Capital One Financial Corp (COF) 2018 Q3 法說會逐字稿

Welcome to the Capital One Third Quarter 2018 Earnings Conference Call. (Operator Instructions)

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

Thanks very much, Leeann, and welcome, everyone, to Capital One's Third Quarter 2018 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 2018 results.

With me this evening are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer; and Mr. Scott Blackley, Capital One's Chief Financial Officer. Rich and Scott are going to walk you through the presentation. To access the presentation and the 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 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. And 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 Capital One website and filed with the SEC.

Now I'll turn the call over to Mr. Blackley. Scott?

Thanks, Jeff. I'll begin tonight with Slide 3. Capital One earned $1.5 billion or $2.99 per share in the third quarter. We had 2 adjusting items in the quarter, which are outlined on Page 13 of tonight's slide deck. We had a $141 million net gain on the sale of an exited business, which was $0.22 per share. We had a build in our legal reserves of $170 million or $0.35 per share related to our ongoing AML investigations from various regulatory and legal enforcement agencies. Part of this build is to pay for a $100 million civil monetary penalty, which has been imposed by the OCC as part of the 2015 AML consent order. As is often the case, our 2015 order had a placeholder for civil monetary penalties. This fine represents the next step in our resolution of this matter with the OCC. We have made significant progress against the terms of the order. The remainder of the legal reserve build is related to residual AML investigation risk, as other agencies besides the OCC continue to investigate AML issues relating primarily to our former check cashing business. We will provide updates of these investigations in our quarterly filings.

These adjusting items were recorded in our other category. Net of these adjusting items, earnings were $3.12 per share. In addition to these adjusting items, we had one notable item in the quarter, which was an impairment charge of $200 million or $0.32 per share related to investment portfolio repositioning to optimize capital and capture increased coupon to benefit future earnings. Provision for credit losses were down 1% on a linked-quarter basis and down 31% year-over-year, primarily driven by allowance releases in our Domestic Card and auto businesses.

Let me take a moment to explain the movements in allowance across our businesses, which are detailed in Table 8 of our earnings supplement. Improving credit results resulted in $144 million allowance release in our Domestic Card business and a $75 million release in our auto business. We increased our commercial reserves by $33 million in the quarter as we increased our allowance coverage ratio. Lastly, our effective tax rate in the quarter was 21.9%. We now expect our 2018 corporate annual effective tax rate to be around 22% before discrete items. This increase is based on our higher income from gains related to business exits and increases in nondeductible expenses from the legal reserves that I discussed earlier.

Turning to Slide 4. You can see that reported net interest margin increased 35 basis points on a linked-quarter basis, primarily driven by seasonality, day count and the absence of the nonrecurring items that we experienced in the second quarter of 2018. Net interest margin decreased 7 basis points year-over-year, primarily driven by increasing deposit costs. We continue to believe that increasing deposit costs will be a headwind to NIM going forward.

Turning to Slide 5. Our common equity Tier 1 capital ratio on a Basel III standardized basis was 11.2%. In the third quarter, we purchased approximately 5.8 million common shares or $570 million of our $1.2 billion 2018 CCAR share repurchase authorization. We continue to view our capital need, based on existing regulations, to be around 11% of CET1. We believe we have sufficient earnings power to support growth in capital distribution. And as I mentioned last quarter, how the capital frameworks in CCAR ultimately incorporate the effects of CESL, as well as the calculation of CESL itself, may impact our view on our capital requirements.

And with that, let me turn the call over to Rich.

Thanks, Scott. I'll begin on Slide 8 with our credit card business. We posted strong year-over-year growth in pretax income, driven by revenue growth and significant improvement in provision for credit losses. Credit card segment results and trends are largely driven by the performance of our domestic credit card business, which is shown on Slide 9.

Before turning to third quarter results, I'll briefly discuss our new long-term partnership to be the exclusive issuer of Walmart private-label and co-brand credit cards, which we announced early in the quarter. Walmart is America's largest retailer, and we have a shared vision of how a card partnership can be a central part of a winning retail and e-commerce strategy. There is great leverage from payments innovation, digital capabilities, data and analytics to deepen relationships, drive digital adoption and create exceptional customer experience. In addition to our agreement to be Walmart's new partner, we are also in the process of discussing the potential acquisition of the existing portfolio of Walmart credit card receivables. As you'd expect, there will be a range of potential outcomes until this process runs its course. For now, all of our guidance and forward-looking statements exclude the potential impacts of Walmart. Pulling up, we like the economics of the deal and we believe that our relationship with Walmart will generate significant value for years to come.

In the third quarter, Domestic Card ending loan balances were up $1.6 billion or about 2% compared to the third quarter of last year. Average loans grew about 7%. The Cabela's portfolio acquisition, which was completed just before the end of the third quarter of 2017, drove the larger increase in average loans. Third quarter purchase volume increased 16% from the prior year quarter. Excluding Cabela's, purchase volume growth was about 10%.

Revenue increased 5% from the prior year quarter. Growth in average loans was partially offset by a decline in revenue margin. Revenue margin was 16.3%, down 42 basis points from the third quarter of 2017. The expected margin pressure from adding the Cabela's portfolio was partially offset by favorable margin impacts from strong credit. Noninterest expense was up about 8% compared to the prior year quarter, largely as a result of higher marketing.

Improving credit trends continued to be a significant driver of Domestic Card results in the third quarter. The charge-off rate for the quarter was 4.35%, down 29 basis points year-over-year. The 30-plus delinquency rate at quarter end was 3.80%, down 14 basis points from the prior year. Credit performance on the loans booked during our growth surge in 2014, 2015 and 2016 is improving year-over-year and is driving most of the year-over-year improvement in the overall Domestic Card charge-off rate. That's why I've said that Growth Math has turned into a good guy.

Pulling up, the competitive marketplace remains intense but generally rational. Supply of card credit is on the high side, although it continues to settle out a bit. Against that backdrop, our Domestic Card business continues to gain momentum. We are booking double-digit purchase volume growth. We're seeing traction in our innovation pipeline. Our investments in marketing are driving strong growth in new account originations, and improving credit continues to drive strong income and returns.

Slide 10 summarizes third quarter results for our Consumer Banking business. Both ending loans and average loans decreased about 21% compared to the prior year quarter, driven by the home loans portfolio sale in the second quarter. The auto business continues to grow, with ending loans up 6% year-over-year. Competitive intensity in auto continues to increase, but we still see attractive opportunities to grow. Ending deposits in the consumer bank were up 6% versus the prior year, with a 38 basis point increase in average deposit interest rate compared to the third quarter of 2017. We expect further increases in average deposit interest rates, driven by higher interest rates and increasing competition for deposits, as well as changing product mix as our national banking growth strategy continues to gain traction.

Consumer Banking revenue decreased about 3% from the third quarter of last year. The revenue reduction from the home loans portfolio sale was partially offset by growth in auto loans and retail deposits. Noninterest expense decreased 7% from the prior year quarter, driven by the exit of the home loans business and lower branch infrastructure costs.

Provision for credit losses was down from the third quarter of 2017, primarily as a result of strong credit performance in our auto business. The auto charge-off rate improved compared to the prior year quarter, and stronger-than-expected auction values drove an allowance release. Over the longer term, we continue to expect that the auto charge-off rate will increase gradually as the cycle plays out.

Moving to Slide 11. I'll discuss our Commercial Banking business. Third quarter ending loan balances were up 2% year-over-year, and average loans were roughly flat. Both trends were driven by our choice to pull back in several less attractive business segments in the second half of 2017. With many of these choices behind us, linked-quarter growth was stronger, with ending loans up about 2% and average loans up about 3%. Commercial bank ending deposits were down 7% from the prior year. Several commercial deposit customers are rotating out of deposits and into higher yielding investments in the rising interest rate environment.

Third quarter revenue was down 1% year-over-year, driven by the effect of the lower tax rate on tax equivalent yields. Noninterest expense was up 4% from the prior year quarter, primarily as the result of technology investments and other business initiatives.

Provision for credit losses was down 14% from the third quarter of 2017, driven by lower charge-offs. The charge-off rate for the quarter was 0.16%. The commercial bank criticized performing loan rate for the quarter was 3.2%. The criticized nonperforming loan rate was 0.4%. While the credit performance of our Commercial Banking business remains strong, increasing competition from nonbanks continues to drive less favorable lending terms in the marketplace. We're keeping a watchful eye on market conditions and staying disciplined in our underwriting and origination choices.

In the third quarter, Capital One continued to drive solid results as we invest to grow and drive our digital transformation, and we saw another quarter of credit improvement across our businesses. Looking ahead, we continue to see good opportunities for account originations in our credit card and auto businesses. As you've seen in the marketplace, we launched a new card product, and we're rolling out our national banking marketing. As a result, we expect fourth quarter marketing expense to be elevated well above the historical seasonal patterns that we typically see between Q3 and Q4.

We continue to work hard to drive operating efficiency as we transform our technology infrastructure and change the way we work. After 2 years of significant improvement, we continue to expect full year 2018 operating efficiency ratio will be roughly flat compared to 2017, net of adjustments. But with the investment portfolio repositioning Scott discussed at the beginning of tonight's call, it will be tight. While the efficiency ratio can vary in any given year, over the long term, we believe we will be able to achieve gradual efficiency improvement, driven by growth and digital productivity gains. We expect long-term improvements in total efficiency ratio will mostly come from improving operating efficiency ratio.

Pulling up, we continue to build an enduringly great franchise with the scale, brand, capabilities and infrastructure to succeed as the digital revolution transforms our industry and our society. Our digital and technology transformation is accelerating and is powering our ability to grow new customer relationships and deepen engagement with new and existing customers. We are well positioned to succeed in a rapidly changing marketplace and create long-term shareholder value.

Now Scott and I will be happy to answer your questions.

Thank you, Rich. We'll now start the Q&A session. (Operator Instructions) Leeann, please start the Q&A.

(Operator Instructions) Our first question will come from Don Fandetti with Wells Fargo.

Rich, just to clarify on the Walmart portfolio. If you were to get just a fantastic price, are you saying you would buy it, meaning that there's nothing structurally that would cause you not to want to own it? It's more of just economics like any other deal. Is that fair? And I know you can't say a lot about it.

Don, we understand this portfolio. For us to agree to buy the back book, it needs to be at a price and at terms attractive to us, which will be determined through the negotiations over the next quarter or 2. There's nothing beyond that.

Got it. And then obviously, the multiple on the stock is in the sort of high 7s, low 8s, and the market's telling us that the cycle is turning. Yet if you just looked at your numbers, it would suggest the opposite. Could you talk a little bit about where you think we are in the cycle? And are you preparing for sort of a weaker credit environment?

Yes, I -- it's a great question, Don, because in so many ways, one can't help but be struck by the -- just how good the economy at this point is. And in some ways, it almost feels too good to be true. And so -- and that's not a credit card comment. A lot of times on these calls, I'll make comments about the card industry, about card supply, about the consumer. We can talk about those things, and maybe I will in a moment. But I think the thing that sort of most catches our attention is just how many sort of planets have aligned to make this environment so positive right now. But we can't forget the longer-term issues out there, the implications of rising interest rates, growing government deficit, trade-related issues and also cumulatively, some of the effect that's been going on with consumer indebtedness, even though sort of the supply issues out there have gotten a little bit better in recent couple of quarters. So what we are doing is taking -- given the sort of dichotomy we feel about the environment here, we're taking a little bit of a dichotomous strategy. So we feel really good about the growth opportunities in the card business to originate accounts. We've got a lot of successful programs going on, as I mentioned, on the marketing side, where we, of course, have seasonally high marketing but -- and we're doing some rollouts of sort of a new product rollout, national banking and so on. But we're leaning into growth opportunities. And what we're doing -- the dichotomous, compensating thing that we're doing is being even more cautious on credit lines, because it's really not the growth of accounts that creates exposure. The exposure comes obviously really, by definition, by the extension of lines and the building of balances. So we -- I -- we've been talking caution for really probably 2, 2.5 years at this point relative to credit lines. But our -- within the last year or so, we've even kind of further dialed back on initial lines and on some of the line increase things we're doing, not because of anything that we see in our own portfolio, but really more out of this just kind of intuitive concern about the marketplace. So our philosophy is let's continue to build the -- capitalize on the window to generate accounts, because if you don't, they're not forever available. You need to capture them in the window, but then be extra careful about the extension of line.

And we'll take our next question from Sanjay Sakhrani with KBW.

Scott, I wanted to make sure I understood the impairment charges on the investment portfolio on its go-forward impacts. I think I heard you say it's going to benefit earnings going forward. Could you elaborate on that? I just want to make sure it's in the other segment in other, I guess, noninterest income, right?

Yes. So in terms of the impact, you've got it right. It's in noninterest income and it does impact the other segment. Basically, this was a securities rotation, Sanjay. So in Q3, we identified around $3 billion of agency MBS that was in AFS and had a mark of around $200 million loss that was sitting in AOCI. As you know, that impacts our capital position and it creates a deferred tax asset for us. In Q3, we identified that we had the intent to sell those securities, and that caused us to move the mark out of AOCI and into earnings. So that's kind of what happened and why we recognized the $200 million. On a go-forward basis, in Q4, we've been selling those securities and reinvesting them in current coupon agency MBS. That improves the capital efficiency of those securities, and it is going to increase the yield on that $3 billion by around 200 basis points. So on a go-forward basis, we would expect to see that improve our net interest margin by just a few basis points. And then I'll just also mention that during the period that we held those, after we put them, we identified these as available for sale. We saw rates move a little bit. And so in Q4, we'll probably have a bit more of a mark on those before we are able to sell the entire portfolio. So that's kind of the picture there.

Okay. And then second question, Rich, you mentioned that the digital transformation is accelerating and it's helping your growth. Can you provide some specific anecdotes? I guess, is Walmart one of them? And maybe just how you feel your moat is relative to your peers.

So the -- let's pull way up on the digital transformation. I think this is the most important thing. It's a thing every company needs to be spending more time talking about, maybe anything other than just risk management itself, given that we're in the banking business. But it is very clear that banking is going to be totally transformed, and everything about how a bank works as it is experienced from the outside and how it works on the inside are going to need to change in order to, in the end, deliver real-time, intelligent, digital customer experiences. So years ago, we declared a bold destination to basically build a technology company that does banking, rather than a bank that uses technology. And so really starting at the bottom of the technology stack and working up, we have been all-in on this transformation for years. And as a lot of the work one does on the -- down deep in the technology stack is not something investors can see, it's not something the outside world can see. Frankly, it feels like that's a lot of cost. It can feel like a lot of cost and not necessarily a lot of benefit, but what we're struck by is everything that we want to accomplish on the technology side, on the -- with respect to customers, product, customer experience, product innovation, leveraging machine learning, some of our national banking aspirations, they all have the same shared path of transformation that they have needed. And being really many years now into this transformation, we can feel everywhere we look inside the company, this -- the benefits accelerating and because each transformation of one thing sort of helps the next. So the question we're often asked is, "That's great and everything, but how can we see it on the outside? And it is -- so where does it manifest itself?" It -- Walmart is certainly a specific example of that. Now there are probably a lot of factors that went into why Walmart made this selection that it did, but I certainly believe that the shared transformation journey we are each on and our investment in payments and digital capabilities was a very important part of that decision. We also see it in the customer experience that by all the metrics that we look at, net promoter scores, some of the external rankings that you see out there, this is -- our customers' experience has been dramatically improving. J.D. Power, each year, does a ranking of the best mobile banking apps. As an example, in 2017, Capital One was #1 in that ranking. Just came out again a few weeks ago, Capital One is #1 in that ranking again. Now we don't -- our company doesn't rise and fall based on some ranking out there, but these are sort of manifestations of things. I would direct you to look at things like our CreditWise tool. There are a lot of folks out there giving credit scoring information. CreditWise is a tool that allows customers to really deeply understand and monitor their credit scores, and it's really a gateway and will be a growing gateway into a whole set of experiences that can help people use credit wisely. If you look at our Auto Finance business, Capital One, a couple of years ago, launched the Auto Navigator product that allows car buyers to independently compare cars, search national inventories, negotiate prices and here's the most unique thing, which I think is, in fact, unique, get preapproved for financing. And this is for basically in a nanosecond for any automobile on any lot in America. Now that real-time, machine learning-driven kind of capability, you can't bolt that on -- you can't build that on the side of a bank. That product stands on the shoulders of years of technology work that's been involved in attracting world-class talent, transforming how software engineering is done, rebuilding our technology infrastructure, transforming our data environment, going to the cloud, transforming how we work and going all-in on machine learning. So what happens is these things -- any one of these sort of shows up, and it's interesting and maybe one looks at it and says, "Well, that -- maybe that's different from another product that's out there." But what we are -- what I am struck by, Sanjay -- and I'm not surprised by it because I believe this is really the payoff that will accelerate here, is that going all-in on this transformation, the benefits -- one doesn't have to pick one benefit versus another, because on the other side of this transformation is the opportunity to be way faster to the market, offer way better products, have way better risk management along credit dimensions, fraud, cybersecurity. That's all a shared path, same thing. Better operating controls in a world where the regulatory requirements and, frankly, the expectations on banks to deliver well-controlled environment in a complex industry, is very, very high, better economics, and all of this in service of the most important thing, which is real-time, personalized experience for our customers, not just in an app, but integrated right into their lives. So that's the journey that we're on. The -- we see its -- the manifestation of these benefits on many dimensions. We -- but it will show up more as it will pop up in different ways for our investors. But the final thing I want to say is that -- is the efficiency benefits that come from this. Now when one embarks on this journey, the efficiency benefits are not immediate, even though one of the most obvious benefits, the technology investment, is the ability to get more efficient. What's striking, though, is it's not like one invests for a couple of years and then suddenly stops investing. We are investing in digital. We will continue to invest in digital. We will always invest in digital until probably one day, we'll look around and 100% of everything that we do is basically digital and so -- but along the way, while technology investment has continued to be significant, the -- we see more -- the sort of meter of the cost benefits that come from this meter continues to increase, and it shows up in a lot of saving on legacy technology itself and the ability to really change the direction of the cost of analog -- the analog channels and operations in the company.

And we'll take our next question from Ryan Nash with Goldman Sachs.

So Rich, I was hoping we could start with the loan growth. Marketing expense was up a lot in the third quarter, as you've been flagging. And you're guiding to the fact that it's going to be up a lot again in the third -- in the fourth quarter. And I was just wondering, are you seeing the window for growth reopening? I know that you don't set growth targets, but what do you think this means for -- this increasing of marketing spend will mean for the improvement in loan growth over time?

So I don't see -- this is not a window the size of sort of the window that we saw in '14, '15, '16 when we had way outsized growth. What we are seeing is just a lot of traction in terms of generating new accounts. Obviously, you see the purchase volume numbers. But for a lot of reasons, probably many of them related to some of the digital innovations that we have done and some of the things happening on the customer side, we're seeing very nice traction in new account origination. And so we are leaning into that. The -- we've already talked about the marketing that goes along with some of these growth initiatives. So the only thing I again want to stress is that the loan growth is going to be more of a function of our -- of what we do about credit lines. It's not entirely -- I mean, because everything that we originate has credit line on it. And so I don't want to overstate this point. But how we dial the knob of credit lines, which will be primarily driven by how we feel the -- and from a line of scrimmage call point of view about the card marketplace and the economy, that will be the biggest driver of the loan growth. But what we're excited about is the ability to generate a lot of accounts. They represent sort of stored opportunity that can be capital -- can be harnessed when we open up those lines at a later point.

Got it. And then Scott, you highlighted $170 million reserve build was to pay for $100 million for the fine for the OCC related to BSA/AML. Can you maybe just remind us where you are with the remediation and what additional investments will need to be made to inevitably get out of the consent order?

Yes, Ryan. So on the consent order, we've been working on that since 2015. I think we've made substantial progress. I think the bulk of the work that we needed to do has been accomplished. And so I don't think that we have a large cost headwind in front of us, and we're hopeful to see that, that thing gets resolved here sooner than later.

And we'll take our next question from Bill Carcache with Nomura.

Rich, I wanted to follow up on one of the points you made earlier. On one hand, it seems from the outside looking in, like we're at a point in the cycle where your underwriting standards are leading your growth in auto and card to continue to gradually slow as we've been seeing for, like, the last 16 to 18 months in both card and auto. But you talked about leaning into growth opportunities, which seems a little bit inconsistent with what we see in the data. And so I was just hoping that you could help us reconcile the difference between what we -- what appears to be showing up in the data versus the point you made about leaning into the growth. And then maybe give us a sense of whether we can expect to see a stabilization in growth at some point.

Okay, sorry. So what are you pointing out in particular that says everything would indicate the other direction? Can you just...

No, I'm sorry. I was just pointing out to, if we look at the year-over-year growth in card and the year-over-year growth in auto, that year-over-year growth is -- it's still positive. It's just been decelerating from the peak of 16 to 18 months ago. So just wondering if you could comment on that versus you had made a point about leaning into the growth.

Yes. But -- so let me talk about card and auto because they're slightly different stories. Let me start with auto. The auto industry, over the last -- I don't know, 2, 2.5, probably 2 years, has had an anomalous situation where even though we're moving along in the credit cycle, the supply and demand situation kind of changed due to the pullback of 1 or maybe 2 significant players in the business. So Capital One really leaned into that growth opportunity. And ever since we've been leaning into that, we have said over time, that opportunity will regress back to something more normal, but we like the opportunity. But let us all remember that where we are in the cycle, let's remember used car prices have been high for so long, we fear the industry forgot about where they are at some point, the only way it's got to be down on some of that stuff. And so -- but a lot of the auto growth has been driven by some positive competitive dynamics in the business. Those still exist. They're not as big as they used to be. And so our growth is slowing, but it is still there. We've got some technology benefits in that space. I think we still feel good about the opportunity, but it's not -- nothing that would jump, be some big change from the trajectory that we're on. On the card side, the card industry, I have been struck by the stability in the card industry. It's kind of -- let me just back up and sort of describe things that have gone on. I think there was a significant window for growth a few years ago. We capitalized on that. Everybody in the industry saw supply shooting up. We saw the -- some of the, in the second quarter of 2016, vintage curves across the whole industry started gapping out. And we, and a number of other players, all identified this. And it was a bit of a shot across the bow to the card industry that don't get too ahead of yourself. And I think the industry, I think, took the caution to heart a little bit. In the meantime, the very competitive marketplace, the pursuit of heavy spenders, all the rewards products' intensity and all of that kind of reached a peak a couple of years ago and it's kind of settled out. So what I see is a stable and a very competitive, but stable -- and I think, relative to what I've seen in 20-some years of having this company, a relatively smart industry, if you will, about the choices that we're -- they are making, such that the card industry continues to offer growth opportunities, not incredibly big growth opportunities, but it offers growth opportunities for a number of players in the business who are pursuing their individual strategies. The point I was making is the particular strategies that we are pursuing, the particular opportunities that we see in the card business are something that we are leaning into. But it's more about account origination, and you should not expect that to lead to some big, outsized growth of loans because we are simultaneously pulling back out of an abundance of caution on the credit line side. So it's sort of inside Capital One it feels like we're really leaning into a growth opportunity. For you as investors, it probably won't feel as much like that. But that sort of gives you some color on how could I simultaneously sit here in these earnings calls and being -- saying, "Wow, I see the marketplace got some pretty good opportunities. We're leaning into the growth," and then we're posting some numbers that are kind of on the low end of the league tables of industry growth. So I think that's the context.

That's super helpful, Rich. If I may, as a follow-up, could you just quickly just elaborate on the competition that you're seeing from nonbanks that you mentioned earlier? And that's it.

Commercial. You're talking about on the commercial side, yes?

Yes, yes.

Yes. So I kind of go back to -- so I start with a little bit of a -- this is a way oversimplified thing, but if you go back and look at recessions, there might be a lot of truth to this particular oversimplified little maxim, which says after a big recession happens, look at which things did the best and be highly skeptical about their performance in the next recession. And maybe the inverse is true for those. So the -- what I was struck by is in the last recession, how well C&I lending did, for example, in general. And then we looked -- and within the banking space, we looked at -- for so many banks, out of the thousands of banks that are out there, they continued to lose the opportunity to generate consumer, consumer side of the business, to generate growth there because it is so scale-driven and so much of the business is being taken over by a few national players. And so, so many banks have been painted into -- a little bit to a corner of limited asset growth opportunities, but certainly seeing good opportunities on the C&I side. And so that's kind of -- I've always felt that, that -- put that on -- in your little cautionary thing. Additionally, what we've seen, of course, now with the U.S. economy and the years of aggressive monetary policy and accompanying low interest rates, low inflation, investors have been pushed out on the risk curve to seek higher returns. And this has caused, as you know, a wide range of assets, from equities to credit securities, to rise in price. And as these asset prices have continued to rise and yields have continued to fall, we just see investors still searching for other ways to continue generating returns. Sponsors are paying higher multiples for companies. They are using more debt to finance them. It's striking and I looked to the chart the other day that just said the percent of deals that involve weakened assumptions, if you will, sort of in the marketplace, there's more aggressive assumptions being used. So even when people are looking at things like EBITDA, the way the EBITDA assumptions are being made, there's weakness all around the edges there. Nonbanks, unhampered by regulation, are accepting more aggressive structures in an attempt to provide their investors return. And this just increased competition has its way of sort of virally spreading out in the marketplace, and that has caused lenders to accept lower yields and to give on terms. Now as a general observation on banks, I think banks have been the pillar of strength and generally of trying to stay very disciplined. But I don't think you can put a wall around these different parts of the marketplace. And so we see things on the banking side that would be in the same direction, if not the magnitude. So what are we doing about this? For one thing, we're watching it and obsessing about it. But we, like pretty much every other bank that we've heard on the call, they're calling for the need to stay disciplined in this case. Specifically, what we have done is to identify the sectors that are particularly vulnerable to these kind of trends or have structural reasons that they be maybe less resilient, and we have reduced exposure in those sectors. And in fact, if you look back at the last number of quarters, probably the last 6 quarters maybe, Capital One's loan growth has been pretty paltry on the commercial side, which is really a lot of that been driven by the dialing back and reducing exposures in all the areas that we identify as having a concern. So that's -- I think that as a cross-calibration across all the marketplaces that we serve at Capital One, I think the C&I, the commercial lending marketplace, particularly on the C&I side, is probably one that looks farther along in the economic cycle, more subject to the classic ways that lenders talk themselves into, "It's going to be okay." But when I calibrate, I feel quite a bit better about the lending conditions that are going on, on the consumer side.

And we'll take our next question from Eric Wasserstrom with UBS.

Just a couple of follow-ups. First, Rich, just going back to Walmart for a moment. My understanding was that historically, buying non-prime assets was very anathema to Capital One. So I guess, I'm wondering, what about this particular portfolio, or perhaps the relationship with Walmart itself, makes it more compelling to do so?

Well, the -- we don't view this deal is -- when we talk about this deal, we don't call it, this is a portfolio. This is a whole conversation about a portfolio acquisition. This is a conversation about a partnership with a company that has an unbelievable franchise and is all-in on really one of the -- on an extraordinary transformation in an industry that is having an extraordinary revolution in it that parenthetically, all of us in banking probably should go to school on, on how that industry is evolving. So we start with Walmart themselves as partner and the benefits of that relationship, a company with a very strong franchise. They're motivated for the right reason about their card program. We've seen a lot of partnership deals out there where the big objective function is how can the retailer just maximize profits from card and things -- from the card -- from the credit card. So Walmart is so focused on leveraging this to build and grow their franchise and drive their digital transformation. And finally, the partnership agreement really aligns our economic and strategic interests. And that's really important to us, because we've seen a lot of things out there where it might be nice to go sign a contract, but the 2 parties are -- have very different objective functions just by virtue of the way the contract is structured. And we've been vocal about that as we've gone around in the industry in terms of what we talk about that we want and we think is best for the partner. So that leads us then back to the back book or the existing portfolio. When you look at partnership deals, with a couple of exceptions, in the industry, it's typically the case that back books follow front books when a retailer switches issuer. There's obviously a lot of benefits from a customer experience and data perspective. But it's not always that back books follow front books. And at Capital One, we have had circumstances where we have done a successful front book deal without taking the back book. And so now, finally, to your question, we -- for -- we see the business logic to have the back book come along with the front book, have it all end in one partner, there's a lot of business logic. To us, it is about price and terms. And I think you are right, Eric, to -- you followed us for a lot of years. We've been very kind of vocal about some of the portfolios that are out there for sale in the marketplace. In general, we -- there are a lot of things that we have passed on. And for us to -- we will agree to acquire this at price and terms that are attractive to us and -- which help us mitigate the issues that we've often been concerned about, about portfolios out there in the marketplace.

And just one quick follow-up on the net interest margin. I was just trying to understand the very significant expansion in NIM with the go-forward expectation of compression, because it seems like many of the dynamics that might drive that, that compression going forward, were also evident in this recent period. So I'm just trying to understand like what's causing this change in cadence.

Eric, let me just go back and talk about the quarter and what happened with NIM in the quarter. So on a quarter-over-quarter basis, net interest margin increased by 35 basis points, which was really driven by 3 factors: First of all, recall that last quarter, I called out several items that were impacting the second quarter that we didn't expect would go forward. We had the U.K. PPI reserve build. We had an excess cash position that we had as a consequence of exiting some of our home loans business. And then we had the seasonal impact of card yield and balances being lower as customers typically increase payments after the tax season in the second quarter. So all those things we expected to not recur in the second quarter or in the third quarter and we saw that actually came to fruition. And then the other part that I would say is that in the third quarter, the -- we had a full quarter of having no home loans portfolio in the -- in our loan book. And so that brought forward some higher yields. And then finally, this quarter, we actually had an extra day to earn income. So that was a positive. Now those were all kind of things that moved -- that drove the performance of the linked-quarters positively. I will say that there continue to be a small headwind in a linked-quarter basis from deposit costs, and that's the one thing that I would expect to continue to be a headwind going forward.

And we'll take our next question from Moshe Orenbuch with Credit Suisse.

Rich, you talked a bit -- and I know you said not to over-rely on it but talked a little bit about the lower credit lines that you've been offering. And can you talk a little bit about how do you balance the risk of kind of adverse selection and how you think about then trying to grow in this environment? Is it that more of the growth is going to be in partnerships? I mean, how should we think about it, given that focus?

Well, Moshe, we are -- gosh, we have many, many years of testing and analysis around that. It's a very sophisticated question you're asking, because a lot of times, attempts to mitigate risk can actually cause risk because of the big role that, as you say, selection, be it positive selection or adverse selection, plays in ultimately the credit performance. This isn't just an actuarial science that repeats itself all of the time. So we -- but there are many positions on the dial, Moshe. And so -- and there's initial credit lines, but then there's also just the frequency and size of credit line increases and circumstances under which one grants it. And I think that we do view there's quite a range over customer relationships in terms of when we sort of monetize the opportunity for a greater credit extension. But I don't want to paint a picture of starvation lines that cause people to say -- that, "This doesn't have utility to me." These are all within what we see as a sweet spot within the continuum of choices that one can make. There's a sweet spot, and we're just dialed down within that sweet spot relative to some other times that we have made choices on the higher end of that sweet spot. The striking thing is there are just so many balances affected by that choice. For example, this is a thing that you look around the card industry and it's probably true even at the moment. But look at the card industry over the years. So often, the greatest loan growth is coming to the companies who, in that particular year, are dialing up their line increase programs. And so often, I think all of us have the mindset that marketing programs are going on and that there must be a one-to-one correspondent marketing programs, between marketing programs and accounts being booked and, therefore, loans. So we're just -- this enables us, Moshe, to lean in and go -- really go for the growth opportunities we see without feeling we have to hold back so much and to overlay the caution that we feel is pretty prudent at the same time. Does that make sense?

Got it, yes -- no. It does. And just as a quick kind of follow-up on the questions around Walmart. Could you just talk for a moment about the different approaches you might take to both Walmart relationship and the rest of your portfolio, depending on whether you do or do not buy the portfolio from Walmart?

Sorry, the different approaches we might take relative to what?

Well, I mean, obviously, it would increase the size of your portfolio 10% or so and the -- I mean, are there any things you would do differently in terms of your core growth if you found out that you weren't buying that portfolio or if you find out that you were?

Our core growth in One minus Walmart or...

Yes.

Yes, our core growth. It wouldn't have any impact on the growth elsewhere because I really want to pull up again we don't have any growth targets at Capital One. We never set growth targets, and I think all the folks who are running different parts of our lending businesses are all out there trying to figure out what is the nature of the opportunity they see and the risks that they see. And this is why Capital One, so often, business by business, is either at the top of the league tables or at the bottom of the league tables in terms of growth. Within individual parts of business, the same thing is true. I mentioned earlier in commercial, I smiled when I looked at a chart of the growth rate of the different subsegments of commercial that had -- and they were in red or green based on what direction they were going and they were very -- they were pretty darn big numbers in both directions, just reflecting differing degrees of choices in individual businesses. Walmart won't have any impact on the growth choices that we have elsewhere and whether or not we get the existing portfolio, because all across our card business, we're leaning in to capture all the growth opportunity that we see and we like our opportunities there. The other thing about Walmart is just understand that it's going to be a while before we finally start the Walmart relationship. From a new account origination point of view, there's a whole bunch of work that has to be done to get ready for this, to get this thing off the ground and so on. So I think the really powerful opportunity for Walmart is not something that's going to be a very near-term thing, but it's really the opportunity to take, not just a pretty big company, but a Fortune 1 company, of which there's only one of those, and really work together to build an opportunity that can really enhance their franchise and accelerate their digital transformation.

Moshe, there's one other thing that I would mention before we move on there. One of the things that would be impacted if we didn't move forward in getting the Walmart portfolio would be our capital position. And so between now and when we might acquire that, you may see us accreting capital above our 11% capital need. In the event that we weren't in a position to move forward in acquiring that portfolio -- and as Rich talked about, we may see that go all the way into Q1 of '19, I think it's unlikely that we would be able to do anything with capital distribution plans until CCAR 2019. So we would end up probably going into that with a higher capital level than we otherwise would.

And we'll take our next question from Rick Shane with JPMorgan.

When we look at the digital investment and we look at the growth of low loan balance accounts, one conclusion that could be drawn is that you were skewing towards a -- and deliberately doing this, towards a younger demographic. Is that one of the facets of what we see going on here?

Rick, I have not looked at data recently to be sure of the answer to that question. I do believe, at times when I have looked over the years at our demographic mix relative to others, I have been struck at the younger lean that we have in the business. And I believe a number of choices we're making are probably enhancing that. Those include the -- pretty much all the variations of the things we're doing on the digital side in the card business, some of the marketing that we're doing and the challenger marketing probably a little younger leaning, some of the marketing stuff that we're doing, then you overlay the national banking side of this, where as we go out to build a national banking franchise, we are, on the checking account side, by definition, going to be attracting people that probably aren't going to be highly focused on physical distribution on the branch on the corner. And what we have -- I think our opportunity on the banking side will be, particularly on checking, attractive to the lower -- the younger demographic. But let me say there's a flip side to this, which is we are offering some -- our marketing is also focusing on, "Hey, by the way, Capital One has great opportunities in our savings products. And unlike a lot of products out there where there's a teaser rate and then suddenly, now you see it, now you don't, we have a very strong, sustainably good rates." And that is particularly attractive, frankly, to the older demographic. So I think we've got something for everyone, hopefully, here. And the final thing I'd say too is a lot of the -- our emphasis on travel rewards and a lot of the heavy spender focus we've had at Capital One just ends up being -- going where the real spending is, which tends to be older.

Okay. So if my hypothesis in part is right that there is an element of this of putting plastic in the wallets of a younger demo, with the idea that you can build a relationship over time, and you're offering them low credit limits today and, as you've touched upon, turning up the credit limit is a very easy and successful way to accelerate loan growth, what do you think the time frame to do that is? Is it a year? Is it 5 years when you look at that customer? And again, put this in the context of inability to market to college students the way that you could a generation ago.

Well, first of all, I want to make a comment about the -- my comment about credit limits is no strategy change for Capital One. It's nothing new that I'm saying about credit limits. We've had this strategy for 20 years. In terms of every year, we make a discrete decision about how much we're originating new accounts and a discrete decision about how much we are building the credit lines and how much exposure that we want to have. So I don't want anyone to go try to figure out the, like, "new strategy" of Capital One. It's really more to point out the higher-than-usual, at this very moment, separation between growth metrics of purchase volume and the metrics we see on new account origination versus the loan growth, which, per the earlier question, kind of doesn't look like it's keeping up with the other numbers or the -- or my words as we're talking here. I think that Capital One, from its founding days, has been very focused on creating long-term shareholder value. Everything is in the context of net present value. Everything good I have ever seen has pain first and gain second. In fact, I've learned to almost run from opportunities that have gain first and pain second, because I've learned that we, as an industry, can't control ourselves when that is the case, but from the really founding of the company, which took a lot of years, the building of all the long-term data on credit performance from which we could understand how things -- where we could extend loans and where we wouldn't, the move to transform the balance sheet of the company out of concern for capital market funding reliance and, therefore, the deep move into banking, the digital transformation that we are many years into, which I talked about earlier. And another one is the national banking strategy that we're talking about here. I -- what we are focused on doing is building a franchise that will endure and generate tremendous shareholder value over time. And the -- some of the things we've been talking about today are just examples of that.

And our final question this evening comes from Betsy Graseck with Morgan Stanley.

Okay. So just a couple of follow-ups here. One, I just wanted to understand, Scott, when you mentioned that you might be holding on to a little bit more capital in the event that you were to buy the back book. Could you give us a sense as to whether or not that's going to impact 4Q share buybacks or not? And then Rich, I wanted to understand from you, what is it about the digital offering that you have that Walmart was so interested in? Because you did mention about together, really delivering a much more enhanced digital experience for the Walmart customer. So I wanted to understand what you're bringing to the table there and if this is something that could not only make more efficient this relationship, but other private-label relationships that you have out.

Betsy, why don't I start there? I think we have ample earnings power and a starting capital position today where we're going to be able to support our current $1.2 billion capital plan, as well as start to accrete capital for the Walmart transaction, should that be something that we end up negotiating a successful agreement to acquire.

Okay. And then Rich, on the question regarding the offering that you have on the digital side with Walmart?

Yes. So I don't want to -- I'm reluctant to use the word offering. I think it's really more the capabilities and possibly really the similarity of the journeys between the 2. Now I don't want to speak for Walmart. They really need to speak for themselves. I think their initial press release, which talked quite a bit about the technology thing, would be a place to look. But I really -- my conversation, I don't want to speak for them, although I'm very impressed by a number of things they're doing in -- all-in on their technology journey. I think for card partnerships, for so long, the card partnership industry has been -- especially when you talk about retailers, because then there's airlines and other things, too. If we just talk about retailers, I think the card partnerships have -- a lot of the partnerships have been focused on how can we just get more cards in peoples' hands, how can we -- there are a lot of players who make quite a bit of money on their -- retailers who make quite a bit of money on their card partnerships. There are retailers who make most of their money on their card partnerships and, in some cases, more than their entire retailing business. The digital revolution and the e-commerce revolution and the payments revolution has actually brought credit cards into a more central role in the future of how retailing is going to work, because on the -- for example, on the -- in a store, the card that is used is just the tail on the dog. In e-commerce, sometimes, it is the dog. The friction associated with how payments work, how people get customers' credentials and into a relationship is a different thing. Then you also -- another aspect of the digital revolution is the tremendous opportunity to build deep customer relationships through data. And of course, that again goes right -- the credit card is right at the vortex of that whole journey. So it turns out it's really hard to bolt payments and data capabilities and transactional and customer experience capabilities onto an existing legacy retailer or an existing credit card company. To be able to break the friction and open up a much -- a very large opportunity in digitally driven commerce, be it either in e-commerce or physical retailer -- retail, requires being well down a path of transformation. And when both the retailer is and the credit card company, the ability to be able to create customer experiences together is something that is really hard to do if 1 of those 2 partners is not on that journey. And it's just, I think, in this particular case, I think -- and I'll speak for myself. Walmart can speak for themselves. I think I'm struck by the nature of the opportunities when 2 companies in very different industries are struck by the size of the opportunity and the transformation that's necessary to get there.

Well, thank you very much, everybody, for joining us on the conference call today, and thank you for your interest in Capital One. Remember, the Investor Relations team will be here this evening to answer any further questions you may have. Thanks, and have a good night.

And that does conclude today's conference. Thank you for your participation. You may now disconnect.