call that we hope to resume the buyback in the fourth quarter. You know, we say that because we're hopeful. Ultimately it'll be a decision that the board helps with. In terms of the 10.5% target, we've been well north of that for quite some time. You know, we have said that we want to step towards that. We intend to step towards that. Certainly the earnings power that the firm's generated and the buybacks as well as dividends, you know, have impacted our ability to get there.
You know, we're gonna step towards that throughout 2023 and 2024. What we said previously is we hope to be around the 10.5% target sometime in 2024 or 2025.
Robert Napoli (Senior Director)
Thank you. The follow-up just on normalization of credit losses. As we think about normalized credit losses, looking back over history, you know, credit cards, you know, high 3s I guess, or mid-3s to high 3s, personal loans in the 4% range. Is that the way we should think? Is there anything that's changed? Should we continue to think about normalized credit losses in that kind of an area?
John Greene (CFO)
Yeah. Yeah. I would put two points out there. First, I would take a look at the historical trends and use that and make certain judgments. The other item here I'm gonna say is a matter of judgment. Certainly, I have a belief that credit cards have increased in the payment priority because, you know, folks can't access the digital economy without a credit card. You know, some folks with a debit card, but most specifically around a credit card. That, I believe, helps prioritize the primary credit card among many other debt obligations that a consumer has. Could that impact the relative charge-off rates versus the historical trend?
My belief is yes, but your judgment is what I'd say you should apply when you're working through your forward-looking outlooks.
Robert Napoli (Senior Director)
Thank you.
Operator (participant)
Thank you. Our next question will come from Don Fandetti with Wells Fargo. Your line is now open.
Don Fandetti (Managing Director)
John, personal loan growth is pretty strong this quarter. Just wanted to get your thoughts on the outlook there and growth and also any updates on your home equity lending initiative?
John Greene (CFO)
Yeah, thanks for the question, Don. Certainly nice growth there. You know, on the personal loan front, you go back and a few quarters, and it was flat. It was flat to down actually if you go back three or four quarters as a result of some underwriting decisions we took. We since strengthened the underwriting for that product, and it's given us greater confidence to be able to market that product. There's been a high level of appeal to it. You know, we'll continue to be mindful of the product in the face of a tougher economic condition.
Certainly, you know, we feel like it's a good product and it's meeting customer needs, and that's helped drive the growth. You know, in terms of kind of forward-looking guidance, I'm not gonna start to do that at a product level. All it would do is ensure that I was wrong more often. If I go to the home equity loan, you know, that portfolio is relatively small, so it's actually not moving the dial at this point from an earnings standpoint. You know, what we've seen is a great level of interest in the second lien product, and we're also originating a first lien product as well. Both products are performing well and nice appeal.
Don Fandetti (Managing Director)
Thanks.
Operator (participant)
Thank you. Our next question will come from Mihir Bhatia with Bank of America. Your line is now open.
Mihir Bhatia (Director and Senior Equity Research Analyst)
Good morning. Thank you for taking my question. Maybe I just wanted to start with, you know, if you just take your guidance for NIM and loan growth, and, you know, I think that effectively works out a fourth quarter NIM of at least 11.2% and $3 billion+ NII. Is that the right way to think about it and frame the exit rate for NIM? Then should NIM NII just increase from there given loan growth and your comments about NIM stability? Am I thinking of that correctly?
John Greene (CFO)
Yeah. Mihir, thanks for the question, and I certainly appreciate the specificity. What I've said about NIM is probably as far as I'm gonna go here on this call. You know, we do expect sequential improvement, as I said. Beyond that, it'll be tough to give specific details.
Mihir Bhatia (Director and Senior Equity Research Analyst)
Okay. Then just wanted to ask about losses normalizing. I think previously you had talked about it being in 2H 2023 is when we get to a more normalized loss rate. I think there was, you know, talk that it could maybe push into even 2024 later. Any update on that? Thank you.
John Greene (CFO)
Yeah. So normalization through 2023 and then, you know, the macro environment will help us determine whether, you know, it pushes 2023 into 2024. Where we're sitting today, we're very pleased with the portfolio performance and, you know, the only surprise is, frankly, the pace of normalization on the upper end is a little slower than we expected, which helped drive the improved guidance that we gave on the charge-off rate.
Mihir Bhatia (Director and Senior Equity Research Analyst)
Thanks. Thank you.
Operator (participant)
Thank you. Our next question will come from Richard Shane with JPMorgan. Your line is now open.
Richard Shane (Managing Director and Senior Equity Research Analyst)
Thanks everyone for taking my question. Look, your customer base really represents a great sample of the domestic population. I'm curious when you look at spending on a category level basis, if there's anything that you're seeing that is a cause for concern? Not asking are people spending more at the pump, that's obvious with the inflationary pressures. Are there categories where you're seeing people use their cards, that are signals for something we should be thinking about?
John Greene (CFO)
Yeah, great question. You know, our base probably does skew a little upward, so more in the prime. But we're seeing continued strength in sales in October. I'd say year-over-year in the low teens. Some of the trends you've heard about were picking up. You know, consumer durables softening in terms of year-over-year. But again, our households, you know, by and large, they have the liquidity to absorb inflation. It causes some pain and they, you know, will switch categories, will downgrade within a category. But I would say, you know, travel is coming off some of the, you know, very strong growth we saw over the summer. You know, a little less strength in travel and consumer durables are probably the key trend.
Richard Shane (Managing Director and Senior Equity Research Analyst)
Got it. Thank you very much.
Operator (participant)
Thank you. Our next question will come from Bill Carcache with Wolfe Research. Your line is now open.
Bill Carcache (Senior Equity Research Analyst)
Thank you. Good morning, Roger and John.
John Greene (CFO)
Morning.
Bill Carcache (Senior Equity Research Analyst)
You mentioned that operating conditions are consistent with late cycle expansion. Historically, Fed hiking cycles have typically ended in slowing loan growth, but your already exceptionally strong loan growth seems to be accelerating, and certainly the whole industry is enjoying strong growth. Can you share any thoughts around how you'd expect a late cycle expansion to end? I'll just layer in my follow-up now. If you can give any commentary around what level of unemployment is implicit in your reserve rate and what a change in unemployment would mean for the reserve rate, that'd be very helpful.
Roger Hochschild (CEO)
Yeah. Great question. I mean, in terms of late cycle, I think back pre-pandemic, you know, we talked about it being late cycle for a couple years, and then it ended in a way that I think no one expected. That's part of why we tend to use a through the cycle loss rate and look to be disciplined in our credit management. While I would, you know, agree it's not a time probably to be widening credit. We're seeing a lot of benefits from the investments in advanced analytics, in particular around the personal loan product.
On the card side where, you know, the growth is, we're achieving the growth while, you know, swapping in and swapping out different populations. Again, with a policy that I think is appropriate for late cycle. It builds on some of the really strong new account production we had in 2021 as those accounts mature. Again, we'll continue to look at it both in terms of our portfolio actions as well as new account originations across all of our products. We feel good about the credit approach and just the traction our products are getting in the marketplace. I'll pass it to John for part two.
John Greene (CFO)
Yeah. Hey, Bill. In terms of kind of fundamental assumptions for kind of reserve setting. As I said earlier, we used a number of different scenarios which included a kind of non-recession scenario as well as a recessionary scenario. The recessionary scenario that we modeled, we certainly didn't weight as much as the non-recession. Also the view in terms of the unemployment rate. There's a pretty wide range right now, right? You know, some forecasts are going north of 6% in a very, what I'll say, a dark scenario. You know, the more optimistic scenario is 4%. We looked at a complete range of scenarios and weighted it more towards stability with increasing unemployment.
GDP, not as big a driver, but certainly an indication for the economy. You know, today we're at about 1%. In 2023, in a recessionary scenario, there'd be mild contraction, not deep contraction. We think overall, there'll be general stability despite a tougher macro.
Bill Carcache (Senior Equity Research Analyst)
Thank you.
Operator (participant)
Thank you. Our next question comes from Kevin Barker with Piper Sandler. Your line is now open.
Kevin Barker (Managing Director and Senior Equity Research Analyst)
Thank you. Concerning the comments regarding unemployment rate and maybe, you know, some slight tightening on underwriting. That being said, are you seeing any any minor shifts in consumer spending or payment patterns that may indicate certain pockets of stress, whether it's, you know, the lower end of prime or other parts, or maybe even certain vintages of customers that are on your books?
Roger Hochschild (CEO)
Yeah. I mean, all the vintages are performing well. As John said, I think we're seeing the normalization occur faster and pretty close to fully normalized for the lower end of prime. While the payment rate has softened a bit, you know, and come down by about 70 basis points, it remains 400 basis points higher than 2019 levels. I think that speaks to the fact that there's still, you know, very strong employment market out there. People can find jobs, can find extra hours. You know, good amount of liquidity that is supporting the debt burden for our segment.
Kevin Barker (Managing Director and Senior Equity Research Analyst)
Okay. I know it's a fluid situation, but the student debt repayment is supposed to restart here maybe early next year. Who knows? Given what's happening with the fighting in the courts. Do you expect any incremental impact to credit with you know a lot of student debt payments? Obviously, the potential forgiveness is obviously a credit positive, but is there something that you could see as a potential headwind as you know student debt repayments restart here potentially in January?
Roger Hochschild (CEO)
Not necessarily. We've watched it closely. I mean, I think we have experienced an elevated payment rate, which, you know, has a damping impact on loan growth as students have put more of their payments towards their private student loans. We don't see anything that would have a significant impact on credit.
Kevin Barker (Managing Director and Senior Equity Research Analyst)
Okay. Thank you for taking my questions.
Operator (participant)
Thank you. Our next question will come from Mark DeVries with Barclays. Your line is now open.
Mark DeVries (Director)
Yeah, thanks. How should we think about how you manage expense discipline if we start to see some revenue and credit weakness, you know, if the economy softens here?
John Greene (CFO)
Yeah, I would just simply say that we will take a look at the opportunities we have in front of us, and we'll make what I hope will be great long-term decisions for our shareholders. We're going to be very, very mindful around discretionary spending and around employment decisions. Overall, we hope we're good stewards of the company.
Mark DeVries (Director)
Okay, got it. Just given where the rewards cost has trended so far this year and the guidance, I think you said it was 2 basis points, but guidance is 2-4 basis points. Is it right to assume that 4Q is a relatively big quarter for expenses? Maybe you've got more of the 5% categories this quarter.
Roger Hochschild (CEO)
Yeah.
I wouldn't necessarily assume that, you know, what the point of the guidance between 2 and 4 basis points is that's what we had said previously still within the range, and we wanted to keep it within the range. You know, that 2-4 basis points is something that we've seen historically and to an extent managed to, and we'll continue to do that. You know, I wouldn't lean on any particular information to assume the fourth quarter is gonna be extraordinarily high or low.
Kevin Barker (Managing Director and Senior Equity Research Analyst)
Okay. Got it. Thank you.
Operator (participant)
Thank you. Our next question will come from Bill Ryan with Seaport Research Partners. Your line is now open.
Bill Ryan (Managing Director and Senior Equity Analyst)
Thanks. Good morning, and couple of quick questions. Just following up on the personal loans business. Historically, it's been heavily focused on your credit card base, and I was just wondering if that's still the case. You also had, you know, I'd say very, very strong credit checks in that business, paying off creditors directly. You know, has anything changed there as well?
Roger Hochschild (CEO)
No. I would say it's pretty balanced in terms of cross-sells to the card base versus broad market. You know, probably the biggest change has been just the continued advancement in analytics and the underwriting approach there. But very, very conservative. A lot of employment verification, etc. Heavily manual processes just to make sure we get it right. 'Cause as opposed to the card business where you can manage credit as you go, you get one shot in personal loans. But again, I would say the performance remains very, very strong there and it's a lot of it thanks to that disciplined approach.
Bill Ryan (Managing Director and Senior Equity Analyst)
Okay. Just one follow-up on the promotional balances that's kind of been brought up on the card book for the last several quarters. Is it still increasing as a percentage of the overall card portfolio, or is it kind of stabilized? Maybe give us some historical perspective of you know where it stands to recent history. Thanks.
Roger Hochschild (CEO)
Yeah. Thanks. It stabilized in the third quarter. Basically, approached stabilization into the second quarter, and it's very close to where it has been historically.
Bill Ryan (Managing Director and Senior Equity Analyst)
Okay. Thanks for taking my questions.
Roger Hochschild (CEO)
You're welcome.
Operator (participant)
Thank you. Our next question will come from Dominick Gabriele with Oppenheimer. Your line is now open.
Dominick Gabriele (Executive Director and Senior Equity Research Analyst)
Hey, thanks so much for taking my questions. Throughout the call and throughout other calls, you've kind of laid out your playbook in pieces, in particular on the credit side for a slowing economy. But maybe, Roger, you can just provide us with a more holistic idea of what Discover would change across, you know, various pieces of the businesses, to protect profitability in a, you know, a tougher economic environment. Then I just have a follow-up. Thank you.
Roger Hochschild (CEO)
Yeah. You know, I'd start by saying we don't necessarily optimize on protecting profitability on a quarter-by-quarter basis. We focus on sort of delivering long-term value to the shareholders. I think, you know, as I've been in this business a while, you know, people who just totally gut marketing in a downturn miss out on what usually turn out to be some of the most profitable vintages. You know, yeah, you cut marketing mainly because as you tighten a credit box, there are fewer people to market to. I think we try and operate our company almost like we're always in a recession. Always be conservative on credit, always be tight on expenses. You know, there's more you can do, especially around discretionary items.
You know, the ability to keep momentum through a downturn has really distinguished us in previous cycles, and we would try and do that again.
Dominick Gabriele (Executive Director and Senior Equity Research Analyst)
Okay. Great. Thank you. You know, I think it'd be really helpful to understand what both of your views are on the normalization of the personal loan portfolio net charge-offs versus the credit card portfolio. You know, consensus has such a huge ramp on the personal loan side versus credit cards for 2023. Not looking for specific guidance, but is there any reason why there'd be such a difference in faster normalization on the personal loan side versus credit card as far as basis point movements as a percentage of loans? Thanks so much, guys.
Roger Hochschild (CEO)
Yeah. I mean, we haven't put out product-by-product guidance, but I would say that, you know, given how we underwrite the Personal Loans, I'm not sure why our portfolio would jump much faster than the card book. In general, we have a higher FICO for the Personal Loans business. They do tend to be a little more volatile than card in a recession, but I wouldn't, you know, that isn't necessarily behavior I would expect.
Dominick Gabriele (Executive Director and Senior Equity Research Analyst)
Great. Thanks so much.
Roger Hochschild (CEO)
All right. Well, thank you.
Operator (participant)
Thank you.
Roger Hochschild (CEO)
everyone for joining us, and thank you, Katie. If there's any additional follow-ups, please reach out to the IR team. We'll be here and looking forward to speaking with you. Thanks, and have a great day.
John Greene (CFO)
Thank you.
Operator (participant)
Thank you, ladies and gentlemen. This concludes today's event. You may now disconnect.