Capital One Financial Corp (COF) 2016 Q2 法說會逐字稿

Welcome to the Capital One second quarter 2016 earnings conference call. All lines have been placed on mute to prevent any background noise.

(Operator Instructions)

I would now like to turn the call over to Mr. Jeff Norris, Senior Vice President of Global Finance. Sir, you may begin.

Thanks very much DeeDee, and welcome everyone, to Capital One's second quarter 2016 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 second quarter 2016 results. With me today are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer; Mr. Steve Crawford, Capital One's Head of Finance and Corporate Development; and Scott Blackley, Capital One' s Chief Financial Officer. Rich and Scott will walk you through the presentation this evening. 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 forward-looking statements contained in today's discussion, and the materials, speak only as of the particular date or dates indicated in the material. 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 will turn the call over to Mr. Fairbank. Rich?

Thanks, Jeff. Good evening everyone, I wanted to begin this evening by welcoming Scott Blackley. In May we announced that Steve Crawford was appointed to the role of Head of Finance and Corporate Development, and that Scott was appointed to CFO, reporting to Steve. This is Scott's first earnings call as the CFO and he will continue to be a key leader in our investor communications.

Scott brings tremendous experience, expertise and insight to Capital One. He has been our controller since March 2011 and our principal accounting officer since July 2011. Prior to joining Capital One Scott held various executive positions at Fannie Mae, and he has more than 20 years of experience in consulting and public accounting, including an appointment to the SEC as a professional accounting fellow, and as a partner with KPMG. Now I will turn the call over to Scott.

Thanks, Rich. I will begin tonight with slide 3. Capital One earned $942 million, or $1.69 per share in the second quarter. Excluding adjusting items, earnings per share were $1.76. Adjusting items in the quarter included a $54 million build in our UK payment protection insurance customer refund reserve, which was partially offset by a gain on sale of our interest in Visa Europe of $24 million. A slide outlining adjusting items can be found on page 11 of the slide deck.

Pre-provision earnings decreased 1% on a linked quarter basis, as higher revenues were offset by higher non-interest expenses. Provision for credit losses increased 4% on a linked quarter basis as modestly lower charge-offs were more than offset by a higher linked quarter allowance build. We have provided an allowance roll-forward by segment which you can see on table 8 of our earnings supplement.

Let me take a moment to explain the movements in our allowance across our businesses. In our domestic card business, we built $290 million of allowance in the quarter. Two factors drove that increase: balance growth in the quarter, and our expectation of rising charge-offs associated with growth math. Our allowance covers 12 months of losses, so as we continue to move through 2016 we are picking up more of the loss increases that we are projecting into 2017. And, as we have been saying, based on the credit guidance we have today, we expect allowance builds to continue.

Allowance in our consumer banking segment increased $58 million in the quarter. This increase was attributable to our auto business, where we built allowance for new originations that included a higher portion of subprime and we expect that auto auction prices will decline from current levels.

Lastly, we had a net $50 million build in reserves in our commercial banking segment. We built allowance in the quarter to address increased risks in our Taxi Medallion lending business, particularly in Chicago where we have around a $100 million portfolio and Taxi Medallion trading values decreased by about 60% in the quarter.

In our oil and gas portfolio, our allowance for the quarter was essentially flat. But we released $57 million of reserves for unfunded commitments coming out of the spring redetermination process.

Turning to slide 4 you can see that reported NIM decreased 2 basis points from the first quarter to 6.7%, primarily driven by lower yields on investment securities. Net interest margin increased 17 basis points year over year, fueled by strong growth in our domestic card business.

Turning to slide 5, I will discuss capital. Our 2016 CCAR results demonstrate our continued commitment to return capital to shareholders. As previously announced, following the approval of our 2016 CCAR capital plan, our Board authorized repurchases of up to $2.5 billion of common stock through the end of the second quarter of 2017. Our common equity Tier 1 capital ratio, on a Basel III standardized basis, was 10.9%, which reflects current phase-ins. On a standardized, fully phased-in basis, it was 10.8%. And, we reduced our net share count by 8.6 million shares in the quarter.

As we continue our parallel run for Basel III advanced approaches, we estimate our common equity Tier 1 capital ratio remains above our 8% target. Given existing and likely changes coming in capital regulations, we no longer believe that advanced approaches will be our long-term constraint. Accordingly, until we exit parallel run for advanced approaches, we plan to only report our standardized approach common equity Tier 1 capital ratio.

Before I turn the call over to Rich, I want to call out that in the third quarter we expect a one-time rewards expense that will reduce net interchange income by approximately $45 million to $55 million. Our rewards liability has been measured on a slight lag to quarter end. In the third quarter we expect to complete some system enhancements that will move the rewards liability cutoff to the last day of the quarter, resulting in a one-time increase in rewards cost in the third quarter. With that, I will turn the call over to Rich.

Thanks, Scott. I will begin tonight on slide 7 with our domestic card business. Growth of loans and purchase volume remained strong, although growth decelerated modestly. Compared to the second quarter of last year, our ending loans grew $9.6 billion or about 12%. Average loans were up $10.1 billion or about 13%. Second-quarter purchase volume increased about 14% from the prior year. Competition is picking up across the domestic credit card market from the rewards space to subprime. Over time, this can have impact on the growth opportunity and even credit quality in the business. While we always watch vigilantly for these effects, we continue to find attractive growth opportunities in the parts of the market we have been focusing on for some time.

Revenue for the quarter increased 12% from the prior year quarter, slightly lagging average loan growth as revenue margins declined modestly with our exit of the back book of payment protection products at the end of the first quarter. Revenue margin for the quarter was 16.6%.

Noninterest expense increased 3% compared to the prior-year quarter, with higher marketing and growth-related operating expenses as well as continuing digital investments. Net interchange revenue for the total company increased 9% from the prior-year quarter versus the 14% growth in domestic card purchase volume.

As we've discussed, there is considerable quarterly volatility in the relationship between these two metrics. For the past several years on an annual basis, net interchange growth has been well below domestic card purchase volume growth. We would expect this difference to continue as we originate new rewards customers in our flagship products and extend rewards to existing customers. Additionally, a few of the largest merchants have negotiated custom deals with the card networks. These deals are putting pressure on interchange revenue, and we expect the pressure to continue.

As we've discussed for several quarters, two factors are driving our current credit trends and expectations. The first is growth math, which is the upward pressure on delinquencies and charge-offs as new loan balances season and become a larger proportion of our overall portfolio. The second is seasonality.

Growth math drove the increase in charge-off rate compared to the second quarter of last year, and seasonality drove the improvement in charge-off rate compared to the length quarter. Our guidance for domestic card charge-off rate remains unchanged. We expect the upward pressure from growth math will continue through 2016 and begin to moderate in 2017.

We still expect the full year 2016 charge-off rate to be around 4%, with quarterly seasonal variability. And while it is still 18 months in the future, based on what we see today, and assuming relative stability in consumer behavior, the domestic economy and competitive conditions, we still expect full-year 2017 charge-off rates in the low 4%s with quarterly seasonal variability. Our domestic card business delivered strong growth and returns the second quarter and we really like the business we are booking. While we continue to closely watch the marketplace, we still see attractive growth opportunities in our domestic card business.

Slide 8 summarizes second-quarter results for the consumer banking business. Ending loans were essentially flat compared to the prior year. Growth in auto loans was offset by planned mortgage runoff. Ending deposits were up about $6 billion versus the prior year. Second-quarter auto originations were $6.5 billion, about 20% higher compared to the second quarter of last year.

Similar to our domestic card growth, we like the earnings profile and resilience of the auto business we are booking, and continue to believe that the through-the-cycle economics of our auto business, are attractive. Sustained success in the auto business requires active management of competitive cycles rather than aiming for arbitrary growth or market share targets. Immediately after the great recession, we had a unique opportunity in auto that we vigorously pursued.

Gradually, as competition intensified, some subprime players adopted more aggressive underwriting practices that we chose not to follow. As a result, our subprime originations stayed essentially flat for a few years before shrinking in 2015, despite growth in the subprime market. Our prime originations continued to grow during this period. In the first half of 2016, these competitive practices seem to have subsided somewhat, which enabled us to grow our subprime originations.

Even though we have had two quarters of stronger growth, the auto market and competitive practices remain dynamic. While we see opportunities for growth, we remain very vigilant about competitor practices. Our underwriting assumes a decline in used car prices. We continue to focus on resilient originations. And we continue to expect a gradual decrease in margins and a gradual increase in charge-offs as the cycle plays out.

Consumer banking revenue for the quarter decreased modestly from the second quarter of last year. Higher revenue from growth in auto loans and higher deposit volumes was offset by margin compression in auto and planned runoff of mortgage balances. Noninterest expense for the quarter increased 1% compared to the prior-year quarter, driven by growth in auto loans and an increase in retail deposit marketing.

As we mentioned last quarter, we have been optimizing both the format and number of branches to better meet the evolving needs of our customers as banking goes digital. In the second quarter, actual charges related to branch moves were about $35 million. Year to date, we've recognized about $45 million of the $160 million in expected costs for 2016. These costs show up in the Other category rather than in the consumer bank segment.

Second-quarter provision for credit losses was up from the prior year, primarily driven by additions to the allowance for loan losses for the auto portfolio, which Scott described. For several quarters we have said that we expect pressure on our consumer banking financial results. We expect the pressure to become more visible in consumer banking quarterly results in the second half of the year. In the home loans business, planned mortgage runoff continues. In auto finance, margins are decreasing and charge-offs are rising modestly. And our deposit business continues to face a prolonged period of low interest rates. We expect that these factors will negatively affect consumer banking revenues, efficiency ratio and net income, even as we continue to tightly manage costs.

Moving to slide 9, I will discuss our commercial banking business. Second-quarter ending loan balances increased 29% year-over-year, including the acquisition of the GE Healthcare Finance business. Excluding the $8.3 billion of loans acquired from GE, ending loans grew about 13% over the same time period. Average loans increased 27% year-over-year, while average deposits increased 3%. Revenue was up 17% from the second quarter of 2015.

Credit pressures continue to be focused in the oil and gas and Taxi Medallion portfolios. Provision for credit losses increased $79 million from the prior-year quarter to $128 million as we continued to build reserves. We have been building reserves over the last six quarters to reflect increasing risk in oil and gas and Taxi Medallion loans. Criticized and nonperforming loan rates were relatively stable in the quarter. The commercial bank criticized loan rate was 5.3% in the second quarter, comprised of the criticized performing loan rate of 3.7% and the criticized nonperforming loan rate of 1.6%.

We continue to focus on managing credit risk and working with our oil and gas customers. As you can see on slide 10, our total oil and gas loans ended the second quarter at $3.0 billion, or about 1.3% of total Company loans. Unfunded exposure decreased to $2.7 billion.

We had a net release from the reserves allocated to the oil and gas portfolio, driven by reductions in our unfunded exposures following the spring redetermination process. But we still expect that oil and gas loans will continue to present challenges. At quarter end approximately $265 million of our total commercial allowance for loan losses was specifically allocated to our oil and gas portfolio. This allowance is about 8.9% of total oil and gas loans. Including unfunded reserves, plus allowance, we held $310 million in total reserves allocated to the oil and gas portfolio.

I will close this evening with some thoughts on second-quarter results and our outlook for 2016. We posted another quarter of strong growth in domestic card loan balances and purchase volumes, as well as growth in auto and commercial loans, driving strong year-over-year growth in revenue and related increases in operating expense, marketing and allowance for loan loss.

Noninterest expense increased modestly from the linked quarter, but second-quarter noninterest expense remains below our expected run rate for the remaining quarters of 2016 for several reasons. Our businesses continue to grow, we expect about $115 million in branch optimization costs to impact the remainder of 2016, and we expect higher FDIC expenses in the second half of 2016.

Our efficiency ratio guidance is not changing. Compared to 2015, we still expect some improvement in our full-year 2016 efficiency ratio, with continuing improvement in 2017, excluding adjusting items. We plan to deliver efficiency improvement despite pressure from elevated branch optimization costs, higher FDIC expenses and recent deterioration in market expectations for interest rates. We expect our card growth will create positive operating leverage over time, and we continue to tightly manage costs across our businesses.

The 2016 CCAR process concluded in the quarter. The Federal Reserve did not object to our capital plan, so we expect to maintain our dividend and repurchase $2.5 billion of stock over the next four quarters. Pulling up, we continue to be in a strong position to deliver attractive shareholder returns driven by growth and sustainable returns at the higher end of banks, as well as significant capital distribution subject to regulatory approval. Now, Scott, Steve and I will be happy to answer your questions.

Thank you, Rich. We will now start the Q&A session. 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 any follow-up questions after the call, the investor relations team will be available. Please start the Q&A session, DeeDee.

(Operator Instructions)

We will start the questions with Betsy Graseck with Morgan Stanley.

A couple of questions, one is on the reserve, just wanted to understand, when during the quarter do you make a decision to do the reserve top up? And is this something that is looking forward just on a four-quarter basis or is this on more of a two-year basis, an eight-quarter basis?

Yes, hey Betsy, it's Scott, thanks for the question. Let me just reiterate, that for our consumer-facing businesses there is three parts that impact the allowance. The first is that we take the outstandings as of the end of the period, the second is that we look at our loss expectation for the next 12 months, and then we also have qualitative factors to account for some of the non-modeled risks.

In this quarter, we had $4 billion of growth. We increased the losses in our allowance window, which is totally consistent with what we have been signaling in our guidance for rising charge-offs, and of course as we do every quarter, we true up qualitative factors. Those are really the factors, the same process we do each quarter for the allowance.

Okay. Second question is just on the interchange that you talked about, pressure on the interchange coming from some specific deals that large merchants are doing with the networks and I think, Rich you've mentioned this on prior calls. I just wanted to get a sense as to, is this an acceleration here and is it large enough for you to consider or think about changing how your rewards are structured?

Betsy, it is the same phenomenon with pretty much the same merchants that I've talked about in the past. So, these are big merchants so therefore, you will see the effects on our metrics as this rolls through, some of it is in there and some is rolling into the numbers. But, it is not -- it will not necessitate a change in anything about our strategy of going after the rewards business and our continued belief in the growth opportunity in that business.

Next question, please.

Next we will hear from Ryan Nash with Goldman Sachs.

Good evening, Rich, good evening Scott. Rich, if I could start off with a question on credit, we have now had 13 months of double-digit loan growth in the US. You are reiterating the guidance on charge-offs at 4% and low 4%s next year, you noted the impact of growth math will decelerate. I'm just trying to understand. If let's just say loan growth were to remain steady or even decelerate from here, given the way that the book seasons, how far out is it going to take for charge-offs to peak, and then related to that, when would you actually expect provisions from growth math to actually peak?

Hey Ryan, look, I am reluctant to predict peaks per se, we like to explain very much the mechanics of how things work. Growth math, which, on the way up and as growth is increasing, growth math works one way and then slowing growth, in some ways works the other way. That would impact provision expenses directly by reducing the allowance builds driven by loan growth. And over time, slower growth could also reduce the pace of growth math related to cards' overall loss rate by accelerating the point at which the natural seasoning of older growth offsets the growth math effects of newer growth.

But a lot depends really on the magnitude and mix of the remaining growth. We are growing at a pretty rapid pace now, so even if loan growth slows a bit from here, it is still quite a bit of growth relative to the highly seasoned back book. So you are right about the math. I am reluctant to pick a peak here because there are a lot of factors involved, but I think that everyone should understand, the way growth math works and the way it works as growth accelerates and as growth is big, and then it tends to be a good guy, as it works through on the other side. Those effects can -- the growth math of a particular vintage has most of its impact over the two years following that, and then there is really a seasoning from there. And so this is really just the net seasoning math of all the different vintages and the size of those.

Got it, maybe if I could just do one unrelated follow-up. Rich, very healthy quarter for growth in auto, you said that you are still seeing competitive pressures. Maybe can you just expand a little bit on those comments, what you're seeing competitively. And one of the regional banks, Huntington, talked about the sensitivity to a fall in the Manheim, they said if the Manheim fell to [100] they would see charge-offs go in auto from 20% to 30%. Can you maybe just talk either quantitatively or qualitatively about how you would expect the sensitivity to charge-offs to a falling Manheim?

Look, as credit people, we are always worriers, right? So we have -- the auto business is a classic business that -- we really like the business, but we need to have our eyes very wide open about where we are in the credit cycle, which may or might not be the very same thing as in the economic cycle, and we have to act accordingly.

At the top of our worry list, is underwriting practices. Because that not only affects volumes as we pull back, but it also can so quickly make its way into credit quality and not only for doing those practices, but it can have ripple effects on the industry. So at the top of our list of concerns has been competitor practices, and we have flagged particularly in the subprime area some concern about that. That, as I mentioned, is actually -- looks like it is mitigating somewhat, I don't want to declare victory on that, but that is a positive here, we will keep an eye on that.

The next thing is just the amount of supply out there. And from the amazingly low levels of supply a few years ago, this has been a very natural return to more and more supply in the industry. And you can see, every year there is a little bit more out there and more competition and that is why, over time margins have gone down. And so far we feel good that some of the most critical things like LTV have stayed -- haven't gotten affected yet. A lot of the pricing, a lot of the impact has been more on the pricing that affects margins.

And then, so that is the competitive side of it. And as we mentioned for quite a long time, we have got to remember the collateral value side of this thing. And the fact that used-car prices have been at record levels for a long time is certainly a matter of concern and we said you know pretty much there is only one way for them to go from here. Interestingly, if you look at the Manheim Index, that is pretty flat, maybe ticking down a little bit. We have our own recovery index on our own business, and that has been actually declining really for the last couple of years. Which is an interesting point, well, why would our recovery index be disconnected a little bit from the Manheim Index?

I think that is a little bit more about, that our mix is a little bit different from Manheim's mix, the Manheim mix. It has -- the Manheim mix has a higher proportion of larger vehicles, they have been increasing in price lately, prices for smaller vehicles have been declining. And on a relative basis, we have more of a mix of smaller cars and fewer trucks basically than the Manheim Index overall. So, I think we see more of that effect than the industry does.

But the main point is I think the only way from here is down, we underwrite to an assumption that this thing is coming down right away. How it actually plays out, we will have to see. I don't think we have got any scenario modeling quantitatively to share with you, but I think you are focusing on the right concerns in the business.

Next question please.

Our next question comes from Eric Wasserstrom with Guggenheim Securities.

Thanks very much. Rich, just to follow up on Ryan's question. It sounded like some of the provision increase in auto had to do with some higher anticipated severity, but is there anything that you are seeing that causes you to think there is going to be a change in the frequency of default in auto?

No, I think, I think that our outlook, we're frankly, relative to last quarter, probably a little more bullish, just more locally bullish about the auto business because of the little mitigation that is going on in the competitive environment of subprime. But I think the way to think about the auto business is that off of the once-in-a-lifetime levels from some years ago, there is a gradual normalization that is very much how the market works. And I think that we see that going on, but we don't see indicators that would suggest that there is some turn in the business. And we talked about the used-car issues we are keeping an eye on, but other than that, I think more this is us worrying as opposed to reporting some real degradation in the business.

Thanks, and if I can just follow up on the optimization costs, can you just remind me what the full-year figure is, and where will we see the benefits of that manifested in the income statement?

When you say optimization you are talking about the branch restructuring cost?

Correct.

Yes, you will see obviously the charges will be broken out in the other area, but they will be spread throughout the income statement, and they will obviously be recognized over time. We are not, we have already recognized about $40 million of the $160 million so that means we have another $80 million to go in the second half.

If you think about this quarter, a good portion of the total charges that ran through our occupancy and equipment line item, which really reflected some accelerated depreciation and some additional costs associated with closures.

It is $160 million total, so $40 million in the first half, the run rate will be up $80 million versus the first half so it will be about $120 million.

Next question please.

Next, we have Rick Shane with JPMorgan.

Hi, guys, thanks for taking the question. I think that in a lot of ways the dispositive factor for Capital One over the next 18 months is going to be, given the ramp-up in card charge-offs, the stabilization that you point to in 2017. What I am trying to understand is given the -- and I think this gets back to Ryan's question as well. Given that you are still in a high-growth mode, at least through the first half of 2016, why aren't we going to see the impact of growth math impact charge-offs in 2017? What gives you confidence that it is going to start to flatten out?

I'm going to be perfectly clear, that the business we are booking this year absolutely impacts the 2017 numbers, and growth math plays out over a multi-year period. So I want to be perfectly clear, we are continuing to book a lot of business here and these vintages then have to work their way through, and they tend to, over the first couple of years, reach their peak and then moderate from there. In fact you can see our guidance about 2017 charge-offs is higher than 2016. So, I want to say that this is how growth math works.

Okay, I think you guys recognize the same thing in terms of how important that issue is given that you provided guidance in terms of charge-offs a little bit, for 2017 a little bit earlier than you have in the past.

Right, well, see, I think our -- absolutely Rick. And the way we looked at it is that, and why we stepped out of character a little bit to provide guidance farther out into the future, is that we were moving into a period where two things were true. One is that we were growing at a pretty rapid rate, and expected to continue to do that, which has in fact turned out to be the case. And, it comes off of just a -- you probably won't see it again in your years of following this industry in terms of how season and recession survived the existing back books is. And so, the impact of all of that led us to feel it was important to give a sense of where, with lots of other things being equal, growth math would take our credit.

And, that's why -- and along the way, too, explain to you how growth math works, but I want to pull up on this. I have found over the many years in building Capital One, that just about anything that is really value-creating involves digging a hole before the benefits come. If it weren't that way everybody would rush in and do it and it actually would kill the opportunity. And you we have many, many, many years of experience in studying credit and understanding how value gets created over time by origination.

And, the key is very solid underwriting, incredibly rigorous what I call horizontal accounting, so one understands the full vintage economics and how those -- how they perform over time. And then finally, helping our investors along the way to understand what comes with that journey. But if we pull way up at this very time when there is -- credit losses are going up, allowance is being built, we feel great about the business that we are booking. We are incredibly happy that we have had the growth opportunity for the period of time that we have. We know competition is increasing, but we are still pretty bullish that we can get some continuing growth opportunities and I think this can be a real value creator for our investors.

Next question please.

Next, we have Arren Cyganovich with D.A. Davidson.

Thanks. Rich, in your prepared remarks you talked about competition picking up in the domestic credit card market across all of the platforms that you work in, rewards, subprime. And my question is more about, you are still finding opportunities in here, but you are also seeing this increase in competition and I'm trying to balance the way that you are discussing this. It seems as though it is becoming more difficult and maybe you are signaling that loan growth could slow a little bit from here. I'm trying to understand what you are trying to tell us in that comment.

Well, I think for those who know me, how I try to operate in this thing, it is less about signaling and more about just describing what we see and sharing with you what are the so-whats of that. So I start with, we are very bullish about our growth opportunity. It is a factual matter that the growth rate is down over some of the highs of the last couple of quarters on a year-over-year basis, but we are continuing to have pretty significant and to us very attractive growth. But we are very obsessive about how competition works. So often people always talk about well, what is the economy doing and how big is the opportunity?

Number one on our list is, what is the nature of the competitive environment, and that, of course, in its most first order effect, affects growth itself. So, it is noteworthy that competition from rewards all the way down to subprime, despite sometimes protestations of folks that they don't do subprime, there is an increase, and in fact the actual growth rate in subprime by our tally, industry is actually higher than in prime. And you can see in the overall revolving debt numbers, growth is up.

So, all other things being equal, that increases the challenge with respect to our own growth rate. But again, we have created some I think pretty unique opportunities and we like the value that we are offering customers, the customer experience and we feel good about that opportunity.

The second thing, I made the same point last quarter and I make it so often. Is when -- there is a very natural -- what we are seeing here is a very natural part of how the competitive cycle works, but increased growth over time tends to make its way into credit metrics in the industry as well. All of us, this is an industry where all of us share a lot of the same customers. So it is a natural part of the cycle that when you have sustained competition, typically we tend to see, on a delayed basis, that that makes its way into industry credit metrics.

And then the thing even more worrisome that we look for, and we have not seen this, is at the next stage in cycles, do people actually start really compromising their underwriting standards and that becomes something that is at the next level in how these cycles evolve.

So we feel great about the opportunity, it is not lost on us as the competition has increased and industry growth is up. And we will watch incredibly vigilantly, we will continue to pursue this growth window because we are very focused on windows of opportunity as a company. We believe in this window, we will continue to pursue it with our eyes wide open. And that is how we operate at Capital One.

Thank you.

Next question please.

Next from KBW we will hear from Sanjay Sakhrani.

Hi, this is actually Steven Kwok filling in for Sanjay. I just wanted to touch back on the competition, is it due to existing players, or are there new entrants that are coming in, in both the credit card and the auto side?

This competition -- by the way, there is not like some big thing that happened in the last quarter, this is a creeping increase in competition. It is primarily by the biggest players in the business who in fact definitionally dominate the business. So, you have seen some increased competition in the rewards space, you have seen some competitors strengthen some of their rewards propositions, value propositions, just volume.

There has actually been people stepping up and announcing they are going to step up some of their marketing and finally, we can see it just in some of the growth numbers across the segment. I would also point out, that there is pulling back beyond credit cards or auto for that matter, there continues to be growth in other forms of consumer credit like installment loans and student loans.

So that is part of the supply equation as well. But, this is something that we give a continuing description about this phenomenon because over time, that these things affect the business. But the main point I want to leave with you is in the card business and really in the auto business, we remain bullish about the opportunity and very bullish about the business that we have been able to generate.

Thanks, and then separately on the efficiency ratio front, how much leverage do you guys have in terms of for next year? Like, how should we think about that?

I don't know that there is much to do beyond the guidance that we have already given you. Is there something else you would like to discuss? That is as far as we have been prepared to go.

Just wanted to quantify in terms of the continued improvement in 2017.

We are not going to go to the quantification. The guidance is what we have stated and it has been stated for a while, so it's going to be a function of a whole bunch of things but that is a long ways out going into 2017.

Next question please.

Next we will hear from Chris Brendler with Stifel.

Hi, thanks, good evening. Can you talk at all about the comments on interchange pressure, looking at your net interchange rate is down about 15 basis points the last two years. How much of that is increasing rewards expense and how much of the decline recently has been from this large margin effect? My sense is most of it is higher rewards expense rather than some significant decrease in interchange rates. Thank you.

Again, I don't think we are going to get into the minutia on line by line which each of these things and the factors that are driving our income statement. We are trying to give you a sense of the major things, but you have kind of heard our commentary on what the impacts are and that is probably where I'd leave it.

Asked a different way, to look back historically, net interchange used to be 150 basis points maybe five or 10 years ago and now we are down to 87, is this a race to the bottom or do you think we'll stabilize at some point?

I think that the entire industry is -- look, there is competition both on the front end marketed products and what are the rewards being offered. And the other trend is a very important one to point out, is the extension of more rewards deeper into various competitors including our own customer base. So, I think that will play out for some time. I don't think this is a race down to zero.

I really believe in the business and I think that we are incredibly bullish about the opportunity in this business and the long-term economics in the business. I think we have wanted to point out that over a multi-year period, there is this migration that has gone on.

We can't just look at the rewards decline in a vacuum. Right, the rewards benefits that we have provided to customers in terms of additional share of wallet have been very important to the business, so there are other things that contribute to the value of that relationship besides just what is happening in that rewards.

Next question please.

Thank you, next we will hear from Moshe Orenbuch of Credit Suisse.

Thanks, I know that you don't think about the reserve as a percentage of loans in the credit card business, but it seems like there's a bit of a disconnect. You have given a lot of specific guidance that you have actually been meeting on a monthly and quarterly basis in terms of the charge-offs, and then there are those of us on this side who seem to be getting wrong the reserve build.

And, with what seems like relative stability in the charge-offs, you're talking about charge-offs that have averaged a little more than 4% for the first half and you are saying pretty much that for the full year. So not a big change in the next couple of quarters and then low 4%s after that, so it doesn't sound like there is a big change in that. I understand that you have got to provide for growth, but are we close to a point where we should be seeing that reserve to loans being relatively stable?

Hey Moshe, it is Scott. I think that using coverage rates is a tough thing for our business because we do have a lot of seasonal activity as you know, so as balances fluctuate, those coverage ratios can send false signals. I think I would say as we have told you, we expect losses to increase 2016 to 2017, and that means that the rate of allowance growth in those periods is going to be more than the loan growth, all else being equal. As Rich mentioned, there is going to be a point where you start to see the growth math effects moderate and at that point we would expect that relationship to change, but we do expect that we are going to continue to see fluctuations in the allowance quarter to quarter.

I really do appreciate that modeling that thing is tough, I'm just going to give you a very blunt hypothetical example. A 10 basis point move in loss rate, which can easily happen not being anything more than noise, can trigger a $90 million allowance change. There's nothing that I would point to and I definitely believe that the most important thing for you to look at in terms of where we think credit is going and what is driving our allowances is the guidance that we have already provided.

Right, Scott, not trying to be combative here, but the problem is if you are telling us the guidance is the same, that is where we are struggling, because if the guidance is the same, and we have seen the additions over the last five quarters, what is different? Is it just that?

But Moshe, we didn't provide you guidance on allowance build.

Understood.

That is not something we are prepared to do. What we can tell you is what drives allowance build. Growth in our portfolio, change in credit card charge-offs, which we have given you insight into, and then Scott provided a very real example, a 10 basis point change which is not very much, which is one-third of the reserve build we had this quarter.

So, you're not trying to be difficult, totally understand the genesis of the question. But over the last 18 months we knew this was going to be a real consideration, we really deliberately tried to talk about the three or four factors that drive our allowance, and actually as Rich said earlier, despite the discomfort, stepped out and went even further trying to predict loss rates in 2017 just to give people a sense as to the fact that there weren't any surprises here. We really like the growth we're having, but think about it as a capital investment in growth. It is something that we believe is going to lead to real economic value creation.

Maybe this will be one of the advantages of Cecil.

Next question.

Our next question is from James Fotheringham with the Bank of Montreal.

Thanks. So, if growth math works both ways, just roughly, how meaningful a deceleration in loan growth from the current level hypothetically would be required to affect a change in provision, say with a two-year view all else being equal? And I'm not looking for precision here. But just roughly, do you need hundreds of basis points in deceleration to affect a change, and is the relationship on the way down linear or is it more of a step change? Thanks.

I don't even know where to -- the fact that we are having deceleration in growth, if you can go back to I think Scott's explanation, excellent explanation, if we have just lower growth next quarter by definition, we are going to have a lower allowance build for that growth. And then, if you have you know lower new originations, then you have a higher percentage of the back book relative to the front book, compared to what you otherwise would have. So that, in some degree, will drive down the allowance build. But that is all else equal as well. So, I don't know that we can go a lot further than that and give you some intuition about the way that this is going to unfold.

That is helpful, thanks.

Look, I don't think people should expect that if the very high growth rate we have been going on turns into a pretty high growth rate, that you're going to see some big sea change here. This is still, we are originating -- these are a lot of originations and as a percentage relative to the back book, we are building -- which is great news for value creation. A bigger and bigger percentage of our book has actually been recently originated, so growth math will be with us in terms of the -- how losses go up. That is going to be with us through -- that is not going to suddenly turn around.

But, I think that what I like so much about this is the coiled spring of economic value for which we are paying up front through higher -- through allowance build and a loss curve that is front loaded, that coils the spring of value creation in a business and in an industry that doesn't have that many of those kind of opportunities.

And this is in many ways really the payoff for the information-based strategy where we have invested for years and I will also point out, too, that we are a Company that, while a lot of companies look around and say, what is the next thing we can buy? We are a Company that is designed to, as an origination-based company, where can we really massively test and find growth opportunities that really pay off in the long term, and work with our investors to understand the journey of how the performance actually plays out.

But the payoff is not going to come in the near term by credit losses turning around and going down. This is over the longer term, each vintage will peak and actually go down and there is a continuing dividend that will be paid over time. But right now, this is the period of rising losses and growth math on the way up.

Next question please.

Thank you gentlemen, our last question of the day will be from Matt Burnell with Wells Fargo. Matt, your line is open.

Hi there, can you hear me now? Thanks for taking my question, just a couple of administrative questions first. The release of the unfunded commitments in the oil and gas portfolio, where did that run through the income statement? Was that in operating expenses?

Hey, Matt, this is Scott, the release actually runs through as part of our provision expense.

Okay. Okay, thank you. And then the FDIC insurance assessments, have you quantified the size of those?

It will be about $20 million a quarter starting in the third quarter.

Okay. And then just on the Taxi Medallion portfolio, I appreciate it is not huge, it's less than $1 billion obviously, but do you have any color as to how you are thinking that will continue to perform? Are there other cities where you are concerned about a meaningful drop in valuation similar to what you saw in Chicago?

Matt, let me start and then others can pile in. First of all, if you look at the allowance build in this quarter, I mentioned that we have $100 million in Chicago and we did observe in that market a pretty steep decline in prices of traded Taxi Medallions. So that is principally what is going on in that market. The other market that we have our principal exposure to is in New York, which is a different market. I think we have talked about that in markets where it is a hail market, prices have seemed to be more stable.

So I don't want to give you too much confidence about where we see things moving in New York, but definitely our level of concern about Chicago is much higher than what we would say in the New York marketplace, it is just a different business model right now.

Okay, thank you.

Thanks very much, everyone, for joining us on the conference call today, and thank you for your continuing interest in Capital One. Remember, if you have further questions, the investor relations team will be here this evening to try and answer them. Have a great evening, everybody.

And that concludes today's conference call. We thank you for joining.