Capital One Financial Corporation

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Good day, and thank you for standing by. Welcome to the third quarter 2022 Capital One Financial Earnings Conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you'll need to press star 1-1 on your telephone. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Jeff Norris, Senior Vice President, Finance. Please go ahead.

Thank you very much, Liz, and welcome everyone to Capital One's third quarter 2022 earnings conference call. As usual, we are webcasting live over the internet. To access the call on the internet, please log on to Capital One's website at CapitalOne.com and follow the links from there. In addition to the press release and financials, we have included a presentation summarizing our third quarter 2022 results. With me this evening are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer, and Mr. Andrew Young, Capital One's Chief Financial Officer. Rich and Andrew are going to walk you through this presentation. To access a copy of the presentation and press release, please go to Capital One's website, click on Investors, then click on Quarterly Earnings Release. Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any key forward-looking statements contained in today's discussion and the materials speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events, or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. For more information on these factors, please see the section titled Forward-Looking Information in the earnings release presentation and the Risk Factors section in our annual and quarterly reports, accessible at the Capital One website and filed with the SEC. Now I'll turn the call over to Andrew.

Thanks, Jeff, and good afternoon, everyone. I'll start on slide three of tonight's presentation. In the second quarter, Capital One earned $1.7 billion, or $4.20 per diluted common share. On a linked quarter basis, period end loans grew 3% and average loans grew 5%. largely driven by growth across our domestic card and commercial businesses. In the linked quarter, revenue increased 7%, largely driven by growth in net interest income. The loan growth I just described and NIM expansion both contributed to the increase in net interest income. I will touch on the NIM more in a moment. Non-interest expense grew 8% in the quarter, driven by an increase in operating expenses. Higher headcount and the associated compensation costs were the single biggest driver of the linked quarter increase. In addition to compensation expenses, the collective impact of a number of smaller items also drove up Q3 expenses. Provision expense in the quarter was $1.7 billion, driven by net charge-offs of $931 million and a $734 million allowance bill. Turning to slide four, I will cover the changes in our allowance in greater detail. The total company's $734 million allowance bill in the quarter brings our allowance balance up to $12.2 billion as of September 30th. Our total company coverage ratio increased 14 basis points to 4.02%. Turning to slide five, I'll discuss the allowance and coverage across each of our business segments. As you can see in the graph, our allowance coverage ratio increased modestly in each of our segments. In our domestic card business, The allowance balance increased $530 million, bringing our coverage ratio to 6.9%. The $6 billion of loan growth in the quarter drove the majority of the allowance build. The impact of continued normalization and a modestly worse corporate economic outlook were partially offset by the release of a portion of our qualitative factors linked to uncertainty in the economy. In our consumer banking segment, the allowance balance increased by $61 million, driving a nine basis point increase in coverage to 2.6%. The modestly worse corporate economic outlook I just mentioned and expectations of credit normalization drove the allowance build. And finally, the allowance increased by $107 million in our commercial business. resulting in a nine basis point increase in coverage to 1.45%. A combination of the modestly worsening corporate economic outlook, an uptick in criticized loans, and loan growth drove the allowance build. Turning to page six, I'll discuss liquidity. You can see our preliminary average liquidity coverage ratio during the third quarter was 139%, well above the 100% regulatory requirement. Total liquidity reserves were roughly flat at about $93 billion, as our liquidity reserves have largely normalized to pre-pandemic levels. Our securities portfolio declined by about $8 billion, driven by a combination of the decline in market value from rising rates and the continued plan runoff of the outsized portfolio we built during the pandemic. The decrease in our securities portfolio was primarily offset by higher cash and cash equivalents. Turning to page seven, I'll cover our net interest margin. Net interest income in the quarter was $7 billion, up 14% from the year-ago quarter, and up 7% from last quarter. Our net interest margin was 6.8% in the third quarter, 45 basis points higher than the year-ago quarter, and 26 basis points higher than last quarter. The 26 basis point linked quarter increase in NIM was driven roughly equally by three factors. First, an extra day to recognize income in the quarter. Second, a continued balance sheet shift towards card away from lower yielding assets. And third, the net benefit of the higher yield of assets relative to higher funding costs. Turning to slide eight, I will end by discussing our capital position. Our preliminary common equity tier one capital ratio was 12.2% at the end of the third quarter. up about 10 basis points relative to last quarter. The $1.7 billion of net income in the quarter was mostly offset by growth in risk-weighted assets, dividends, and a little over $300 million in share repurchases. We continue to estimate that our longer-term CEP1 capital need is around 11%. And with that, I will turn the call over to Rich. Rich?

Thanks, Andrew, and good evening, everyone. I'll begin on slide 10 with third quarter results in our credit card business. Year-over-year growth in purchase volume and loans, coupled with strong revenue margin, drove an increase in revenue compared to the third quarter of 2021. Credit card segment results are largely a function of our domestic card results and trends, which are shown on slide 11. In the third quarter, strong year-over-year growth in every top line metric continued in our domestic card business. Purchase volume for the third quarter was up 16% year-over-year and up 47% compared to the third quarter of 2019. Ending loan balances increased $22 billion or about 22% year-over-year. Ending loans grew 5% from the sequential quarter. And revenue was up 21% year over year, driven by the growth in purchase volume and loans, as well as strong revenue margin. Strong credit results continued in the quarter. Both the charge-off rate and the delinquency rate are well below pre-pandemic levels and continue to normalize. The domestic card charge-off rate for the quarter was 2.2%, up 84 basis points year over year. The 30 plus delinquency rate at quarter end was 2.97%, 104 basis points above the prior year. On a length quarter basis, the charge off rate was down six basis points. The delinquency rate was up 62 basis points from the length quarter. Non-interest expense was up 28% from the third quarter of 2021. including an increase in marketing. Total company marketing expense was $978 million in the quarter. Our choices in domestic card marketing are the biggest driver of total company marketing trends. In our domestic card business, we continue to lean into marketing to drive resilient growth. We're keeping a close eye on competitor actions and potential marketplace risk. we're seeing the success of our marketing and strong growth in purchase volume, new accounts, and loans across our domestic card business. And strong momentum in our decade-long focus on heavy spenders continued in the third quarter. Heavy spender marketing includes early spend bonuses driven by continued strong account growth and spending, as well as investments in franchise enhancements like our travel portal, and airport lounges. In the third quarter, our marketing continued to drive strong growth in heavy spender accounts and strong engagement and spend behaviors with both new and existing customers. Our decade-long quest to build our heavy spender franchise has brought with it significantly increased levels of marketing, but the sustained revenue, credit, resilience, and capital benefits of this enduring franchise are compelling, and they're growing. Slide 12 shows third quarter results for our consumer banking business. In the third quarter, we continued to pull back on growth in auto in response to competitive pricing dynamics. Many auto lenders appear to have reflected rising interest rates in their marginal pricing decisions. but others have not, and they have gained market share and pressured industry margins. We chose to pull back on auto originations, which declined 28% year over year and 20% from the linked quarter. Driven by the decline in originations, consumer banking loan growth is slower than previous quarters. Third quarter ending loans grew 5% to the year-ago quarter, on a linked quarter basis, ending loans were essentially flat. Third quarter ending deposits in the consumer bank were up 2% year over year. Consumer banking deposits were flat compared to the sequential quarter. Consumer banking revenue was up 7% year over year as growth in auto loans was partially offset by the year over year decline in auto margins and the effects of our decision to completely eliminate overdraft fees. Non-interest expense was up 13% compared to the third quarter of 2021, driven by continuing investments in the digital capabilities of our auto and retail banking businesses and the increased marketing for our digital national bank. The auto charge-off rate and delinquency rate continued to normalize in the third quarter. The charge-off rate for the third quarter was 1.8%. 0.05%, up 87 basis points year-over-year. The 30-plus delinquency rate was 4.85%, up 120 basis points year-over-year. On a linked quarter basis, the charge-off rate was up 44 basis points, and the 30-plus delinquency rate was up 38 basis points. Slide 13. shows third quarter results for our commercial banking business. Third quarter ending loan balances were up 2% from the sequential quarter, driven by growth in selected industry specialties. Average loans were up 7% in the quarter. Ending deposits were up 6% from the second quarter. Average deposits were down 2% in the quarter. Third quarter revenue was up 12% from the linked quarter. Non-interest expense was also up 12%. Commercial banking credit remained strong in the third quarter. The commercial banking annualized charge-off rate was 5 basis points. The criticized performing loan rate was 5.97%, and the criticized non-performing loan rate was 0.57%. In closing, we continued to drive strong growth in card revenue, purchase volume, and loans in the third quarter. Loan growth in our consumer banking business was slower compared to previous quarters as we pulled back on auto originations, and our commercial banking business posted another quarter of strong revenue growth. Credit results remain strong across our businesses. Charge-off rates and delinquency rates are below pre-pandemic levels, and credit continues to normalize. We typically see an increase in operating expense over the second half of the year, of any year. This year, the timing of some of our investment opportunities drove a larger than usual third quarter increase in operating expense, which was up 11% from the second quarter. we expect that this year's length quarter increase in fourth quarter operating expense will be smaller than the approximately 7% length quarter increase we've seen on average over the last five years. Turning to operating efficiency ratio, relative to full year 2021, we expect annual operating efficiency ratio to be roughly flat in 2022 and modestly down in 2023. As usual, our operating expense and efficiency expectations exclude any potential adjusting items. Pulling way up, we're in a strong position to deliver compelling long-term shareholder value as modern digital technology continues to transform banking. We continue to see opportunities to lean into marketing and resilient asset growth that can deliver sustained revenue annuities. Our growth opportunities are enhanced by our digital transformation. We continue to closely monitor and assess competitive dynamics and economic uncertainty. Powered by our modern digital technology, we're continuously improving our proprietary underwriting, marketing, and product capabilities. And we're managing capital prudently to put ourselves in a position to thrive in a broad range of possible economic scenarios. And now we'll be happy to answer your questions. Jeff?

Thank you, Rich. We'll now start the Q&A session. Remember, as a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to one question plus a single follow-up. If you have additional follow-up questions after the Q&A session, the investor relations team will be available after the call. Liz, please start the Q&A.

As a reminder, if you'd like to ask a question at this time, please press star 1 1 on your telephone. Our first question comes from a line of Kevin Barker with Piper Sandler. Your line is now open.

Thanks for taking my questions. I appreciate the comments around credit and how we're still in a normalization. back to pre-pandemic levels, particularly in some key asset classes. But at what point do you say that the year-over-year growth rate and delinquency rates is too fast relative to what you would expect for a typical normalization?

Yeah, Kevin, so thank you for your question. Yeah. Let me just pull up and just comment on normalization. You know, first of all, the context of where we are, because consumer credit remains strong, as you can see from the metrics. And, you know, our domestic card losses in the third quarter were about half of free pandemic levels. And our delinquencies are, and we've often said this, unmistakably normalizing. but right now they remain about 20% below pre-pandemic level. There's not a certain point where we would, you know, we don't look out there and say if the rate of growth of delinquencies exceeds a certain number, then we will pull back. But let me comment, first of all, that we've said for a long time, Kevin, and I know you know this, that normalization is bound to happen. It would be shocking if it didn't happen. And we've been talking for a bunch of quarters now saying it started, you started, you needed a magnifying glass to see it. And we talked about that. And now of course you can see it in the numbers and it's, you know, definitely normalizing. What the, the rate at which it's normalizing is, is, frankly, more gradual than we generally expected, but we didn't really have a roadmap to know exactly what pace it would normalize. We just had believed so strongly that it would. So what we do with, you know, rather than say there's a certain number that would lead us to make a certain decision, we, of course, look at this as, you know, with what's happening with every segment and micro segment of our business and how it's performing. We look for starters at the back book, and that is normalizing as, you know, as, well, frankly, like everything here, more gradually than expected. But still, the back book is clearly normalizing as well. We then look for other patterns of normalization. And here are some of the patterns that we see, Kevin. It's more pronounced in the front book of new originations than in the existing back book. And by the way, that would be shocking if it weren't the case, because 100% of the time in our history, front books normalize faster during periods of change. And we, you know, so that's But we confirm again that front books are normalizing faster. It also seems that normalization is more pronounced at the lower end of the market. And, of course, those are the populations that improved more and more quickly earlier in the pandemic. You know, lower income consumers, may also be feeling more pressure from inflation, so these trends shouldn't be surprising. But at kind of a high level, what we see is very normal and basically the way we're leaning into the marketplace is very consistent with what we've been saying for a bunch of quarters now. But what we do at the micro level at the segment level and the sub-segment level is look at the various metrics both on the back book and on the front book to see what the patterns are and we're comfortable with what we see in terms of front book vintage curves as a general point and across a vast majority of all the segments that we operate in. We have around the edges, we've done a little bit of dialing back in particular pockets where metrics are normalizing a little bit faster. We also sort of pull up and say, what are the risks that we would expect to see at a time like this with orthogonal looks through our book? We brainstorm on what all the risks we could see. We go hunt for them. In a couple of places, we have seen effects that cause a little bit of trimming around the edges, but the collective amount of trimming in the card business is pretty small relative to the overall scale of our growth. As you know, the In the auto business, we have pulled back. At the very same time we're leaning into the card business, we're pulling back in the auto business. But maybe I'll save that for another question.

Okay. And then just to follow up, I mean, is there anything – I appreciate the look at the granular side of the business and what you see within your book on a very micro level. But from a macro level, is there anything that you'd look at that would – make you pull back that may not be apparent at the micro level. In particular, I think you made some prepared remarks about changes in the corporate outlook in particular. Thank you.

Sorry, changes in the corporate... Can you repeat that last part, changes in corporate outlook?

I believe in your prepared remarks you said there was changes in the corporate outlook that may have affected... part of your allowance? Was there anything in particular that stood out that may cause you to pull back when you think about the macroeconomic outlook?

Well, we, of course, at the whole time we're doing the microexamination one segment at a time, we are looking at the macro trends. It's really striking the level of inflation that And as I've often said, you know, we collectively, you know, everybody on this call, you know, none of us and, you know, nobody across the business world has really lived something like this since the, you know, the early 80s. So we're especially looking for effects that might be different this time, Kevin, with respect to inflation and how that can play out. So we're always on the lookout, but the net impression I would want to leave here is very much the same impression that I've left with you the last many quarters here.

Next question, please.

Our next question comes from Ryan Nash with Goldman Sachs. Your line is now open.

Hey, good evening, everyone.

Hey, Ryan.

Hey, Ryan. So maybe just to start on the cost and efficiency side, Rich, so it's good to hear that you'll be back on the efficiency improvement journey next year. So I guess just a two-part question. You know, you talked about OPEX ramping less in the fourth quarter, but just given the level of marketing spend and how the spend has shifted under the hood in terms of moving up markets, Should we expect to see less than historical seasonality on the marketing side? And then second, just, you know, can you help us with the magnitude of the efficiency improvement into next year and what is actually driving the improvement? Is it a pulling back on hiring or something else? Thanks.

So I don't think we're here to declare a – you know, I want to – make a comment about, about marketing seasonality. It's, it's not as, that's not as much of a physics kind of thing as, as certain things like, you know, credit and delinquency seasonality with consumers. You know, I, I think, so I'm not here to declare, you you know, changes in the pattern of seasonality in marketing. The big driver of our marketing is the opportunities that we see as well as the investment in building businesses like our, you know, heavy spender business and our national bank. With respect to the drivers of operating efficiency improvement, You know, just kind of pulling up on the journey that you mentioned, you know, we've been focused about this and talking with investors about operating efficiency for years, and we've achieved a 440 basis point improvement from 2013 through 2021, even as we have invested in a comprehensive transformation of our technology over that same period of time. And we know that investing in technology modernization and driving for efficiency improvements are on a shared path. Technology investment helps our revenue growth and helps drive productivity improvements. And beneath the surface of the high level of investment has been significant productivity gains from modernizing our tech stack, eliminating legacy vendor costs, driving customers to digital, and driving more automation in the company. And at the same time, of course, we have continued to lean into this technology journey and the opportunities that it generates. And so it's a very shared path, and I think that... Our guidance for modest improvement in 2023 is a reflection of continued traction in growth and operating productivity while also continuing to invest in future opportunities.

Got it. I guess as a follow-up question, maybe one for Andrew. Andrew, you laid out the details of some of the drivers as it pertains to that interest margin. Fully understand that there's a seasonal component to it in 3Q, but Can you maybe just talk about the positioning of the balance sheet from a rate perspective? Do you think that you can continue to see the margin drift higher and maybe just talk about some of the drivers as you look out over the course of the next couple of quarters during the rising rate cycle? Thanks.

Sure, Ryan. You know, recall it's probably helpful to start with a little bit of history here. And, you know, you'll recall our NIM was compressed last during the pandemic, largely driven by a balance sheet that was skewed much more towards cash and securities than card loans. And as we progressed over the course of the pandemic, you saw that begin to normalize. And so just by way of evidence, a year ago, our NIM was I think 635 I'd said in my prepared remarks and at that point card was closer to 27%. I think of our interest earning assets and cash and securities was something like 33. Cards now shifted to be just over 30% and cash and securities are down to 27%. So I share that to say we're now operating, you know, much closer to our pre-pandemic balance sheet mix. And our NIM is roughly in a similar spot to where it was before the pandemic. So to your question then about rate risk, you can see in our queue, you know, our rate risk disclosures were really only slightly asset sensitive at this point. And, you know, keep in mind that's relative to forwards. So the 150 basis point projected moves over the next couple of months, you know, are already sort of embedded in that neutral baseline. And so as I think about, you know, the future, there's a number of things that can impact NIM, you know, not to mention seasonality, but the credit impacts on revenue and competitive pressure on, you know, loan margins and deposit pricing. But, you know, as we sit here today, you know, I think a lot of the things that we pointed to in the past in terms of balance sheet mix at least have largely run their course. So hopefully this gives you, you know, some sense of the primary forces at play with NIM.

Next question, please. Our next question comes from Betsy Gracek with Morgan Stanley. Your line is now open. Hi. Good evening.

Hi, Betsy. Hey, Betsy.

Okay, just to follow up on that for the follow-up question, so now that you're back to the pre-pandemic mix of liquidity and loans, how should we think about where the balance sheet projects from here in terms of funding mix and funding stack? And maybe you could speak a little bit to your thoughts on the buyback, because I noticed this quarter it was down a bit, $313 million down a bit from the prior two quarters, which averaged about $2 billion. So if you could help us understand how you're going to be funding the loan growth and what kind of mix we should be expecting should liquidity go down even more than what it was pre-pandemic. Thanks.

Okay, I'll take I think what I heard is the first two questions there, Betsy, in NIM and funding, and then I'll turn it over to Rich to talk about buyback. So on the NIM side and, you know, the asset portion of that, I just want to clarify, you know, what will drive it from here. I do think if you look back historically, cash and securities were roughly 25% of our balance sheet. We're a little bit above that, but given our needs for liquidity and how we use the investment portfolio, I would think that something in that 25% range of the size of the balance sheet is a reasonable assumption for that. Then on the loan side, it really becomes a matter of just marketplace dynamics, what we see as opportunities for growth. And so whether card is growing more quickly than, say, auto or commercial, its percentage of the rest of the balance sheet could drift up. But I don't want to give any indication of how we think that's playing out, and there's certainly not a target that we have in terms of the, you know, the asset side of the balance sheet. On the funding side, you know, we aim to have a diversified mix of of funding that's largely skewed to retail deposits, which again, historically has been something I think around 70% of our overall all funding. And we have commercial deposits and brokered CDs and then securitization and wholesale funding other sources of wholesale funding. And so again, I would say if you look back to pre-pandemic levels over history compared to where we are today, we're kind of back in a relatively similar place there. So I think I heard in your question, not just mixed, but how do we fund growth from here in making marginal decisions for funding incremental loan growth? We're going to weigh a variety of factors, our customers' appetite for different deposit products and our ability to build customer relationships with them, the economics of different funding instruments, the duration of funding, our liquidity needs. So we're going to throw all of that into our decision-making process to figure out how to fund those. But I also think it's important to think about those funding choices at the margin. It's not just about the liability side. We also have asset growth choices at the margin too. So we're just going to look at the total integrated economics of both sides of the balance sheet to make those choices. And I'll hand it over to Rich to talk about buybacks.

Thanks, Andrew. Betsy, we So with the question, with respect to why did you slow down your share repurchase pace this quarter, so we repurchased roughly $300 million of shares during the third quarter. About a year and a half ago, we had a CET1 in the high 14s. Since then, we've been repurchasing shares, and our CET1 ratio has come down into the low 12s. And the pace of our repurchases is, of course, driven by a number of factors, including our actual and forecasted capital, earnings, of course, growth, economic conditions, market dynamics. And at this point, there remains, you know, some pretty sizable error bars around some of these factors, particularly growth and economic uncertainty. And so it's not lost on us at times like this. It's prudent risk management to be conservative with our capital actions. And, you know, this is a very dynamic process, and under the new SCB rules, we're able to maintain flexibility in our capital decisions.

Next question, please.

Our next question comes from Sanjay Sakrani with KBW. Your line is now open.

Thanks. Rich, you mentioned you're keeping an eye on your competitors. I'm just wondering if you could just drill down a little bit on that, given you've had a lot of fintechs in this space growing, and obviously it's a very unpredictable next 12 to 18 months. Maybe you could just talk about domestic card and auto as well, because you mentioned a number of different variables there.

Thanks. Sanjay, did you want me to talk about competition in those spaces, or is it a competition-driven question?

I guess competition, but also how it might have an impact on credit as we look forward, because you've had some new players underwriting as well.

Right. So the Let's talk about competition in the card business, and then I'll talk about it in the auto business. But generally in the card business, competition continues to be, you know, high, but largely stable and rational over the past decade. few quarters. Now, here I'm really talking about the major, you know, the banking industry, the classic competitive set within the card business. But, you know, we certainly have seen marketing levels that have returned to really beyond pre-pandemic levels. So we certainly have an eye on that. You know, on the rewards competition side, there's Here or there, there are new things that people come out with, but there's generally a stability in that space on APRs in the card business. The issuers have generally adjusted headline rates along with the change in the prime rate, so there's kind of a stability in the margins there. Again, we see a pretty stable, competitive environment among major card players. The thing that we've mentioned a number of times is concern about the fintechs and their impact on a business like the card business, less so by the fintechs actually running around issuing credit cards, but more by the impact from other credit products like installment loans, buy now, pay later loans, and others that can affect the portfolio of borrowing that our customers, current and prospective customers, might have. So we were pretty concerned, and we've talked about it a number of times, about the rapidly growing extent of FinTech credit extension, compounded by the fact no one could measure the size of it because many of these folks, like many of the Buy Now, Pay Later players, for example, not reporting to the credit bureaus. The other thing that caught our eye, of course, all along the way here is virtually every FinTech that enters lending enters in the lower side of the market. There's virtually no one that enters, you know, right at the heavy spender side of the market. They just don't have the scale for those thin margin businesses. And so the fintech excesses to the extent that they're there, you know, were logically and inferentially from what we see would be more in the lower end of the market. And that, of course, is something we watch pretty carefully to the best extent that we can see it. Now, one thing that just intuitively is a helpful thing to the cause here is that fintechs have generally struggled. They seem to have dialed back quite a bit. So there may be less pressure in that particular space. But Another thing to keep our eye out for here is it's not just the amount of volume of marketing or the intensity of competition, it's the underwriting choices that folks make. Another thing that, Sanjay, that we have had our eye on is basically FICO drift and you know, you can absolutely see out there the reduction in the size of the subprime population. Now, we can all ask ourselves, is that really, you know, just great news that the size of subprime America has declined? Or how much is that a you know, a shorter-term impact from all the stimulus, the forbearance, the spending pullbacks and things that happened during the pandemic. So we ourselves do our best to try to normalize for those effects in our underwriting. And so where I would put is to say I think the competitive risks that exist and that we have seen out there are more in the lower end of the marketplace, even with credit cards themselves. If you look at the data, there's been the highest, you know, there's been more growth in the lower end of the market in terms of just credit card customers than anywhere else. All of this is something we're watching incredibly carefully. And to the earlier question that was asked about how do we do underwriting, we, of course, do everything we can to look at every segment and to look for any changes that we're seeing ultimately in our own performance. We've trimmed around the edges in a few places, but overall, So far it looks pretty good, but partly how we do this, we don't just run around and just let the numbers do the talking. We do a combination of using actually, you know, machine learning monitoring-based methodologies to look for early signs of things being off of expectation within our portfolio. And then at the same time, broad strategic logic on what would you expect to happen from this competitive environment, from this credit environment, from this inflationary environment. So that's a window into that side of the business. On the auto side of the business, the competition, our issue with the competition is really not an underwriting issue at this point. The general risks that we talked about just a couple minutes ago exist in that space as well on the credit side. But the elephant in the room is really the pricing of auto loans at this point by a number of players. And while that is not directly a credit concern, it lowers the You know, it lowers the margin in the business. It lowers the buffer of resilience and so on. And we manage very carefully to trying to keep a maximum amount of resilience in downturns and, you know, lower margins lead us to, you know, pull back on the, you know, least resilient parts of the business.

Next question, please.

Our next question comes from Moshe Ornluck with Credit Suisse. Your line is now open.

Thanks. Rich, you had an earlier question about kind of the change in delinquency rates. And I'm just, I'm wondering whether if you think that this cycle, there will be a different, any sort of different relationship in your two major businesses, you know, in card and auto, between the loss rate and delinquency rate, better or worse relationship? as we go through the next 18 months or so of credit normalization.

Well, Moshe, as usual, that's a very insightful question. Let me just comment a little bit on just a little bit of a calibration of how we think about credit in the card and auto businesses. The The first point would be it's normalizing in both places, but overall credit has been strong in both our card and our auto business. But there are three effects that are driving faster normalization of auto losses than of card losses overall. And the first is that normalization tends to be more pronounced in the front book of new originations. That's a universal thing that applies across our consumer businesses. But because the front book in auto, the front book replaces the portfolio much more quickly than in card, overall portfolio losses should normalize more quickly in the auto business. The second is is that recovery rates are much higher in auto than in card. Now, recoveries tend to be lagged relative to charge-offs. So some of the exceptionally strong performance we saw in auto, including the quarter where we actually had negative charge-offs, that was boosted by higher recoveries from earlier charge-offs. Now that we've seen low charge-offs for an extended period in auto, the raw material for future recoveries is coming down, even if the recovery rate stays strong. And this will have a bigger impact in auto than in card, but it will be in effect in both businesses. And it's not something that I think gets a lot of airtime. out there, but, you know, recoveries are definitionally about what's happening with a, if you will, the back book of recoveries. And in both of our businesses, the back book, which has been the byproduct of the great news of the last few years in terms of credit, the back book, there's just less to work with. But it's especially in effect in auto. And finally, auto vehicle values are now normalizing, which is a headwind relative to a year ago and contributes to the pace of credit normalization in that business. And given where used car prices have been going to sort of record levels over the past year, the general direction of that is much more likely to be down rather than up. So that also contributes to a difference between those two businesses.

Got it. Thanks. As a follow-up, you know, it's good to see, you know, guidance or some form of expectation of a improving efficiency ratio. But as, you know, as I look at it, it seems like your balance sheet is still asset sensitive. And so, you know, to the extent that revenue growth is impacted and positively impacted by margin expansion, I mean, wouldn't one really naturally expect to see that efficiency ratio improve? Because, you know, that doesn't really come with a lot of attendance costs. So just wondering, you know, how to think about that and, you know, what's, you know, what's the right way to think about that, you know, spend, you know, kind of like for like spending versus revenue growth.

Moshe, let me take the first part of that and then I'll hand it over to Rich in terms of asset sensitivity. You can see last quarter's Q and And I would expect it'll be a fairly similar number this quarter, you know, an up 100 basis point shock. Last quarter was, you know, 70 basis point impact to 12-month NII, which is something like a couple hundred million dollars of NII. And, again, that's a shock relative to forwards. So... you know, I just want to clarify that when you talk about us being asset sensitive, we've already baked into our baseline the anticipated, call it 150 basis points of additional Fed moves over the next couple of quarters. So achieving what I just described suggests a shock beyond that. But I think you should walk around with at this point, we are pretty neutral from an asset sensitivity. So I just wanted to clarify that before Rich provides the broader answer.

Yeah, Moshe, I've often said, and you and I have, gosh, we've been working together for two or three decades now, Moshe, and I've often said that I know we do a calculation that says this is, on the things that we can measure, this is the impact of, say, a rise in rates. I've often said it can look good on paper to have a rise in rates, but I, for three decades, have been rooting against rises in rates because of the sort of unquantifiable other aspects on the business. Now, of course, no one out here is rooting for the kind of inflation that we're seeing and the kind of risk there, but I just want to flag that while the math talks about certain benefits that come, just a couple, kind of obvious, but I think important things that affect many of our metrics in the business. One is the conversation that we just had about the auto business. I think most businesses in the world, most industries struggle when the cost of goods sold goes up, struggle to get that to make its way into pricing. And the auto business is a classic example of this. And particularly since, unlike if you're You know, selling groceries at the store, it's pretty clear what's the cost of goods sold and therefore how you might want to price those groceries. In this business, with the complexity that comes from how any particular auto lender calculates their funds transfer pricing and really effectively what is their margin, that can put pressures in the business and what we're seeing in auto, the compression in margins, the growth opportunity that we're losing right now, that can sort of swamp the math of Andrew's, you know, interest rate calculations. And then, of course, I think the biggest issue is the impact of rising rates on auto. you know, on the economy and on potentially credit outcomes. And back to our friend, the operating efficiency ratio, you know, credit, credit impacts make their way into the operating efficiency ratio, of course, you know, through, well, through the growth line, you know, through how much growth we can get and also things like the, you know, fee and finance charge reserve impacts that come. So I'm not, yeah, so that's why I think in many ways the kind of progress that we, you know, continue to hope to achieve over the years in operating efficiency ratio might be more in spite of rather than because of higher rates.

Next question, please. Our next question comes from Aaron Saganovich with Citi. Your line is now open.

Thanks. I was hoping you could talk a little bit about the card acquisitions that you're having today. You're a full-spectrum lender, but you're, I guess, I would characterize, I guess, newer in the heavy spend section with your VentureX card. Are you acquiring more of that segment and then Also, have you been pulling back at all in maybe a revolver or non-prime segment recently?

Yeah.

So we have talked a lot about the traction that we're getting at the top of the market in the pursuit of heavy spenders. And I wouldn't call us relatively new player in that business. We're one of the actually – pretty significant players in the space, but certainly not the biggest, not even close. But I think that the bigger point there is that we continue to see more traction there. And whenever you see metrics about growth in purchase volume, we don't share metrics about what kind of growth rate we're getting at each spender level in the marketplace, but the higher the spender level, the higher, the even faster growth rate we've been getting. So that's a manifestation of, you know, of the success we're getting, and it's both the byproduct of the investment we're making, but also leads us to continue to lean in to those investments. But for all you here of our enthusiastic audience, comments about the top of the market. I don't want to leave an impression that we are therefore less enthusiastic about the opportunity elsewhere. We continue to grow across the credit spectrum. We, you know, have several decades of experience in the lower end of the market. And, you know, one of the real benefits of our tech transformation has been allowing us to build a lot more sophistication, more data, more machine learning and other things into the credit underwriting process, and that allows us to be stronger and have more growth opportunities and better credit quality at the lower end of the market. So the story, the net impression I want to leave with you is one of very, you know, continued success across the spectrum. There are places, however, that we, for a long period of time, have been cautious about and, frankly, doing our best to minimize. And one of those is high-balance revolvers. So high-balance revolvers, which just – what – The term we – that term to us, just to clarify that concept, is not necessarily what are the balances that any revolver – any customer might have with us, but it's collectively their total bureau balances. And we have been very cautious about booking customers for years now, and even more so after the Great Recession, booking – with a high level of revolver balances across that consumer's portfolio. It tends to be, you know, to not go there ties one hand behind their back a little bit in terms of growth because, you know, growing high-balance revolvers is a good way to grow, and it also tends to be quite profitable business. But that is a segment that we have been concerned about the resilience and downturns, and so we've tended to, for years now, try to de-emphasize that. I say de-emphasize. No one can fully get out of a segment like that because we can't control it. whether our own customers turn into high-balance revolvers, but what we can control is whether they enter as high-balance revolvers. So that's a little window into maybe where we go a little more lightly. Thank you.

Next question, please. Our next question comes from Don Fandetti with Wells Fargo. Your line is now open.

Hi, Rich. Can you talk a little bit on the move to the public cloud? It's been a bit since we've heard a lot on that. Are you still feeling like it's improving your new product development rollout?

Yes. Well, Don, we feel great about our move to the public cloud. It's a central part of our technology transformation, probably the most salient part of it, but certainly not the only part, but, um, you know, this, this transformation, uh, has involved, uh, a transformation in terms of the tech talent within the company, bringing lots of, you know, thousands of engineers in house, bringing more of the tech, uh, investment inside the company as opposed to reliance on vendors, so many of them industry-wide who are old-school legacy vendors and quite expensive at that. It's involved transforming how we build software. It's involved going to the cloud. It's involved transforming our data ecosystem. It's involved modernizing all of the applications on which the company is built. So there's been a lot to this journey, and, you know, we're a decade into it. The benefits are all around us, and, you know, our it really starts in many ways with benefits in the tech business itself, where our technology teams are moving faster, getting products to market sooner. And, you know, our software engineers are just way more modern tech stack to work with and automated software delivery methods and can also improve to your cloud point, benefit by the tremendous, not just, well, the tremendous and continuing innovations that are happening on the cloud. Our customer experiences continue to get, you know, more and more, just better and better. And some of the, we notice it in net promoter scores and occasional awards that Capital One wins. The new products we've been able to innovate, things like Capital One Shopping, virtual cards, dealer navigator, instant issuance, many things have been very benefited there. I mentioned earlier the ability to get some transformational improvements on underwriting, fraud management, and a lot of things behind the scenes that leverage the power of big data and machine learning in real time, that has been very beneficial. Our transformation also is changing how we work inside Capital One. Our new marketing platforms are, you know, part of the reason that we're investing more these days in marketing is really the power of mass customized technology. machine learning-driven marketing. So that's been a good thing. And it's also, as I mentioned earlier, had a bunch of benefits in terms of enhancing productivity of the business. And the final thing I would say there, Don, is that the tech transformation is really helping us get more of the thing we needed to start with to make it happen. And that was talent. The biggest elephant in the room for corporate America who sit on legacy tech stacks is you need lots and lots of very modern, best in class tech talent in order to drive that transformation in a world where the scarcest, the tightest, And most competitive labor market I've seen in the history of building Capital One is the competition for really modern tech talent. The transformation requires so much of that talent, and one of our rewards is now as we get on the other side of the canyon and really have a tech stack built like the – very modern tech companies, the ability to attract talent is accelerating, and that's part of a virtuous cycle. That is why we did it. It's why we went on this journey, and it's something that we see to this very day, and it's also why we continue to invest more in the opportunities that we see.

Next question, please. Our next question comes from Rick Shane with JP Morgan. Your line is now open.

Hey, guys. It's Rick Shane. I think I just got called on. Andrew, quick question for you. When we look at the reserve rate on the domestic card portfolio, it ticked up slightly. Most of the build was a function of portfolio growth. You know, context is... year over year, the single biggest increase in delinquencies that we've seen. I'm curious when you think about the factor setting the allowance going forward, have you incorporated the trajectory of how fast delinquencies are increasing or is it a function of where delinquencies are now and an economic outlook? And can you capture that sort of rate of change?

Sure, Rick. Well, let me just start by talking about the inputs to the allowance. I just think it's important to sort of ground on the mechanics, the entirety of the mechanics, not just the piece that you called out. So the first factor, of course, is just the size of the balance sheet. The second is really aligned to what you were just talking about, but it's kind of a combination of factors, and that is really our outlook for future losses net of recoveries against that balance sheet. So that starts from a place of looking at what is in the delinquency buckets today, which gives us a really good view of how the next say, six months or so of losses are going to play out. And then after that period, we have an assumption of continued normalization from those unusually strong levels. And then beyond that horizon, as I think you know under CECL, there's just an assumption of a gradual revision to historical averages. And then the third point is we apply qualitative factors against all of those expectations to account for uncertainties around economic downsides and inflation-related risks. And so when we think about the allowance going forward, yes, I mean, today's allowance, of course, does incorporate in what is in the delinquency bucket today and what that implies. But as we go forward, the allowance is really going to primarily be determined by just the growth in the balance sheet, and we saw that impact the allowance this quarter. But then secondly, every quarter we continue to normalize, we are going to be replacing lower loss content of the current quarter with higher loss content of future quarters, which again will be informed by how the delinquencies are playing through each successive quarter. So, you know, there's a number of other, you know, modest considerations, but that's really the two big forces at play. And hopefully that gets to kind of the nature of your question.

It does. And I guess what I'm really trying to understand is that if we follow the path that you expect in terms of normalization, and what's embedded in the reserves today and economic outlook doesn't change. Because again, I realize that's something you can't control. If you follow the expected path, does that mean the allowance stays static or do you follow along that path? I think that's what I'm really trying to get to.

Well, you're going to follow along that path because then when we get to a quarter from now, we're going to apply all of those same factors to the allowance at a quarter from now, and the change in the allowance is just going to be the quantum of allowance we have today compared to the quantum of allowance that we would have doing those exact same things a quarter from now.

Next question, please.

Our next question comes from Bill Karkash with Wolf Research. Your line is now open.

Thank you. Good evening, Rich and Andrew. Following up on that last question, what level of unemployment would you say is implicit in your allowance? And marrying some of the micro with the macro from the earlier discussion, how does Capital One view the risk that some of the credit normalization trends that you're seeing currently will ultimately be accompanied by some degree of degradation to the extent that the Fed proceeds through the hiking cycle?

Why don't I take the first one, and I must admit I'm not quite sure I followed the second, so I'll see if Rich followed that. Otherwise, we'll come back to you for clarification. But in terms of unemployment, I'm not going to provide specific metrics or economic assumptions. I will say, though, Bill, we are generally consumers of, like, industry forecast as opposed to developing our own. So I think you could look at general consensus expectations for all of the key economic variables and assume that that kind of roughly approximates what underlies our economic views on those variables. And I'm looking at Rich to see if he followed the second part of your question.

Bill, I think your question was I'm going to put it in different words just to see if I'm saying the same thing. We've got normalization going on right now with an economy that's, you know, in some ways certainly employment-wise and some metrics, you know, not in a terrible place. And you have normalization – when normalization meets – potentially significant economic worsening coming out of the, or maybe catalyzed by the Fed going through their tightening right now. How do we feel about that? Was that your question? Yes. I'm going to start doing earnings calls by just asking the questions and then answering them. So, but... Look, that is a great question, and I think none of us should just be mathematical about normalization. Now, I've talked about how the root word in normalization is normal, because what is abnormal is that credit ever got to this once-in-a-lifetime place it did during the pandemic. So, as I've said, in absolutely normal times, this thing should change. normalize. So the way, so we look at that and say, you know, and expect that, you know, that should continue. And then we look at the economy and the way that we would always look at that is we've done, you know, many times we've been looking down the gun barrel of a potentially, you know, highly uncertain and maybe likely a worse economy. And it's certainly hard to be in the prediction business. But what we do is we, you know, there's a couple of big things that we do as an approach. First of all, we underwrite to an assumption of worsening. We try to make it so if things go bad, it's not a surprise that, you know, it would be really bad banking to – you know, be underwriting to, you know, good scenarios. And I know everyone tries to be conservative, but I'm just saying with over three decades in building this company, at the heart of it is underwriting that looks in the rearview mirror of how programs are doing and overlaying a worsening assumption on that because that is – could happen and we need to be resilient to that. So you'll often hear Capital One talking about the word resilience. Without a crystal ball about what's going to happen over time, the critical thing is what is the resilience of the loans that we are booking? And we spend a lot of time, for example, in the card business just looking at the ratio of revenue margin to the charge-off rates and stressing that and all kinds of things. So we underwrite to worsening. That's a very important thing. Secondly, it is the management of credit decisions at the micro level so that we're looking for the earliest indications of where problems can occur. And like I said earlier, that's both... Let me just give you a little bit of window into that. We, of course, have our way that we look at how all our businesses are doing and all of our vintages are doing. We leverage machine learning, though, to also look for... aberrations and anomalies that happen faster than they would show up with a report and maybe coming from sources that would not be our standard set of variables by which otherwise our models would look at the business. And so, you know, real time machine learning driven monitoring is really important in any environment, but we you know, it's really important in an environment like this because we're looking for, because we expect anomalies to happen. We expect some of our segments to be stressed in even the current environment, certainly as things get worse. And so we're on the lookout and we have machine learning to help us. And then, as I mentioned earlier, and sorry to be repetitive, but But it's not just letting the machines and the models do the work. It's standing back and saying, you know, gathering people around and saying, let's think of all the things that could go wrong. What do you think would go wrong? And where would weaknesses appear? And then, based on that intuition, we go hunting for them. And it's... All of the different approaches have been bearing fruit lately. You know, on a more modest basis in the card business, on a little bit bigger basis in the auto business, and I would expect as the environment gets, if it gets a whole lot worse from here, we're going to, you know, there's going to be a lot of active trimming all over the place. And, you know, and so it's a combination of literally the most micro and analytical of approaches marrying the most intuitive and big picture judgmental approach to managing risk.

Next question, please.

Our next question comes from Mihir Bhatia with Bank of America. Your line is now open.

Hi. Thank you. I think she called on me. But I wanted to ask about the – I appreciate your comments earlier about, you know, you're enthusiastic about all of card lending, so full spectrum. But just given the recent focus on the higher spend and the more transactor type customers. I was wondering if you think that, you know, growing that portion a little bit, maybe that portion has been growing at an outsized rate. How has that growth of that subsegment potentially changed the card portfolio's performance through the cycle or in a downturn?

You know, that is a great question. In fact, let me pull up for a second before I answer your question. We have very gradually across the business, paralleling the move to the top of the market, all across our business, we have been leaning harder into the spender side of the business and just continuing to be most attracted to customers who are there to spend and whose patterns would be more consistent with the spending side of the business, even as there is a bunch of revolving. So across our business, there has been a very gradual but purposeful migration for years toward the spender side. So I'll put that down there. And then the second thing is the – avoidance of high-balance revolvers, and then thirdly, the thing you're pointing to, the importantly increasing mix of heavy spenders in our business. The impact, I think when a downturn comes, these things that we've been leaning into things we've been avoiding, you know, should be all other things equal beneficial to the performance of the business in terms of the credit losses themselves, the payment rates that we experience there during the business, and Part of why we have leaned into spenders more is just because all the evidence that we have seen is that tends to just be pound for pound a more resilient group. So while it's not a controlled experiment, I think the net effect of these changes will be beneficial to the credit results. I think, enhance the resilience of the business that we have booked.

Thank you. And then just if I could ask just about the tech investments that you've been making. Can you talk about just how do they improve your ability to flex expenses as the competitive or macro environment changes? Thanks.

You know, ironically, I think they may make things a little less flexible to – on the expense side, let me explain that. An increasing part of our cost structure as a company is our – you know, is our – is the tech business that we have built. It's got a lot of fixed costs to it, and, you know, so – that is not. I wouldn't want to set an expectation that our sort of tech stack and our tech company that we have built is a more variable cost business because, if anything, it might be a little more fixed cost business. Now, you know, Within that, choices on what we invest in and the timing of those always create flexibility, and in stressful times, they're certainly on the investment side within tech, can be more flexibility there. But the tech investment, though pulling way up, has tremendously enhanced Capital One's overall flexibility. Our ability to turn quickly into in the marketplace to make credit choices. If you look back to when the world went into vertical freefall of uncertainty in the pandemic, just look back at how quickly Capital One turned with respect to some of the pullbacks we did. That would not have been possible in the more legacy world that we lived in before. So The ability to respond quickly, the ability to create changes in the offerings to consumers, the ability to create flexibility in offerings, flexibility in forbearance, new ways to adapt to the marketplace, everything about Capital One, the speed of change. of managed change is dramatically different from before. We also, and this is probably the most important recession resilience point, is the monitoring point I made earlier, to have put in place a much more comprehensive real-time monitoring capability with root cause analysis that's much more comprehensive than what we could have done before will allow us to be informed earlier on about things that are happening. And I do want to say I've been asked by a number of investors, you know, Rich, we know you well enough to know how cautious you are about the economy and about downturns and the utmost respect for how risk can play out in these businesses. Why are you leaning into the marketing opportunity? And one of the reasons that we're doing that is this substantially improved measurement, monitoring, and speed of response, and the level of segmentation and micro-segmentation by which we can do that allows this sort of paradoxical thing to lean in more than we otherwise might have been able to do.

Next question, please.

Our final question this evening comes from Dominic Gabriel with Oppenheimer. Your line is now open.

Hey, can you hear me? This is Dominic from Oppenheimer. Yes, Dominic. Oh, okay. Sorry. I guess so. Is there any reason, Rich, why you would expect the payment hierarchy among consumer products in which they choose to pay or default, let's say, in times of severe stress? Is there any reason why Anything you're seeing that would change that hierarchy this cycle around from previous cycles? And then I just have a follow-up. Thank you.

Dominic, that's a great question. I can only sort of speculate here, but the most striking thing about the global financial crisis and Great Recession that from a payment hierarchy point of view, is what we saw with people literally walking away from their mortgages. And what was really high on the payment hierarchy was auto loans. And that may be kind of a more universal resilience point on the auto side because people still have to drive to work. So that's probably more of a sustaining insight. I think that we got to look at student loans and think about where, I think we've already observed that's pretty low in the payment hierarchy and trends these days and forgiveness and various things there would probably ensure that's on the lower end. Another one that I would probably just speculate to add to the hierarchy this year is this time around, is fintechs. And I think the fintechs who don't report to the credit bureaus may have enjoyed their stealth opportunity to grow, but that's probably not lost on the consumers. And so I think one of the reasons we've really leaned harder into having spending be the anchor part of a consumer credit card relationship is that it's not only a healthier place to be from the consumer point of view, but I think counting on that credit card and making sure that you've got that in a downturn, that helps from a payment hierarchy point of view.

Okay, great. I just want to go back to the tech investment and spend and how you think about it over the cycle and perhaps even some of the peers that you talk to at conferences. How do you, as one of the country's largest banks, think about the investment that you put on and what do you find does have, what type of economic factors, is it NIM, is it NII growth changes, is it credit growth changes that can have you put the brakes on the edges on, you know, year-over-year growth and tech investment spend. Thank you so much.

Well, you know, thank you, Dominique. These are all great questions. You know, we – in case you haven't noticed, I have a pretty – deep conviction about the benefit of these tech investments. And that's not just how I feel. That's how all of us collectively feel here at Capital One. And the benefits of that tech investment are so comprehensive. All of the company, inside this company, we can see them everywhere. and they just so enhance how we work, the ability to manage risk, the ability to serve customers, the ability to create new products, the ability to grow. And because we see such benefits, we are continuing to lean into tech investments. And as I mentioned earlier, there's sort of under the surface quite a bit of productivity gain coming from the tech investment. But on the other hand, at the same time, we're leaning in pretty hard into tech investments such that it's, you know, the effects are not that dramatic. In fact, over, you know, close to a decade, there's been a more gradual kind of improvement in operating efficiency. You know, there's always the opportunity if times get really tough to pull back on tech investments, but we are not viewing these like luxury investments and just, you know, what to do on a sunny day because they are very materially transforming the opportunities of this company and the ability to manage risk. and the ability to weather the very downturn that might motivate that reduction in investment.

Well, thank you, everyone, for joining us on the conference call. We'll be here this evening to answer further questions you may have. Have a good evening, everyone.

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