Capital One Financial Corporation (COF) Q2 2016 Earnings Report, Transcript and Summary

Welcome to the Capital One Second Quarter 2016 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. [Operator Instructions]. Thank you. 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, Dede, 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 the financials, we've 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 this 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 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 the Capital One website and filed with the SEC. Now I'll turn the call over to Mr. Fairbank. Rich.

Thanks Jeff and good evening everyone. I wanted to begin this evening by welcome 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 a CFO, and he’ll 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. And now I’ll turn the call over to Scott.

Thanks Rich. I’ll begin tonight with slide 3, Capital One earned 942 million or a $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 slight outlining adjusting items can be found on page 11 of the slide deck. Pre-provision earnings decreased 1% on a linked basis as higher revenues were offset by higher non-interest expenses. Provisions 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 report 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, balanced 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’re projecting in to 2017. And as we have been saying, based on the credit guidance we have today, we expect allowance build to continue. Allowance in our consumer banking segment increased 58 million in the quarter. This increase was attributable to our auto business, where we build allowance for new originations that included a higher portion of subprime and we expected auto auction prices will decline from current levels. Lastly, we had a net $50 million build in reserves in our commercial banking segment. We build 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 per 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, fuelled 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 returning 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 account 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 measures on a slight lag to quarter end. In the third quarter, we expect to complete some system enhancements that will move their rewards liability cut-off to the last day of the quarter, resulting in a one-time increase in rewards costs in the third quarter. With that, I will turn the call over to Rich.

Thanks Scott. I’ll 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. Overtime 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’ve 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%. Non-interest 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 quarter versus the 14% growth in domestic card purchase volume. As we’ve discussed, there’s 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’d expect this difference to continue, as we originate new reward 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 linked 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 rates to be around 4% with quarterly seasonal variability. And while it’s 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 rate in the low force with quarterly seasonal variability. Our domestic card business delivered strong growth in returns in the second quarter, and we really like the business we are booking. While we continue to closely watch the market place, 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 at auto loans was offset by planned mortgage run-off. 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’re 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 origination stayed essentially flat for a few years before shrinking in 2015, despite growth in the subprime market. Our prime originations continue to grow during this period. In the first half of 2016, these competitive practices seemed to have subsided somewhat, which enabled us to grow our subprime originations. Even though we’ve had two quarters of stronger growth, the auto market and competitive practices remain dynamic. While we 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 run-off of mortgage balances. Non-interest 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’ve 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 cost for 2016. These costs show up in the other category rather 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’ve 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 run-off 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’ll 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 a $128 million, as we continued to build reserves. We’ve been building reserves over the last six quarters to reflect increasing risk in oil and gas and taxi medallion loans. Criticized and non-performing 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 rates of 3.7% and the criticized non-performing 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’ll 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 losses. Non-interest expense increased modestly from the linked quarter, but second quarter non-interest 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 cost 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 overtime, and we continue to tightly manage cost 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’ll now start the Q&A session. As a courtesy there are other investors and analyst 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 Dede.

[Operator Instructions] We’ll start the question with Betsy Graseck with Morgan Stanley. Please go ahead.

Couple of questions, one is on the reserve. Just wanted to understand when during the quarter do you make decision to do the reserve top up and this is something that’s looking forward just on a four quarter basis or is this on a - more of a two year basis, an eight quarter basis.

Besty its Scott, thanks for the question. Let me just reiterate that for our consumer facing businesses there’s kind of three parts that impact the allowance. The first is that we take the outstand as of the end of the period, the second is that we look at our loss expectations 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 every quarter we true-up qualitative factor. So those were really the factors, the same process that we do each quarter for the allowance.

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 network. And I think Rich you’ve mentioned this on prior calls, 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’s the same phenomenon with pretty much the same merchants that I talked about in the past. So these are big merchants so therefore you’ll see the effects on our metrics as this rolls through. Some of it is in there and some is rolling in to the numbers. But it will not necessitate a change in anything about our strategy of going after the rewards business and continue to believe in the growth opportunity in that business.

Next question please.

And next we’ll hear from Ryan Nash with Goldman Sachs.

Rich, maybe if I could start off with a question on credit. We’ve now had 13 months of double-digit loan growth in the US. You’re reiterating the guidance on charge-offs for and low for us next year. You noted the impact of growth math will decelerate. So I’m just trying to understand if let’s just say loan growth were to remain steadier 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 mix to actually peak.

Hey Ryan, Look I’m reluctant to predict peak per say, 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 build driven by loan growth. And overtime 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. So, we are growing at a pretty rapid pace now, so even if the loan growth flows a bit from here, it is still quite a bit of growth relative to the highly seasoned back book. So you’re right about the math, I’m 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. 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’re still seeing some competitive pressures. Maybe can you just expand a little bit on those comments, what you’re seeing competitively and one of the regional bank Huntington talked about the sensitivity to a fall-in in the Manheim. They said if the Manheim fell a 100 they would see charge-offs go from 20 to 30. Can you may be just talk quantitatively or qualitatively about how you would expect the sensitivity to charge-offs to a falling Manheim.

As credit people we are always worriers, right. And 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 may not be the very same thing as in the economic cycle and we have to act accordingly. So 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 in to credit quality and not only for those doing those practices, but it can ripple effects on the industry. So it’s a top of our list, its concerns has been competitors practices, and we have lagged particularly in the subprime area some concern about that. That as I mentioned is actually looks like its mitigating somewhat, I don’t want to declare victory on that, but that’s a positive here and we’ll 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’s a little bit more out there and more competition and that’s why overtime 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 pricing, a lot of the impact has been more on the pricing that affects margins. So that’s kind of the competitive side of it, and then as we mentioned for quite a long time, we’ve 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 concern and we said pretty much there’s only one way for them to go from here. Interestingly if you look at the Manheim index, that is pretty flat, may be 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. Interesting point, well why would our recovery index would be disconnected a little bit from the Manheim index? I think that’s a little bit more about that our mix is a little different from Manheim’s’ mix. 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, the only way from here is down and we underwrite to an assumption that this thing is coming down right away. How it actually plays out, we’ll have to see. I don’t think we’ve got any like scenario modeling quantitatively to share with you, but I think you’re focusing on the right concerns in the business.

Next question please.

And our next question comes from Eric Wasserstrom with Guggenheim Securities.

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’re seeing that caused you think that there’s going to be a change in the frequency of default in auto.

No, I think that our outlook was frankly relative to last quarter probably a little more bullish, just more locally bullish about the auto business because of a little mitigation that’s 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 life time levels from some years ago, there’s a gradual normalization that’s very much kind of how the market works, and I think that we see that going on, but we don’t see indicators that would suggest that there’s some turn in the business and we talked about the used car issues we’re keeping an eye on, but other than that I think more this is us worrying as oppose to reporting some real degradation in the business.

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

When you say optimization you’re talking about the branch restructuring cost?

Correct.

Well you’ll see obviously the charges will be broken out in the other area, but they will be spread throughout the income statement, they’ll obviously be recognized overtime. We’ve already recognized about 40 million of the 160 million so that means we have another 80 to go in the second half.

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

It’s a 160 total, so 40 in the first half, the run rate will be up 80 versus the first half, so it will be about 120.

Next question please.

And next we have Rich Shane with J.P. Morgan.

I think in a lot of ways that the positive factor for Capital One over the next 18 months is going to be given the ramp up in car charge-offs the stabilization that you point to in 2017, what I’m trying to understand is, and I think this sort of 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’s going to start to flatten out?

I want to be perfectly clear that the business we’re 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 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 how a growth math works.

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 for ’17 a little bit earlier than you have in the past.

Absolutely Rich. The way we looked at it is that and why we stepped out of character a little bit to provide guidance farther out in to the future is that we were moving in to a period where two things were true, one is that we were growing at a pretty rapid rate and expected to do continue to do that, which is 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 seasoned and recession sort of survived the existing back book is. And so that impact of all of that let us to feel it was important to give a sense of where, with a lots of other things being equal growth math would take our credit. And along the way to explain to you how growth math works. But I want to pull up on this, I found over the many years in building Capital One, just about anything that’s 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 actually would kill the opportunity. We have many years of experience in studying credit and understanding how value gets created overtime by origination. But the key is very solid underwriting, incredibly rigorous, what I call horizontal accountings that one understands the full vintage economics and how they perform overtime 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, allowances being built, we feel great about the business that we are booking. We’re incredibly happy that we’ve had the growth opportunity for the period of time that we have. We know competition is increasing, but we’re 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.

And next we have Arren Cyganovich with D.A. Davidson.

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 and reward subprime. And my question is more about you still finding opportunities in here, but you’re also seeing this increasing competition. I’m trying to balance the way that you’re discussing this. It seems as though that it’s becoming more difficult and maybe you’re signaling that loan growth could slow a little bit from here. I’m trying to understand what you’re trying to tell us in that comment.

I think for those who know me, how I try to operate in this thing. It’s less about signaling and more about just describing what we see and sharing with you what are the - so what’s of that. So I start with, we are very bullish about our growth opportunity. It is 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’re 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’s 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 effects growth itself. So it is noteworthy that competition from rewards all the way down to subprime despite sometimes protestation 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’ve created some pretty unique opportunities and we like the value that we’re offering customers and the customer experience and we feel good about that opportunity. The second thing and I made the same point last quarter and I make it so often is, what we’re seeing here is a very natural part of how the competitive cycle works. But increased growth overtime tends to make its way into credit metrics in the industry as well. 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 in to industry credit metrics. And then the thing that even more worries and that we look for and we have not seen this is sort of the next stage in cycles do people actually start really compromising their underwriting standards and that becomes something that is kind of at the next level in how these cycles evolve. So we feel great about the opportunity, it’s not lost on us as a 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’s kind of how we operate Capital One.

Next question please.

And next from KBW we’ll here from Sanjay Sakhrani.

I just wanted to touch back on the competition, is it due to existing players or are there new entrants that are coming in both the credit card and the auto side?

This competition, by the way there’s not like some big thing that happened in the last quarter. This is a creeping increase in competition, it’s primarily by the biggest players in the business who in fact definitionally dominate the business. So you’ve seen some increased competition in the reward space, you’ve seen some competitors strengthen some of their rewards proposition, value propositions. There’s actually been people stepping up and announcing they are going to step up some of their marketing, and finally we can see it in just in some of the growth numbers across the segment. I would also point out that there is sort of 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’s part of the supply equation as well, but this is something that we’d give a continuing description about this phenomenon, because over time 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.

And then separately on the efficiency ratio side, how much leverage do you guys have in terms of for the next year. How should we think about that?

I don’t know there’s much to do beyond the guidance that we’ve already given you. Is there something else that you’d like to discuss just kind of as far as we’ve been prepared to go?

Yeah just wanted to quantify in terms of the continued improvement in 2017.

We are not going to go to the quantification, the guidance kind of is what we’ve stated and it’s been stated for a while, so it’s going to be a function of a whole bunch of things, but that’s a long way out going in to ’17.

Next question please.

And next we’ll hear from Chris Brendler with Stifel.

Can you talk at all the comments on interchange pressure, as I look at your net interchange stands about 15 basis points last two years? How much of that is increasing rewards expense and how much of the decline recently has been from this 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’re going to get in to the main issue on line by line with each of these things and the factors that are driving our income statement. We’re trying to give you a sense of the major things, but you’d kind of heard our commentary on what the impacts are that’s kind of probably where I’d leave it.

I guess ask a different way, if I look back historically net interchange used to be a 150 basis points maybe five-ten years ago and now we’re down to 87. Is this the rate for the bottom or do you think it will stabilize at some point?

I think that the entire industry is - look there’s competition both on the front-end kind of marketed products and what are the rewards that are being offered. And the other trend is very important one to point out is, the extension of more rewards deeper in to 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 that over a multi-year period there is this migration that has gone on.

And again just look at the rewards decline in a vacuum. The rewards that we’ve 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’s happening in that rewards.

Next question please.

And next we’ll hear from Moshe Orenbuch with Credit Suisse.

I know that you don’t think about the reserve as a percentage of loan in the credit card business. But it seems like there’s a bit of disconnect, right, you’ve given a lot of specific guidance that you’ve 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 that seems to be getting wrong of their reserve build. With what seems like relatively stability in the charge-offs right, you’re talking about charge-offs that averaged a little more than 4% for the first half and you’re saying pretty much that for the full year. So not a big change in the next couple of quarter and then low fours after that. So this doesn’t sound like there’s a big change in that. I understand that you’ve 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 its 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. And so you know as sounds fluctuate that those coverage ratios can send false signals. I think I would say that as we told you we expect losses 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. And as Rich mentioned, there is going to be a point where you start to see the growth math effects moderate and at that time we would expect that relationship to change, but we do expect that we’re going to continue to see fluctuations in the allowance quarter-to-quarter. I really to appreciate that modeling that thing is tough. And I’m going to just give you a very blunt hypothetical example, a 10 basis points move in loss rate which can easily happen, not be anything more than noise can trigger a 90 million allowance change. So 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 think credits’ going and what’s driving our allowances as well as the guidance that we’ve already provided.

Scott we’re not trying combative here, but the problem is if you’re telling us that the guidance is the same, that’s where we are struggling, because if the guidance is the same and we’ve seen the additions over the last five quarters, what is different? Is it just that --.

We didn’t provide you guidance on allowance still.

Understood.

So that’s not something that we’re prepared to do. What we can tell you is what drives allowance, growth in our portfolio, change in credit card charge-offs insight in to, and then Scott provided a very real example, a 10 basis points change which is not very much which is one-third of the reserve build we had this quarter. So you’re not difficult to totally understand the genesis of the question, but over the last 18 months as we knew that this was going to be a real consideration and 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 surprises here. We really like the growth we’re having, but think about it as a capital investment in growth. It’s something that we believe is going to lead to real economic value creation.

Or maybe this will be one of the advantages of [CCAR].

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

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 roughly do you need hundreds of basis points in deceleration to affect the change, and is the relationship on the way down linear or is it more of a step change. Thanks.

The fact that we’re having deceleration in growth if you go back to I think Scotts excellent explanation. If we just lower growth next quarter, by definition we are going to have a lower allowance build for that growth. And then if you have lower new originations than you have a higher percentage of the back book relative to the front book comparing to what you otherwise would have. So that and that in some degree will drive down the allowance filled. But that’s 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.

I don’t think people should expect that if the very high growth rate we’ve been going on turns in to a pretty high growth rate that you’re going to see some big sea change here. This is still - we are origination at - these are a lot of originations and as a percentage relative to the back book 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’s going to be with us through - that’s not going to suddenly turnaround. But I think what I like so much about this is coiled spring of economic value for which we are paying upfront 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 kinds of opportunities and this is in many ways really the pay-off for the information based strategy where we invested for years. And I’d also point out too that we’re a company that while a lot of companies look around and say what’s the next thing we can buy. We are a company that is designed to as in 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 pay-off is not going to come in the near-term by credit losses turning around and going down. Over the longer term each vintage will peak and actually go down and there’s 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.

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?

Matt this is Scott. The release actually runs through as part of our provision expense.

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

Yeah, that will be about 20 million a quarter starting in the third quarter.

And then just on the taxi medallion portfolio, I appreciate it’s not huge, it’s than a $1 billion obviously. But do you have any color as to how you’re thinking that will continue to perform, are there other cities where you’re concerned about a meaningful drop in valuation similar to what you saw in Chicago?

Matt let me start and other can pile in. So 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 medallion. So that’s principally what’s going on in that market. The other market that we have our principal exposure to its in New York, which is a different market. I think we’ve talked about that in markets where it’s a hail market, prices are seemed to be more stable, and so I don’t want to give you too much confidence about where we see things move in to New York. But definitely our level of concern about Chicago is much higher than what we would say in the New York market place, it’s just a different mix and small right now.

Well thanks 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.