Capital One Financial Corporation (COF) Q3 2018 Earnings Report, Transcript and Summary

Welcome to the Capital One Third Quarter 2018 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 Finance. Sir, you may begin.

Thanks very much, Leanne, and welcome, everybody 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've 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 this presentation. To access a copy of the presentation and press release, please go to Capital One's website, click on Investors and 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 in 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. And with that 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 two 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 $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 at 1% on a linked-quarter basis and down 31% year-over-year primarily driven by allowance for leases 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 non-deductible 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 non-recurring 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 in 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, where $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 and capital distribution. And as I mentioned last quarter, how the capital frameworks and CCAR ultimately incorporate the effects of CECL as well as the calculation in the CECL 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 strong 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're 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 impact 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. Non-interest 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're 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. Non-interest 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 value 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 into 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 yield. Non-interest 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 credit sized performing loan rate for the quarter was 3.2%. The credit sized non-performing loan rate was 0.4%. While the credit performance of our commercial banking business remains strong increasing competition from non-banks continues to drive less favorable lending terms in the market place. 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 two 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'll be able to achieve gradual and 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're 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. As a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to one question plus a single follow-up. If you have any follow-up questions after the Q&A session, the Investor Relations team will be available after the call. Leanne, 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 is nothing structurally that would cause you not to, want to own it, it's more of just economics like any other deals. 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 two.

Got it and then just sort of.

There's nothing beyond that.

Got it, and then obviously the multiple in the stock is in the sort of high sevens, low eights, and the market is 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?

It's a great question, Don, because in so many ways, one can't help, but we struck by 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 you know 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 deficits, trade related issues, and also cumulatively some of the effects 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 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 originates 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, new product rollouts, 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 build of balances. So, we've been talking caution for really probably two, 2.5 years at this point relative to credit lines, but 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. 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.

Next question, please.

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, and just I want to make sure it's in the other segment in other, I guess non-interest income, right?

Yes, so in terms of the impact, you've got it right, it's in non-interest 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 now, I just also mentioned that during the period that we held those after we put them, we identified this is 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're 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 mode is relative to your peers.

Let's pull way up on the digital transformation. I think this is the most important thing, it's the 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 on this transformation for years and as a lot of work one does on the down deep in the technology stack it's not something investors can see, it's not something the outside world can see. Frankly it feels like that a lot of costs, it can feel like a lot of cost and not necessarily a lot of benefits. But what we're struck by is, everything that we want to accomplish on the technology side, on the - inspect the customers, product - customer experience, product innovation, leveraging machine learning, some international 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 benefit is accelerating because each transformation of one thing sort of helped 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. Walmart is certainly a specific example of that, there are probably a lot of factors that went into why Walmart made the selection that it did, but I certainly believe that the shared transformation journey we reach in 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. Our customer 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 number one in that ranking, just came out again few weeks ago, Capital One is number one 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 manifestation of things. I would direct you to look at things like our CreditWise tool. There are 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 whole set of experiences that can help people use credit wisely. If you look at our auto finance business Capital One 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 pre-approved 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 this - you can't build 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 maybe that's different from another product that's out there. But what I'm 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 than the market, offer way better product, have way better risk management, along the credit dimensions, fraud, cyber security, that's all shared path, same thing better operating controls in a world where the regulatory requirements and frankly the expectation is 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. This is for our customers, not just an app but integrated right into their lives. So that's the journey that we're on the - we see - the manifestation of these benefits on many dimensions 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 of 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're 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 a 100% of everything that we do is basically digital. But along the way while technology investment has continued to be significant. 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 the analog channels and operations in the company.

Next question please.

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

So Rich, I was hoping we could start with 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 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 up marketing spend will mean for the improvement in loan growth overtime. Thank you.

So I don't see this, this is not a wind the size of sort of the window that we saw in 2014, 2015, 2016 when we had way outsized growth. What we're 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're leaning into that. 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 what we about credit lines. It's not entirely I mean because that we originate has a 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, from a line of scrimmage call point of view about the card market place and the economy, that will be the biggest driver of the loan growth. What we're excited about is the ability to generate a lot of accounts, they represent sort of stored opportunity that can be harnessed when we open up those lines at a later point.

Got it. And then Scott, you highlighted $170 million reserve build for $100 million the fine for the OCC related to 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 orders? Thanks.

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 thing gets resolved here sooner than later.

Next question please.

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 pointless 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 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.

Sorry, what are you pointing at in particular that says everything would indicate the other direction? Can you just?

No, I'm sorry. I was just pointing out, 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 you know 16 to 18 months ago. So just wondering if you could comment on that versus [indiscernible] point about leaning into the growth.

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, probably two years has had anomalous situation where even though we're moving along in the credit cycle, the supply and demand situation kind of changed due to the pull back of one or maybe two significant players in the business. So Capital One really leaned into that growth opportunity and ever since we've been leaning into that, we've said overtime 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 exists 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 a some big change from the trajectory that we're on. On the card side, the card industry I've been struck by the stability in the card industry kind of let me just back and sort of describe things that have gone on. I think there was a significant window for growth few years ago, we capitalized on that. Everybody in the industry saw us, supply shooting up, we saw some of the - in the second quarter of 2016 vintage curves across the whole industry starting gapping out and we and a number of other players, all identified this and it was a bit of shot across the bow [ph] to the card industry that don't get to ahead of yourself and I think the industry took the caution to heart 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 the 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 [audio gap] 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 they're 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're pursuing, the particular opportunities that we see in the card business are something that we're 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're 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 the low end of the league tables of industry growth. So I think that's the context. Thank you.

That's super helpful. Rich. Thank you, if I may as a follow-up. Could you just quickly just elaborate on the competition that you're seeing from non-banks that you mentioned earlier and that's it. Thank you.

You're talking about on the commercial side.

Yes.

So I kind of go back to, I start with a little bit of - 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 sceptical about their performance in the next recession and maybe the inverse is true for those. So what I was struck by 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 continue to lose the opportunity to generate consumer side of the business, 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 - put that in your little cautionary thing. Additionally what we've seen of course now with the US 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 assets 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're using more debt to finance them. It's striking and I looked through 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 is weakness all around the edges there. Non-banks unhampered by regulation are accepting more aggressive structures in an attempt to provide their investors return. And this just increase 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, so one thing we're watching and obsessing about it, but we like pretty much every other bank that we heard on the call, they're calling for the need to stay disciplined in this case specifically what we've done is, to identify the sectors that are particularly vulnerable to these kinds of trends or have structural reasons that maybe less resilient and we have reduced exposure in those sectors and the fact if you look at last number of quarters probably in the last six quarters, maybe Capital One's loan growth has been pretty [indiscernible] on the commercial side which is really a lot of that been driven by the dialing back and reducing exposures in all of the areas that we identify as having a concern. So I think as a cross calibration across all the market places 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 further along in the economic cycle, more subject to the classic ways that lenders talk themselves into you know it's going to be okay, but when I calibrate I feel quite a bit better about the lending conditions that are going on the consumer side.

Next question please.

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 [ph] 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 we don't view this deal 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 should go to school on; on how that industry is evolving. So we start with Walmart themselves as a 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 the credit card. So Walmart is so focused on leveraging this to build and grow their franchise and drive their digital transformation and finally and the partnership agreement really aligns out economic and strategic interest 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 two parties 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 it's best for the partner. So that leaves 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 is typically the case that back books follow front books, when a retailer switches issuers. There is obviously a lot of benefits from a customer experience and data perspective, but it's not always the back book follow front books and at Capital One we've had circumstances where we've done a successful front book deal without taking the back book and so now finally to your question. 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 a about price and terms and you know I think you're right Eric, 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 there are lot of things that we've passed on and for us to, we will agree to acquire this at pricing terms that are attractive to us and which help us mitigate the issues that we've often been concerned about portfolios out there in the marketplace.

Great, thank you for that and then 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 cause it seems like many of that dynamics that might drive 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 cadent.

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 is really driven by three 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 UK 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, is that in the third quarter we had a full quarter of having no home loans portfolio in our loan book and so that brought forward some higher yield 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 on a linked quarter basis from deposit cost and that's the one thing that I would expect to continue to a headwind going forward.

Next question please.

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 of it, as you say selection, be it positive selection or adverse selection plays and 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 on the Moshe and so there initial credit lines but then there's also just the frequency and size of credit line increases and the circumstances under which one granted and I think that we do view there's a quite range over customer relationships in terms of when we sort of monetize the opportunity for 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's 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?

Yes, it does and just 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 approach is, we might take relative to what.

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

Our core growth in one minus Walmart.

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 risk that they see and this is why, Capital One so often business-by-business is either at the top of the leading tables or 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 the chart of the growth rate of the different segments of commercial that had and they were in red or green based on what direction they were going and they were pretty darn big numbers in both direction 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 into capture all the growth opportunities that we see and we like our opportunities. The only 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 going to be 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 are only one of those and really work together to build an opportunity that can really enhance their franchise and accelerate their digital transformation.

Moshe, just 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 needs 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 2019. 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.

Next question please.

And we'll take our next question from Rich Shane with J. P. Morgan.

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 deliberating this towards a younger demographic. Is that one of the passives what we see going on here?

Rich, I've 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 of 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, the new overlay of the national banking side of this, where as we go out to build a national banking franchise, we're 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. 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 flipside to this, which is we're offering some, our marketing is also focusing on hey [ph], 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 very strong sustainably good rates and that is particularly attractive frankly to the older demographics. So I think we've got something for everyone hopefully here. And final thing I would say to is, a lot of our emphasis on that travel rewards 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 putting plastic in the walls of like younger demo with the idea that you can build a relationship overtime. And you're offering them low credit limits to that and as you've touched upon turning up the credit limit as a very easy and successful way to accelerate loan growth. What do you think the timeframe to do that is, is it a year or is it five years, when you look at the customer? And again put this in the context of inability to market to college students the way that you could a generation ago.

So I want to make a comment about, 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're 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 “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 for the earlier question kind of doesn't look like it's keeping up with the other numbers 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've ever seen has paying first and gained second. In fact, I've learned to almost run from opportunities that I've gained first and paying second because I've learnt 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 would 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 in the banking, the digital transformation that we're many years into which I talked about earlier and another one is, the national banking strategy that we're talking about here. What we're focused on doing a building a franchise that will endure and generate tremendous shareholder value overtime and some of things we've been talking about today are just examples of that.

Next question please.

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 onto to a little bit more capital in the event that you would 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 Walmart customer? So 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 part of label relationships that you have.

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

Yes, 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 two. 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've really my conversation I don't want to speak for them although I'm very impressed by a number of things they're doing and all in 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 is airlines and other things too. If we just talk about retailers I think the car partnerships have a lot of the partnerships have been focused on how can we just get more cards in people's hands, how can we there are a lot of players who make quite a bit of money - 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 in the 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, 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, the credit card is right at the vortex of that hole 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 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, if one of those two partners is not on that journey and it just, I think in this particular case. I think and I'll speak for myself, Walmart can speak for themselves. I'm thinking I'm struck by the nature of the opportunities when two 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 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.