Discover Financial Services - Q3 2023

Transcript

Operator (participant)

Good morning. My name is Chelsea, and I will be your conference operator today. At this time, I would like to welcome everyone to the third quarter 2023 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 will now turn the call over to Mr. Eric Wasserstrom, Head of Investor Relations. Please go ahead.

Eric Wasserstrom (Head of Investor Relations)

Thank you, Chelsea, and welcome to this morning's call. I'll begin on slide two 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 earnings press release and presentation. Our call today will include remarks from our Interim CEO, John Owen, 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 John.

John Owen (Interim CEO and President)

Thank you, Eric, and thanks to our listeners for joining today's call. As I shared a few months ago, I had three priorities in my role as interim CEO. First is to continue delivering a great customer experience at every touch point, which we do by providing our customers award-winning service and products. At the heart of this is a team of more than 20,000 employees connected by common values and a shared mission to help people achieve a brighter financial future. My second priority is to advance our culture of compliance. We have made significant strides in this area. By now, you've all had the opportunity to review the consent order issued by the FDIC in September.

Consistent with the terms of this Consent Order, we have made meaningful investments in improving our corporate governance and enterprise risk management capabilities and expect to drive further enhancements across the organization in the coming quarters. We've also started a process of engaging with our merchant partners on the Card Misclassification Issue, to remain in active dialogue with our regulators on this topic. The resolution of this issue is likely to be complex and we anticipate it will take several quarters to fully resolve. My third priority is to sustain our strong financial performance. In the third quarter, revenue was up 17% year-over-year, driven by strong asset growth. Our credit losses continued to perform in line with expected ranges. In addition, we were off to a strong start with the launch of our Cashback Debit product.

We continue to believe that this product will be an important channel to welcome many new customers into our company. To highlight the Discover experience and support our brand and banking products, we're proud to have just introduced a new national advertising campaign featuring celebrity spokesperson Jennifer Coolidge. As we continue to advance our priorities, we are focused on preserving and enhancing the elements that make Discover a great place to work. Last month, we were ranked among the 2023 Fortune Best Workplaces in Financial Services and Insurance. This accolade builds upon our recognition as one of Fortune's 100 best companies to work for. Before handing the call off to John Greene, I'll briefly comment on the CEO search. The board is considering several excellent candidates, both internal and external. We remain confident that we will identify the next outstanding leader for this organization in the coming months.

In summary, we continue to target excellence in all parts of our business, driving sustainable, long-term financial performance. I will now hand the call off to John to review our results in more detail.

John Greene (EVP and CFO)

Thank you, John, and good morning, everyone. I'll start with our financial summary results on slide four. In the quarter, we reported net income of $683 million, down from just over $1 billion in the prior year quarter. Provision expense grew by $929 million, reflecting an increase in reserves and charge-offs. Strong loan growth, along with changing macroeconomic and household liquidity conditions, drove the increase to our reserve balance. Charge-offs increased due to portfolio seasoning and remained in line with expectations. Revenue grew 17%, deposits grew 23%, and expenses increased 6% year-over-year. Further details are reflected on slide 5. Net interest income was up $479 million year-over-year, or 17%.

Our net interest margin ended the quarter at 10.95%, down 10 basis points from the prior year and down 11 basis points sequentially. This decrease was driven by higher funding costs, which were partially offset by the benefits from higher prime rates. Receivable growth was robust. Card increased 16% year over year, reflecting new account growth and a lower payment rate versus the prior year. The payment rate declined about 30 basis points quarter over quarter, but remains just under 200 basis points above 2019 levels. Sales volume was relatively flat for the quarter. Personal loans were up 25%, driven by strength in originations over the past year and lower payment rates. We continue to experience strong consumer demand while staying disciplined in our underwriting. Student loans were up 1%.

Deposit growth in the quarter was solid, with average consumer deposits up 23% year over year and 4% sequentially. Our direct-to-consumer balances grew $4 billion. Looking at other revenue on slide six. Non-interest income increased $97 million or 16%. This was primarily driven by higher transaction processing revenue from our PULSE business, an increase in loan fee income, and strong net discount and interchange revenue. Moving to expenses on slide seven. Total operating expenses were up $86 million, or 6% year over year, and up 4% from the prior quarter. This increase is driven primarily by investments in our compliance and risk management programs and is reflected across several of our expense line items. Looking at our major expense categories, compensation costs were up $24 million or 4%, primarily from increased headcount.

The increase in information processing expense was driven by software licensing renewals. Professional fees reflect an increase in third-party support as we focus on accelerating our compliance and risk management efforts. Moving to credit performance on slide eight. Total net charge-offs were 3.52%, 181 basis points higher than the prior year, and up 30 basis points from the prior quarter. In card, we continue to see the effects of seasoning of newer accounts, which have higher delinquency rates than older vintages. Losses remain consistent with targeted ranges. These newer vintages support strong long-term profitability. Turning to the allowance for credit losses on slide nine. This quarter, we increased our reserves by $601 million, and our reserve rate increased by 22 basis points to just over 7%.

The reserve increase reflects a modest deteriorating macroeconomic outlook, increasing delinquencies, and higher loan balances. Our macro assumptions reflect a relatively strong labor market, but also consumer headwinds from declining savings rates and increasing debt burdens. Looking at slide 10, our Common Equity Tier 1 for the period was 11.6%. The sequential decline of 10 basis points was driven largely by our strong organic asset growth. We declared a quarterly cash dividend of $0.70 per share of common stock. Concluding on slide 11 with our outlook. We now expect our loan growth to be in the mid-teens as declining payment rates are offsetting the impact of slowing sales. There is no change to our NIM expectations to be approximately 11% for the full year.

We're maintaining our expectations for operating expenses to be up low double digits, and there is no change to our expected range for net charge-offs to be between 3.4% and 3.6% for the year. In conclusion, our business fundamentals remain strong. We continue to generate solid financial results while building out our compliance and risk management capabilities and prudently investing in actions that drive sustainable long-term performance. With that, I'll turn the call back to our operator to open the line for Q&A.

Operator (participant)

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 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 Sanjay Sakhrani with KBW. Your line is open.

Sanjay Sakhrani (Managing Director and Senior Analyst of Consumer Finance and Payments)

Thanks. Good morning. Just wanted to get a little bit more on the reserve build. As we look ahead, John Greene, you know, can you just talk about, like, how we should think about that reserve rate increasing from here? Because obviously, you made some adjustments, but you said the credit numbers are performing pretty consistent with your expectations. So is it a reflection on how you see things unfolding next year? Maybe if you just talk about the relation and how we should think about that reserve coverage on a go-forward basis, assuming, you know, the unemployment assumptions don't change much.

John Greene (EVP and CFO)

Yeah. Thanks, Sanjay. Appreciate the question. So, let me back up and just give a little bit of overview in terms of what happened in the quarter and why we increased the reserve rate. So, as we took a look at the portfolio performance and the loan growth, obviously, we had to make a reserve build for loan growth, and that represented about 50% of the $600 million. The other 50% or approximately $300 million reflected our view on the macros. Now, while the unemployment numbers remain relatively in line and strong by historical standards, you know, we are seeing some indications of stress.

If we go back to the pandemic and the learnings there, we found that certainly unemployment remains an important factor in terms of reserve, but there's other factors. What we've done over the past year is try to build into those other factors into our loss models and reserve models, and we've done that. So as we took a look at household net worth and savings rate, both have deteriorated, and we're seeing deterioration more specifically in lower FICO bands. So we use those macro factors in order to capture loss content that we felt was appropriate from a reserving standpoint....

So as we look at reserve levels today and into the future, there's a couple things that I'll say are just kind of general process items. First, it'll be dependent on the macro views and whether they remain stable or deteriorating. Second, certainly the portfolio performance will be a very, very important factor. And then third, will be the timing and trajectory of loss content. So as losses become closer in terms of our projection per-period, they're probability adjusted and therefore could increase reserve rate. Now, there's a lot of detail that I just provided, so let me give a view of our expectations. So first, the portfolio is performing generally well, although we are seeing mildly increased stress at the lower FICO bands to mid-FICO bands.

We're also seeing the 2022 vintage perform slightly worse than 2021, 2023, although highly profitable. So, as we look forward to 2024, you know, we'll run our process and adjust the reserve as we deem most appropriate. An important piece will also be the charge-off trajectory. So what we've said previously is we expect charge-offs to peak sometime around the midpoint of the year to the second half of the year, in the second half of 2024. So if we don't see a slowing in delinquency rates between now and first quarter, certainly that could be an indication that, you know, we'll have to take incremental provisions. So a lot there.

Hopefully, enough for you to be able to digest and move forward with.

Sanjay Sakhrani (Managing Director and Senior Analyst of Consumer Finance and Payments)

Yeah. Thank you. That's great. And just under the banner of sort of regulatory stuff, you know, question number 1, it doesn't seem like there's a whole lot to update in terms of other actions. We obviously got the consent order. And then I saw in the perspective for 2023, you still have a pause for the capital management piece, not any change to that. So could you just give us a sense of sort of how to think about that unpausing of the share repurchase? I know John Owen mentioned it might take several quarters to resolve the merchant issue, so just trying to reconcile those comments. Thanks.

John Greene (EVP and CFO)

Sure. Yeah. Yeah, I'll take that one too, Sanjay. So, let me first start out by saying our capital allocation priorities aren't changed. So, invest in the business and return excess capital to shareholders. You know, that's very clear from our business model, our management team, and our board. The second piece to the answer relates to our continued work on the card tiering issue and other governance issues. So, we're making reasonably good progress on both of those. And, what we'll do as part of our 2024 planning process, is we'll make a recommendation to the board regarding our capital actions and specifically, the buyback. And then we'll provide an update on our January call associated with our fourth quarter earnings.

John Owen (Interim CEO and President)

Let me just add a little bit to-

Sanjay Sakhrani (Managing Director and Senior Analyst of Consumer Finance and Payments)

Okay, cool.

John Owen (Interim CEO and President)

Let me just add a little bit to John's answer on kind of where we are from a regulatory standpoint. You know, the FDIC Consent Order that was made public this month related really to findings from end of 2021, looking back. So we've said before, we've made significant investments in our risk management compliance capabilities over the last 18 months. From a spending standpoint, we've increased our spending from $225 million in 2022 to about $460 million in 2023. What I would tell you is we've made good progress resolving many of our issues, but we still have a significant amount of work to do before we're satisfied with where we are. On the Card Misclassification Issue, it's not part of that FDIC Consent Order. It's a separate matter.

Where we are on that, as we've mentioned before, we did have an outside law firm complete an investigation on the Card Misclassification Issue. That work is substantially complete at this point in time. You know, we've shared that results of that with our board of directors and also with our regulators. At this point in time, we're awaiting feedback from our regulators.

Sanjay Sakhrani (Managing Director and Senior Analyst of Consumer Finance and Payments)

Thank you.

Operator (participant)

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

Bill Carcache (Managing Director and Senior Equity Research Analyst of Financials)

Thank you. Good morning. I wanted to follow up on the reserve rate comments. John Greene, you referenced several macro variables impacting the reserve, and you also cited higher delinquencies, which, you know, are more idiosyncratic. Some investors are concerned that rising DQs may be a function of more than just seasoning. Maybe could you just help us with, you know, what your response would be to the concern that some investors have expressed that the outsized reserve build is a sign that Discover may have reached for growth too aggressively during the pandemic and is now facing the consequences, perhaps what could ultimately end up being greater credit degradation in 2024 and possibly beyond? You know, particularly since we're still in an environment where the unemployment rate is 3.5%.

John Greene (EVP and CFO)

Yeah. Thanks, Bill. So, let me go back a little bit, and be real clear about what happened at the second half of 2021 and 2022 in terms of origination. So second half of 2021, we resumed, and we went back to our traditional credit box. In the early part of 2022, we continued with that traditional Discover credit box. We did do a test in marginal prime and near prime, which we turned on. We saw the results, and we turned off in the second quarter or early third quarter of 2022. So about six months of origination, not dramatic volume by any means, but certainly a test. It was a good opportunity to learn to see if we could capture some profitable share.

What we found was those accounts weren't meeting our return or volatility thresholds, so they were shut down. The rest of the 2022 vintage was within the traditional credit box that Discover had, and 2023 remains there, although we're peeling back. I will say, this, the 2022 vintage was certainly outsized as a result of demand and great execution from our marketing team. The profitability of that still remains very, very strong in the short term, medium term, and long term.

So, if we're gonna do it all over again, at this point, we'd certainly answer definitively, "Yes, we would continue to originate the loans that we put on the books." But the vintage is significantly larger than other vintages, so the natural loss content of new originations is somewhere between 12-24 months, and we expect that to play out. And as I said, the delinquencies and charge-offs to peak sometime in 2024. So I hope that is helpful in terms of giving a little bit of color in terms of the process we went through, our risk tolerance, and what we expect to see from those vintages.

Bill Carcache (Managing Director and Senior Equity Research Analyst of Financials)

Yes. That's helpful. Thanks, John. I appreciate that. If I could ask a follow-up of John Owen, could you speak to the possibility of potentially... You know, I guess, your overall interest level in potentially pursuing strategic alternatives for any of the other businesses, whether that be student lending or, or anything else? And, and, you know, or, or is that more likely to wait, to... You know, are you more likely to hold off until the new CEO kind of comes on board, which you mentioned is probably in the next several months?

John Owen (Interim CEO and President)

Yeah, happy to talk about that. As you know, we really can't speculate or talk about rumors or selling parts of the business. What I can tell you, as part of our strategic planning process that we do every year, is to evaluate all of our businesses for returns and fit from a strategic standpoint. We do that as an annual process. We are going through that process as we speak. But again, that's something we do as part of our annual planning process.

Bill Carcache (Managing Director and Senior Equity Research Analyst of Financials)

Thank you for taking my questions. Appreciate it.

Operator (participant)

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

Ryan Nash (Managing Director and Equity Research of Financials)

Hey, good morning, guys.

John Greene (EVP and CFO)

Good morning, Ryan.

Ryan Nash (Managing Director and Equity Research of Financials)

So, you know, John, you reiterated the expense guidance for 2023, which is obviously a positive, and I'm sure you're going through the budgeting process right now. But I guess, based on what you know today regarding, you know, the consent order, the work that, you know, John Owen, that you referenced, you know, that, that you're doing, you've made substantial progress, plus overall inflation, any sense for, you know, what expense growth is going to look like into 2024? Or maybe just talk about some of the moving pieces that you expect to drive the expense base next year.

John Greene (EVP and CFO)

Sure. And, you know, I'm not going to be real specific on 2024. We're still in the process of building out the budget, and we're yet to share our recommendation with the board. But I can give you a general kind of direction of what we're seeing. So, the first point I think is important to put out there is that, you know, we continue to target our efficiency ratio to be below 40%. Now, that's over the medium term. Obviously, our execution this year with the revenue growth and even with substantial investments in compliance and in other areas of the business shows an efficiency ratio significantly below 40%. But over the midterm, that's something I think investors can expect.

The second piece that's important is that, despite a significant amount of investment in risk and compliance resources, we will continue to be disciplined in our allocation of expense dollars, and we're focused on making sure that the expense dollars that we do spend either help us with our compliance and risk management programs overall, or generate positive earnings potential for the firm. So they're the focal point. In terms of some of the things we continue to look at, we're looking at our facilities footprint. We expect to be able to continue to make some progress on that. Our third-party spend, we're scrutinizing significantly with the help of our procurement and vendor management teams.

And we're going to continue to look at resource levels to make sure they're appropriate for the environment and what we're trying to execute on. So, I hope that provides some context, Ryan, on how we're thinking about the expense base in the aggregate, and, you know, that'll translate into what we hope is a reasonably good set of expense and efficiency numbers into the future.

Ryan Nash (Managing Director and Equity Research of Financials)

Got it. No, thanks for the color in. Maybe the follow-up on some of Sanjay and Bill's questions. So if I think about the comments that you and John made regarding, you know, the trajectory of the 2022 vintage, you know, 2023 likely hasn't begun to season yet, inflation's weighing on consumers. Can you maybe just help us understand, you know, more broadly, just thinking about the, you know, how we should see the trajectory of delinquencies? Meaning, could we actually see, you know, the underperformance that we've experienced get worse as we sort of go through, you know, this next period of time, given that, you know, you do have this really big vintage that's coming through?

And any commentary on, you know, framing, you know, how much of this is seasoning, and how much of the delinquency performance is seasoning of the book versus actual underlying deterioration that you're seeing in the core customer base?

John Greene (EVP and CFO)

Yeah. Lots of parts there, Ryan. Let me start by kind of walking through what we're seeing in the portfolio. So we are seeing kind of differences in performance on customers that historically have been transactor versus revolver. So our revolver base, we're seeing a more significant decrease in sales activity, which makes sense, right? As they try to manage their household budget. We're seeing accounts that transacted in 2021, 2020, and 2022 beginning to revolve more. So the revolve rate is back to where we were historically. And the 2023 vintages, early indications are that it's performing very, very well. 2022 is performing well, but not as well as 2023.

So, you know, my expectation is that delinquencies will slow in the first half of 2024. If that doesn't happen, that's an indication that the stress that the consumers are seeing is more significant than what we're observing today.

Ryan Nash (Managing Director and Equity Research of Financials)

Thanks for all the color, John.

Operator (participant)

Thank you. Our next question will come from John Hecht with Jefferies. Your line is open.

John Hecht (Managing Director and Equity Research of Consumer Finance)

Hey, guys. Thanks very much. Actually, most of my questions, and, and in fact, just even the last question was exactly overlapping. So maybe I'll just quickly ask, you know, number one is, you know, maybe a quick update on kind of the competitive environment, you know, what kind of, you know, zero balance kind of transfer activity you're engaging in, and other kind of factors that you would tie to competition, as kind of the credit environment maybe migrates a little bit. And then, what are you guys on that front, what are you doing with respect to underwriting, to account for some of these changes that you're seeing as well?

John Greene (EVP and CFO)

Great. Yeah, I'll take that. So, you know, the environment continues to be competitive from a card origination standpoint. We are seeing less competition in kind of the lower FICO band. So remember, we're a prime revolver, so we're focused on prime customers, and the lower tier of our origination envelope is frankly less competitive. So, we're careful as we're looking at that, to make sure that those folks seeking credit are worthy of credit and not going to turn into a subsequent charge-off. The upper prime remains very, very competitive. The rewards competition, you can see it by the television ads, has certainly subsided significantly. So, the market's always competitive.

The competition varies among various FICO bands, and you know, we're going to continue to compete and generate, you know, positive new accounts, but we're also mindful of the credit situation.

John Hecht (Managing Director and Equity Research of Consumer Finance)

Great. Thank you, guys, very much.

Operator (participant)

Thank you. Our next question will come from Jeff Adelson with Morgan Stanley. Your line is open.

Jeff Adelson (Executive Director)

... Hey, good morning. Thanks for taking my questions. John Greene, just wanted to follow up on the commentary of peak losses. I think you mentioned sometime in mid to late 2024. I think last quarter, you talked about maybe this getting pushed into 2025. Is there a risk that maybe the peak kind of plateaus at or around those higher levels? Or do you think as your 2020 vintage kind of peaks out and starts moderating in size, the losses in delinquency should just naturally drift lower?

John Greene (EVP and CFO)

Yeah, I think it will peak. And then, upon its peak, I think it'll stabilize up there for a few quarters, maybe two to three quarters, and then we expect it to come down. You know, that's all subject to kind of the macro environment, obviously. But in terms of what we're seeing today, that's the expectation.

Jeff Adelson (Executive Director)

And then just on the sales volumes, I know they were pretty flattish this quarter. Just wondering, under the hood, what's going on there? Is this representative of maybe more of a slower growth in new accounts? Is maybe your same store customer still growing at a faster pace year-over-year? And then just maybe, thinking through the dynamic of faster network volumes, faster debit volumes, anything going on there that's driving your debit and network volumes to reaccelerate versus your proprietary card volumes to slow?

John Greene (EVP and CFO)

Yeah. So let me start with sales. So, you know, what we're seeing is, you know, a downward trend in sales. So if you go back to the fourth quarter of 2023, we're at about 10% year-over-year growth. First quarter, it was 8%, 2.5 in the second quarter, and about 1% here in the third quarter, and through mid October, about 1%. Interestingly enough, the dynamics are changing in terms of categories. So, online spend is up at around 4%-5%. Everyday spend is up about 3%. That's largely inflation driven, we believe.

Discretionary is flat to down, with the exception of entertainment expense or entertainment related categories, which is up north of 20%, which is hard for me to understand at this point, but we're trying to dig into the details. In terms of implications for next year, we're going to assume a relatively modest sales growth, maybe you know, slow in the lower single digits. The transactor revolver components of that, I mentioned that already. So more pullback on the revolver base. The other piece of your question is, oh, debit. Yeah, debit transactions.

We've had great execution from our Pulse business, so we've expanded a number of contractual arrangements, and also, debit choice routing has actually made a difference in the volume. So, you know, our Pulse team is executing well, and, you know, appears to be capturing some share.

Jeff Adelson (Executive Director)

Very great. Thanks for taking my questions.

John Greene (EVP and CFO)

You're welcome.

Operator (participant)

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

Rick Shane (Managing Director and Senior Equity Research Analyst)

Thanks, guys, for taking my questions this morning. Hey, look, you've cited a couple of things that are driving the increase in delinquencies. You've talked about seasoning and vintage. You've talked about some exposure to lower FICO scores within the cohort. At the same time, you guys are starting to apply a lot more machine learning to your portfolio and your process. I'm curious if you are identifying other factors that are contributing to the increase in delinquencies, whether it's age, demographic, geography. What might be other factors that are contributing to this in the context of strong labor markets? And then the follow-up to that is, with that information, can you then apply different servicing strategies to enhance that performance?

John Greene (EVP and CFO)

Yeah. Yeah, you're into the secret sauce of underwriting, Rick, but I'll give you a little bit of overview. So, you know, we spent a lot of time trying to revive or to update our models. And, you know, we looked at no exaggeration, probably 300 different risk identifiers or risk splitters. And what we did find is savings rates are important, household net worth is important... the amount of credit on us so on the credit report and Discover's balance sheet, as well as the amount of credit off continue to be really, really important.

And then also, there's some work being done on cash flow underwriting because of some of the off-bureau credit that we experienced or the whole market experienced in 2021 and 2022. So, you know, we're going to continue to look to refine our models and see what we can do to identify accounts that are going to be highly profitable and originate those. In terms of the second part of your question around servicing strategies, there's been a lot of work done on best time to contact, and we've got some machine learning models that are focused on that, as well as best channel to contact. So is it via phone, email, text, or other means?

All that work is ongoing, and frankly, it’ll never stop. It will be a continued refinement of the models so that we can collect effectively and originate profitably.

Rick Shane (Managing Director and Senior Equity Research Analyst)

Got it. Hey, John, it's very interesting and very helpful. Thank you.

Operator (participant)

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

Mihir Bhatia (Director and Senior Equity Research Analyst)

Good morning, and thank you for taking my questions. To start, I wanted to actually ask about personal loans. You're continuing to see some very healthy growth there. Can you talk a little bit more about some of the drivers? I think I know you mentioned a little bit of payment rate pullback, but what about from a competition standpoint? What's driving that? And then just related to that, to the comments you've been making about on the credit card side, wanted to understand if you're seeing any meaningful deterioration in credit there, anything on the vintage? Do the vintage comments apply here? Anything like we should be thinking about there? Are you tightening underwriting currently in that personal loan space, too? Yep, thanks.

John Greene (EVP and CFO)

Yeah. Thanks, Mihir. So, you know, our average ticket on a personal loan is significantly larger than many of our competitors. And the predominant share of the volume now is for debt consolidation efforts, and important to recognize that as part of our underwriting process, when there's a debt consolidation customer, somewhere between 70%-80% of the disbursement goes to the creditors to ensure that the overall cost of debt for that customer is lowered, and therefore, their ability to pay is high. So that's an important distinction. In terms of growth, what we've seen is, you know, a high level of demand, but also a reduction in the payment rate.

And that reduction in the payment rate has also been responsible for a very significant chunk of the growth that we've seen in the quarter. In terms of kind of the performance there, it is what I'll say returning to more historical performance metrics, but again, highly profitable and you can see from the report or from the details in terms of delinquency rates, they've remained you know very very low relative to historical standards.

Mihir Bhatia (Director and Senior Equity Research Analyst)

Okay. That's helpful. Thank you. Maybe if I could just turn back a little for a second to the compliance issue question and the timing, et cetera. It sounds like from what you're saying, related to the merchant mispricing issue, the outside law firm has completed the investigation. You've discussed results with regulators already. So I think a lot of what a lot of people are just trying to understand is what needs to happen for the buyback to resume? I understand it's difficult to put a specific date out there, but is the overall message, it's going to take several quarters for those to resume? Maybe just help us understand what needs to happen here for you to get comfortable.

Again, like, I understand you don't want to put a specific time frame, but is the right message like it's going to be several quarters more? Thanks.

John Greene (EVP and CFO)

Yeah. So, no specific timing on the resumption. So, what we want to do is have, you know, further dialogue with our merchants to ensure we're progressing the remediation and the negotiations. We also continue to have discussions with our regulatory agencies, and we're looking to progress those. And we're also reviewing our capital positions, right? There's a number of pulls on capital this year. Certainly, the phenomenal loan growth that we've seen. We've got the Basel Endgame that's on the horizon. We have the CECL phase in also impacting capital levels. So, you know, we're gonna take a look at the profitability for 2024.

Take a look at the progress we're making on the card tiering issue and overall risk and governance items, and make a recommendation to the board. So I'll say my key summary here is that our capital priorities haven't changed. We're, you know, we're focused on generating positive earnings to be able to invest in the business and return excess capital to shareholders. You know, our margin rates remain robust. Our return on equity, you know, this quarter and for the year, remains really, really strong. So it's a matter of just making sure we've got the right balance between investing and return of capital.

John Hecht (Managing Director and Equity Research of Consumer Finance)

Okay. Thank you.

Operator (participant)

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

Bob Napoli (Senior Director)

Thank you. Follow up on return on equity. One of the questions we get, I mean, obviously, Discover's reported very strong ROE for a very long time. With the changes in regulations and potential capital changes, what are your thoughts on Discover being able to generate the types of return on equity that we've seen over the last 15 years or so?

John Greene (EVP and CFO)

Yeah. You know, certainly, you know, relative to kind of history and then going forward, a couple important points. So we have, we have operated with capital well above our operating target for the better part of, I don't know, at least as long as I've been here, four years now. And, you know, we are approaching the 10.5% target. I will, I will say that our, overall capital position does, does remain very, very strong, right? So regulatory minimums, 4.5%, the SCB, 2.5. So the required capital, 7%, and we're at, eleven point six percent here on CET1, for the quarter.

So, you know, my expectation is we're gonna manage the business to continue to generate high returns and deliver a high level of return on equity overall, and be able to invest in the business and return excess capital to shareholders. So, you know, as we go out three to five years, it's you know, a bit challenging to predict a regulatory regime and you know, the expectations for institutions such as ours in terms of overall capital levels. But, you know, we're well positioned to generate positive capital and return capital.

Bob Napoli (Senior Director)

Thank you. I appreciate that. And then, just, on, like, the overall, the long-term growth of your business, your core customer, the TAM of your business, and, the ability for Discover to grow, I mean, I think historically, you know, high single digit kind of loan growth, is, you know, and spending growth. What are your thoughts? Is the ability to grow at those types of rates what we should continue to expect? And how does the Cashback Debit product maybe, you know, affect, you know, that growth?

John Greene (EVP and CFO)

Yeah, I mean, certainly our expectation is to continue to grow at least in line with kind of the historical norms. The Cashback Debit product, we actually think has a lot of power behind it. So the features of the product itself are super, right? So 1%-1% cash back on debit transactions. You know, we have a positive kind of business impact from our ability to capture interchange on those transactions, so that's positive. And then it's a whole new customer outlet for us.

So, you know, executed well, it'll bring in a new cohort of customers that, you know, we can then underwrite and cross-sell to, and further help the customer experience in terms of meeting additional banking needs and turn that checking product into a credit card relationship or perhaps a personal loan down the road. So we're super excited about it.

Bob Napoli (Senior Director)

Thank you.

Operator (participant)

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

Kevin Barker (Managing Director and Senior Equity Research Analyst)

I just wanted to follow up on, you know, some of the spending on tech, in particular in the info processing line. Could you provide a little more detail on some of the projects that you have in place and whether you expect those to be ongoing, or are there additional projects that you anticipate, particularly around tech investment and other investments that you're making within the franchise? Thank you.

John Greene (EVP and CFO)

Yeah. So, you know, we're a digital institution, so the first piece is, yeah, we're gonna continue to invest in tech and advanced analytics to kind of help the customer experience and then also help us to generate positive returns. Some of the specific projects that we're working on: so we've got a number of advanced analytics programs around collections and around originations in order to be able to kind of service the customers well and then target the right sort of customers. We also did a bunch of work last year and into this year in terms of improving the closure rate of leads from a lead into a funded customer, whether it was a savings or credit customer.

You know, this year, you know, we're investing heavily in our risk and compliance systems, so certainly there's tech spend going on there. We also have tech spend related to our on-prem servers and moving to a hybrid and cloud environment. That's certainly a significant spend. And then also, given the risk and compliance issues that we've seen historically, we're spending a lot of time taking a look at how our core systems work, the data that goes in, and the data that comes out, and what we do with the data, and looking to kind of reduce the amount of manual touches to that data.

All of that is, you know, part of the reason, you know, or the reasons why we're seeing an information processing and tech spend overall increase this year.

John Owen (Interim CEO and President)

Two other areas I would call out. Around our fraud detection, we continue to invest heavily in our fraud detection. That's an ongoing battle every quarter, but we've made significant investments in fraud and continue to push on that area. The second thing around our digital capabilities as a digital bank. We've got a very easy-to-use system, easy application process, very easy for customers to open up our Cashback Debit. And so we spend a lot of time and effort in customer flows and customer engagement, and how we onboard customers in a more seamless manner.

Kevin Barker (Managing Director and Senior Equity Research Analyst)

Thank you for all that detail. And just to follow up on, you know, your investment on, you know, enhancing recovery rates. Have you seen any particular shift in the recovery rates you have today, or where they're trending relative to past cycles?

John Greene (EVP and CFO)

No specific changes to recovery rates. We are seeing more customers seek credit assistance and negotiate settlements. There seems to be a cottage industry developing around that. And that's... Back in, I think it was the month of July, we saw a chunk of charge-offs come through as a result of settlements from these institutions. But overall recovery rates remain strong. The pool of charge-offs to be able to capture recoveries from obviously is increasing as the charge-offs increase. So, you know, that's actually part of our how we take a look at overall credit and reserving.

Kevin Barker (Managing Director and Senior Equity Research Analyst)

Thank you, John.

John Greene (EVP and CFO)

You're welcome.

Operator (participant)

Thank you. Our next question will come from Erika Najarian with UBS. Your line is open.

Nick Rocco (Analyst)

Hi, good morning. This is Nick Rocco on for Erika. Thanks for taking our questions. Most of them have been answered, but just wanted to follow up with one question on loan growth. So obviously, card growth remains really robust, and you raised your guidance to mid-teens for the year. And I'm just wondering, given the comments on the stress in the lower and mid FICO scores, and then, then the, the delinquency trends, and then your comments that the revolve rate has really normalized, I'm wondering if you can help us with which parts of the FICO band in your portfolio are driving the loan growth, and, whether you're seeing any outsized contribution from those on the lower end?

John Greene (EVP and CFO)

Yeah. So, now what we're seeing is kind of loan build driven by two factors. So it's somewhere between 30%-40% of the build is, or the loan growth is from new accounts, and then the remainder is coming from payment rate normalization. So we're seeing kind of portfolio customers increasing their balances. So and that normalization of payment rate is pretty consistent on the upper bands to the call it the midpoint to the top two-thirds of the portfolio. The bottom third, the payment rate normalized last year. And you know, we're seeing that at pretty close to historical levels, maybe a mild deterioration from that.

Nick Rocco (Analyst)

Got it. Thank you for taking my question.

Operator (participant)

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

Dominick Gabriele (Executive Director and Senior Analyst of Equity Research)

Hey, thanks so much. Something sort of related to that. So if we just think about the year-over-year spending growth, roughly 1%, I guess, what was the year-over-year growth in the number of cards or, or new accounts? And also, what was the—and just added to that, what is the benefit that Discover saw to spending in the quarter related to gas on the growth? And then I just have a follow-up for next.

John Greene (EVP and CFO)

Yeah. So, you know, we grew, and we made public comments on this. In 2022, we grew accounts about 20% overall. This year, as we've taken a look at kind of the credit performance, we're on pace to kind of originate about the same number of overall accounts. So the growth in terms of new accounts will be relatively flat, but the new account generation will be pretty consistent year-over-year. You know, that could change if we pare back credit here in the fourth quarter into next year. In terms of gas, that was interesting. So, gas was up 1% in the quarter. It was also 5% category.

When you adjust for kind of the deflationary impact, the usage there was, or at least through our card, was up over 10%.

Dominick Gabriele (Executive Director and Senior Analyst of Equity Research)

Okay, great. And then, you know, obviously you have a lot of student loans. You're one of the major players. We have the moratorium ending. I know that that doesn't affect you directly, perhaps in your own loans, because they're private loans. But what are you seeing in the data that you're watching of how this is might be affecting either payment rates or demand for private loans or, you know, refinancings? Anything you can provide, as far as how this affects the consumer that you're seeing in your data, you know, only in 19 days or whatever, but anything you can provide, would be really helpful. Thank you.

John Greene (EVP and CFO)

Yeah. So, so we're not seeing anything in our data yet whatsoever. We did, actually, a couple of quarters ago, quantify what we thought the impact could be to our portfolio in terms of charge-offs. And as it turns out, based on the executive order direction in terms of kind of the repayment, structure that the Biden administration is putting in place and making kind of payments levels, associated or tied to income levels, we expect the impact on our portfolio to be, de minimis. Now, we'll see how it all plays out legislatively, but, we're not expecting a significant impact, certainly this year.

And, you know, we'll evaluate to see what happens and take a look at our data to make a determination if it is gonna have an adverse impact on our charge-offs. But today, nothing.

Dominick Gabriele (Executive Director and Senior Analyst of Equity Research)

Got it. Thank you.

John Greene (EVP and CFO)

You're welcome, Dominick.

Operator (participant)

This concludes the Q&A portion of the call, and I'd now like to turn the floor back over to Eric Wasserstrom for any additional or closing remarks.

Eric Wasserstrom (Head of Investor Relations)

Well, thank you very much for joining us this morning. If you have any additional questions, please reach out to the IR team, and we look forward to hearing from you. Thanks very much. Take care.

Operator (participant)

Thank you, ladies and gentlemen. This concludes today's program, and we appreciate your participation. You may disconnect at any time.