Capital One Financial Corporation (COF) Q1 2023 Earnings Report, Transcript and Summary

Good day, and thank you for standing by. Welcome to First Quarter 2023 Capital One Financial Earnings Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Jeff Norris, Senior Vice President of Finance. Please go ahead.

Thanks very much, Amy, and welcome, everybody, to Capital One's First Quarter 2023 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, capitalone.com, and follow the links from there. In addition to the press release and financials, we've included a presentation summarizing our first quarter 2023 results. With me this evening are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer; and Mr. Andrew Young, Capital One's Chief Financial Officer. Rich and Andrew will walk you through this presentation. To access a copy of the presentation and the 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 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 that are accessible at the Capital One website and filed with the SEC. With that, I'll turn the call over to Andrew.

Thanks, Jeff, and good afternoon, everyone. I'll start on Slide 3 of tonight's presentation. In the first quarter, Capital One earned $960 million or $2.31 per diluted common share. Pre-provision earnings of $4 billion were flat to the fourth quarter and up 3% relative to the fourth quarter net of adjustments. Period-end loans held for investment declined 1% and average loans were flat. Total deposits grew throughout the quarter, increasing 4% on average and 5% on an ending basis. The increase in deposits was driven by strong retail deposit inflows, which was slightly offset by a decline in our commercial deposits. Our strong retail deposit growth drove our percentage of FDIC insured deposits, up 2% to end the quarter at 78% of total deposits. We have provided additional details on deposit trends on Slide 18 in the appendix. Revenue in the linked quarter decreased 2%, primarily driven by lower noninterest income while net interest income was largely flat. Noninterest expense decreased 3% in the quarter, driven by a decline in marketing from the seasonally higher fourth quarter. Operating expenses were up about 2% on a GAAP basis and roughly flat net of the fourth quarter adjusting items. Provision expense was $2.8 billion, driven by net charge-offs of $1.7 billion and an allowance build of $1.1 billion. Turning to Slide 4, I will cover the changes in our allowance in greater detail. The $1.1 billion increase in allowance brings our total company allowance balance up to $14.3 billion as of March 31st. The total company coverage ratio is now 4.64%, up 40 basis points from the prior quarter. In our allowance, our assumptions for key economic variables remain similar to those of last quarter. We continue to assume economic worsening from today's levels on most measures. I'll cover the drivers of the changes in allowance and coverage ratio by segment on Slide 5. In our Domestic Card business, the allowance balance increased by $867 million, increasing our coverage ratio by 69 basis points to 7.66%. Our build in the quarter was primarily driven by 3 factors: the first factor is the impact of underlying growth in the quarter, which replaced seasonal balances from the fourth quarter for which we held minimal allowance. The second factor is the impact of removing the relatively lower loss content from the first quarter of 2023 and replacing it with higher forecasted loss content for the first quarter of 2024. Recall that our allowance methodology uses a 12-month reasonable and supportable forecast period, before it begins to revert to our historical loss average with additional consideration of qualitative factors. And finally, the third factor in our allowance build was the impact of acquiring the BJ's portfolio in the quarter. In our Consumer Banking segment, the allowance balance declined by $32 million, mostly driven by the decline in loans. The coverage ratio increased by 2 basis points and now stands at 2.82%. And finally, in our Commercial Banking business, the allowance increased by $245 million. The coverage ratio increased by 28 basis points and now stands at 1.82%. The allowance increase was driven by a $262 million reserve build related to our $3.6 billion commercial office portfolio. The coverage on the commercial office portfolio increased about 770 basis points and now stands at 13.9%. We have provided additional details on this portfolio on Slide 17 of the presentation. Turning to Page 6. I'll now discuss liquidity. You can see our preliminary average liquidity coverage ratio during the first quarter was 148%, up from 143% last quarter and 140% a year ago. Total liquidity reserves in the quarter increased by $20 billion to $127 billion, primarily driven by increased levels of cash. Our cash position ended the quarter at $47 billion, up $16 million from the prior quarter. This increase in our cash position was primarily driven by the strong consumer deposit growth I referenced earlier. We expect average cash balances in the near term to be elevated relative to pre-pandemic levels. In addition to the higher cash, the market value of our AFS securities portfolio grew $5 billion to $82 billion at the end of the quarter. Turning to Page 7. I'll cover our net interest margin. Our first quarter net interest margin was 6.6%, 24 basis points lower than last quarter and 11 basis points higher than the year ago quarter. The 24 basis point quarter-over-quarter decline in NIM was driven by 2 factors: first, 15 basis points of the decline was a result of having 2 fewer days in the quarter; and second, the mix impact of the elevated cash balances that I previously described pressured NIM by approximately 11 basis points. Outside of these 2 effects, higher asset yields roughly offset higher funding costs. Turning to Slide 8. I will end by discussing our capital position. Our common equity Tier 1 capital ratio ended the quarter at 12.5%, flat to the prior quarter. Net income in the quarter and lower risk-weighted assets were offset by common and preferred dividends, the $150 million of share repurchase we completed in the quarter and a 17 basis point impact from the phase-in of the CECL transition. At the end of the first quarter, the unrealized losses in AOCI from our AFS investment portfolio were $6.7 billion. If we were to include the impact of these unrealized losses in our regulatory capital, our CET1 ratio would have ended the quarter at 10.5%, and we continue to estimate that our longer-term CET1 capital need is around 11%. With that, I will turn the call over to Rich. Rich?

Thanks, Andrew, and good evening, everyone. I'll begin on Slide 10 with first quarter results in our credit card business. Year-over-year growth in loans and purchase volume drove an increase in revenue compared to the prior year quarter. Credit Card segment results are largely a function of our domestic card results and trends, which are shown on Slide 11. In the first quarter, strong year-over-year growth in every top line metric continued in our Domestic Card business. Purchase volume for the first quarter was up 10% from the first quarter of 2022, ending loan balances increased $23 billion or about 21% year-over-year and revenue was up 17% year-over-year, driven by the growth in purchase volume and loans. Revenue margin declined 58 basis points from the prior year quarter and remains strong at 17.7%. Revenue margin continues to benefit from growth in the high-margin segments of our card business. In the first quarter, that benefit was more than offset by 2 factors: first, loans are currently growing at a faster rate than purchase volume and net interchange revenue. That dynamic is a tailwind to revenue dollars, but a headwind to revenue margin. And second, as charge-offs increase, we're reversing more finance charge and fee revenue. Both the charge-off rate and the delinquency rate continued to normalize. The domestic card charge-off rate for the quarter was up 192 basis points year-over-year to 4.04%. The 30-plus delinquency rate at quarter end increased 134 basis points from the prior year to 3.66% and is now essentially at its March 2019 level. The charge-off rate hasn't caught up yet. But based on what we see in our delinquencies, we think the monthly charge-off rate we'll get back to 2019 levels around the middle of this year. Noninterest expense was up 11% from the first quarter of 2022, driven by higher operating expense, partially offset by a modest year-over-year decline in marketing. Total company marketing expense was $897 million in the first quarter. Our choices in domestic card marketing are the biggest driver of total company marketing. First quarter marketing was down about 2% from the year ago quarter and down about 20% from the fourth quarter of 2022 as the first quarter is typically the seasonal low point for domestic card marketing. We continue to see attractive growth opportunities in our Domestic Card business. Our opportunities are enhanced by our technology transformation, and we're leaning into marketing to drive resilient growth. As always, we're keeping a close eye on competitor actions and potential marketplace risks. We are seeing the success of our marketing and strong growth in domestic card new accounts, purchase volume and loans across our card business and strong momentum and our decade-long focus on heavy spenders at the top of the marketplace continues. Slide 12 shows first quarter results for our Consumer Banking business. In the first quarter, auto originations declined 47% year-over-year and 6% from the linked quarter. Driven by the decline in auto originations, Consumer Banking ending loans decreased $2.2 billion or 3% year-over-year. On a linked-quarter basis, ending loans were down 2%. We posted another quarter of strong retail deposit growth. First quarter ending deposits in the consumer bank were up almost $33 billion or 13% year-over-year and up 8% compared to the sequential quarter. Average deposits were up 9% year-over-year and up 6% from the sequential quarter. Powered by our modern technology and leading digital capabilities, our digital-first national direct banking strategy continues to get good traction. Consumer Banking revenue was up 12% year-over-year driven by deposit growth. Noninterest expense was up 4% compared to the first quarter of 2022. The auto charge-off rate for the quarter was 1.53%, up 87 basis points year-over-year. The 30-plus delinquency rate was 5.0%, up 115 basis points year-over-year. Compared to the linked quarter, the charge-off rate was down 13 basis points and the 30-plus delinquency rate was down 62 basis points. The linked quarter trends were consistent with expected seasonal patterns. Slide 13 shows first quarter results for our commercial banking business. Compared to the linked quarter, first quarter ending loan balances were down 1% and average loans were down 2%. The decline is the result of choices we made earlier in the year to tighten credit as well as higher customer paydowns in the quarter. Ending deposits were down 6% from the linked quarter. Average deposits declined 7% decline. We saw normal outflows throughout the first quarter as clients use their cash for payroll, tax payments and other business as usual disbursements. And consistent with the general trend we've seen for several quarters, we also continued to manage down selected less attractive commercial deposit balances. First quarter revenue was up 10% from the linked quarter. Recall that revenue in the prior quarter was unusually low, driven by a company neutral move in internal funds transfer pricing. Excluding this prior quarter impact, first quarter commercial revenue would have been down 10%, driven by a decline in noninterest income from our capital markets and agency businesses. Noninterest expense was down 5% from the linked quarter. The Commercial Banking annualized charge-off rate was 9 basis points. Criticized loan balances increased primarily in our commercial real estate business. The criticized performing loan rate increased 60 basis points from the linked quarter to 7.31% and the criticized nonperforming loan rate was up 5 basis points from the linked quarter to 0.79%. In closing, once again, we delivered strong growth in domestic card revenue, purchase volume and loans in the first quarter. We continue to see opportunities for resilient domestic card growth that can deliver sustained revenue annuities, and we continue to lean into marketing. And as always, we're closely monitoring and assessing competitive dynamics and economic uncertainty. In our Consumer Banking business, loans declined modestly and consumer deposits grew in the quarter. Our national digital-first consumer banking strategy continued to grow and gain traction, and we're leaning into marketing to grow our consumer deposit franchise. In our commercial bank, ending loans and deposits were down compared to linked quarter, reflecting our cautious stance in the commercial banking marketplace. Our commercial bank continues to focus on winning through deep industry specialization. And across our businesses, credit trends continued to normalize in the quarter, and we reached or we're approaching pre-pandemic levels at quarter end. We continue to expect that the full year 2023 annual operating efficiency ratio net of adjustments will be roughly flat to modestly down compared to 2022. And our balance sheet demonstrated its strength through the recent period of turmoil in the banking industry. In the first quarter, we built additional balance sheet strength as we increased allowance for credit losses, grew retail deposits and maintained or increased strong levels of capital and liquidity. Pulling way up, the future of everything in banking is digital. And with each passing quarter, banking is accelerating toward its inevitable destination. Capital One is at the vanguard of a very small number of players who are investing to build and leverage a modern technology infrastructure from the bottom of the tech stack up to truly transform technology and put themselves in an advantaged position to win as banking goes digital. Our modern technology capabilities are generating and expanding set of opportunities across our businesses. We are driving improvements in underwriting, modeling and marketing as we increasingly leverage machine learning at scale. We are transforming the customer experience in banking. And our tech engine drives growth efficiency improvement and enduring value creation over the long term. Our investments to transform our technology and to drive resilient growth, put us in a strong position to deliver compelling long-term shareholder value and thrive in a broad range of possible economic scenarios. And now we'll be happy to answer your questions. Jeff?

[Operator Instructions] If you have any follow-up questions after the Q&A session, the Investor Relations team will be available after the call. Amy, please start the Q&A.

[Operator Instructions] And our first question is from Kevin Barker with Piper Sandler.

I just want to follow up on the reserve build within the card portfolio. You said it in the slide presentation worsening credit trends and domestic credit cards. But at the same time, your prepared remarks said this is more of a normalization than anything else and you continue to grow. So what gives you confidence that this reserve build and the fairly rapid increase in delinquency and net charge-offs is truly a normalization as opposed to signs of further deterioration that's likely to occur.

Kevin, thanks for your question there. Yes, let me just talk about this. Look, I think as we -- as things get back to where they were pre-pandemic, at some point, the word normalization, we'll need to retire that because things get pretty normal. So let's just talk just a little bit about what we're seeing and what's inherent and how we're in our outlook. So at this point, many of our credit metrics have returned to their pre-pandemic levels. Others have not yet, but they're headed there. And we have -- we've particularly pointed as probably the best single metric to look at is delinquencies and delinquencies in the first quarter were at 3.66%, which is essentially back to 2019 levels, excuse me. Now our charge-offs haven't caught up yet, but based on what we see in our delinquencies, we think they'll get back to 2019 levels around the middle of the year -- of the year, excuse me. And our credit metrics tend to move what I've seen just over the many years, probably a quarter or 2 ahead of the industry in both directions. We saw that in the global financial crisis, and we saw it again in the pandemic, and we're probably seeing it again here. So first of all, just relative to our outlook and how we think about in terms of forecasting our losses going forward. There is one effect that's more of a Capital One effect. It's an effect that exists for everyone. I think it's more pronounced for Capital One relative to our loss rates, which is related to recovery. So let me just pause and explain that 1 for a minute. Past charge-offs are, of course, the raw material for future recoveries and we just lived through 3 years of very low charge-offs. So our recoveries will be unusually low in the short to medium term. This is a larger headwind for us than most others because we tend to have meaningfully higher recovery rates than the industry average and because we tend to work -- most of our recoveries we tend to work them on our own as opposed to selling them. So the recoveries come in over time and not all at once as would be the case in a debt sale. So that's just a Capital One effect that we've been talking about for a while, and that is inherent in sort of the math of how our charge-offs are working and will work over time. The other effect is the economy. And we are assuming material worsening of labor markets with the unemployment rate rising from today's very low levels to above 5% by the end of 2023. We are also assuming adverse effect from inflation and some further worsening of consumer profiles from the sort of the flip side of their extraordinary outperformance in the earlier period during the pandemic. So that's just a comment about how we create outlooks. We continue to feel very good about the business. We are leaning into our growth opportunities, our originations are coming in consistently solid, and we like the opportunities we see out there. We underwrite -- we always have underwritten for worsening scenario. So as the economy -- and sort of as credit performance normalizes, which we've expected for a long period of time, we are just continuing right on the path we have been on for quite some time. Every quarter, we trim a little bit around the edges where we see or where we anticipate an effect where customers might be a little bit more vulnerable. We're also struck by the continued expansion of opportunities that are very resilient, and we're leaning into those. So we -- this business is built to anticipate volatility in losses and higher loss rates. And what we're doing is consistent with things that we have expected and we continue to really feel good about the opportunities.

Okay. And then in the past, you made comments that the new growth -- the flow rates were relatively normal on a lot of your newer business. Do you continue to see that? And then also in the near term, are you still seeing the type of traction from your marketing spend, I guess, in the first quarter as you did in 2022?

Yes. So on your question about flow rates. Let me just -- why don't I just seize the moment a little bit and just talk about a bunch of our credit metrics and where they are. So we've talked about delinquencies we've talked about losses. Our individual flow rates have normalized and if we look at very early entry flow rates and a couple of delinquency buckets. In some cases, they're just a tick higher than they were in the way back at 2019 levels, but things are basically back. Our payment rates have -- payment rates are a striking thing because you saw just the electrifying -- well, sorry, if you look at the trust data, the electrifying increase. The whole industry's flow rates increased pretty dramatically. Capital One's increased the most. And that was a striking effect driven really by 2 different things. One is the flip side of the -- or a manifestation of the extraordinary credit performance of the consumer where they just were in such a good position. They just were paying the card off at high levels. And it was also a manifestation of the continuing mix shift towards the top of the market and the traction we were getting in heavy spenders. So payment rates have declined from the very high levels. They're not even close to where they were originally. But because of these 2 effects, if we separate them out and sort of look segment by segment, we see that payment rates are declining in every segment, but not yet back to where they were pre-pandemic. So that's something to keep an eye on there. Our revolve rate is roughly flat to last year and remains below pre-pandemic levels. But I think, again, there's a growth in transacting balances effect there. So we'll have to sort of adjust for that. And then a very important one is new originations. Let's talk about that. So we see early performance that is consistent with our expectations, the earliest delinquencies, so we, of course, look very carefully at the early delinquencies on our most recent vintages that would be some months ago because they have to have a few months where we can start reading them. But the earliest delinquencies on our newest monthly vintages of origination are consistent with pre-pandemic originations as we compare 1 segment at a time on current originations versus several years ago. And then vintage over vintage month over month for recent vintages, we're seeing pretty stable risk levels. So we feel very good about that. One thing that I've commented on over time is we have continued to -- in anticipation of market changes trim a little bit around the edges so that our -- the fact that our originations are performing on top of -- sort of where they were several years ago is also the result of some active anticipatory management. And so probably it offset some underlying worsening that's happened in the marketplace. So if we pull up on that set of metrics, we are -- we continue to feel very good about the choices we're making, as I said before, the -- this is -- puts us in a position to continue to lean into the marketing. We enter our originations, anticipate worsening as just a matter of underwriting anyway. And so we're leaning into the marketing even as we continue to trim a little bit around the edges here or there. And so in some ways, our message here is just very, very similar with the feel of how this has been for really quite a few quarters now.

Next question comes from Betsy Graseck with Morgan Stanley.

So just want to make sure I understand on the reserve ratio. I know you already spoke a lot about it. So I just want to make sure I understand you just say yes or no. Is it fair to assume that the reserve ratio should go up every quarter where the macro stays in the current situation that we've got right now because the book that's rolling on is worse quality than the book that's rolling off. Is that fair?

I don't want to limit myself to a yes or no, Betsy, given the framing of your question. The short answer is no. And I will spare you from the allowance tutorial answer that I provided a quarter ago. But really, the mechanics are -- we have assumed for the losses or reserved for the losses that based on the current balances, that were on the books at the end of the quarter, what we assume we will experience over the next 12 months. And so if you're just replacing loan for loan with similar characteristics, you wouldn't otherwise have a build. I'm getting -- if I'm interpreting the nature of your question correctly.

Okay. And then the follow-up question is just on a slightly different topic, which has to do with the expense ratio. I know you mentioned that you're looking for the operating efficiency to be flat to down this year on a year-on-year basis. I'm just wondering how to square that with what you mentioned on the marketing side where it sounds like you see a lot of opportunities in card and you are planning on leaning into the marketing side. So I just wanted to square those 2 things up.

Well, Betsy, let me just clarify, and then I'll turn it over to Rich. When our guidance for efficiency relates to operating expenses, it is not a total efficiency point. And so it would exclude whatever choices we make in marketing from that calculation. But I'll turn it to Rich to respond to the broader question.

Yes. Well, I was going to say the same thing. So our guidance is with respect to operating efficiency ratio to be flat to modestly down relative to 2022. And we continue to put a lot of energy into that, of course. The total efficiency ratio includes also the marketing side of the business, as we've talked about. That's not part of our specific guidance. Our marketing choices are very dependent on the opportunity that we see, and Betsy -- you and most of the people on this call have known Capital One for a long time. And when we see opportunities, we really lean in on them. And so we can talk about marketing maybe on another question, but that's the efficiency point there.

Our next question comes from the line of Moshe Orenbuch with Credit Suisse.

Great. Rich, you had mentioned that you expected the card charge-offs to kind of reach 2019 levels by the middle of the year. You also talked a little bit about assuming higher unemployment over time. I guess, what's the -- what should we think about as the trajectory, I guess, in other words, which is 2019 a stopping point? Or is -- if your expected unemployment levels are reached, then we would expect to see those losses go up even higher.

Moshe, just with respect to unemployment rate. I want to make a comment on that. All companies, including Capital One, try to look into limited historical data. And the thing I often call trying to model on 2 humps of the camel because it's only been a small number of times in the history of the card business that various economic metrics have gone up and gone down. So limited to the camel hump point, we all do our best to try to look at the drivers of -- and the correlations with respect to credit losses. A striking thing all along in our journey has been the -- sort of parallel movement of unemployment rates and credit losses. So the -- it turns out from a modeling point of view, while often in the standard way people talk about things is to focus on the level of unemployment, in many of our models, actually, the rate of change is what matters most either as a measure like monthly job creation or is the change to the unemployment rate. So an increase in the unemployment rate from the 3s to the 5s is pretty material worsening. But that's more of a window into the -- well, we would be cautious about even though historically, card losses almost strikingly to the number of average industry card losses. They've been pretty close to the unemployment rate over those 2 humps of a camel in the past. But I think that -- I think we lean a little harder into the effects that happened when unemployment rate changes. And therefore, that just happens to be a bigger element in our own models. I do want to just make a couple of other points, just intuitive points about the economy. So we start with a consumer that's in a very strong place. We know that. And the consumer excess savings on average is, of course, winding down, but it's still there. But of course, credit losses play out at the margin, not just on average. But there are just a couple of effects that none of us will know until sort of after the fact one of the two, I'm going to talk about will never know, but I just want to comment on those because those affect our outlook of where credit losses can be. One, of course, is inflation. And none of us really have historical data in the card business to understand or predict the effects of significant increases and levels of inflation, but we are expecting inflation to impact consumer credit by compressing real incomes and as kind of a separate effect from an unemployment effect. And we -- since we haven't seen sustained inflation for more than 40 years, we can't really model this effect directly, but we make informed assumptions in our outlook to sort of account for this effect. So for example, a way to think about this is if there is a decline in real income that happens with this, we can look at our history and our cross-sectional evaluation of how people do as a function of different income levels, and then we can sort of extrapolate from those credit effects and proxy how something like inflation can have an effect there. So it's sort of using proxies, but it matches off to an intuitive assumption that high levels of inflation are going to be challenging for people. And finally, the other effect is, as I intuitively think about the marketplace, over all the years of sort of my journey in this, we've tended to see that periods of abnormally good credit are followed by periods of worse credit and vice versa. And the credit performance we saw over the past 3 years was unprecedented. So there's -- what maybe we could call a catching-up effect that happens on the other side of that for consumers who might otherwise have charged off over the past 3 years. And sort of the reverse of this effect happened in the global financial crisis, where charge-offs were accelerated and then it was kind of followed by a period of strikingly benign credit. This is an effect, I intuitively believe, we can't measure it. We won't even in hindsight, be able to measure it, but I just think it's part of the intuition that we bring into the business. So when we pull kind of way up on things, we share with you the credit metrics that we see. And pretty much what you see is all that we see. So now we're all in the business of saying, where does this go from here? I shared with you some intuitive views that would lead to higher charge-off levels over time. And when we look at those, when we look at our card how we underwrite in card, we both can believe effects like this or -- will happen over time and also how strong the opportunity in card continues to be. So that's just a little window into how we think about that. And then that's sort of me talking, but then, of course, Andrew leads the whole process relative to -- and our Head of Credit, the whole process relative to the allowance build. But anyway, those are some thoughts about credit and how the kind of factors that may play out over time.

Great. Maybe just switching gears a little bit. You mentioned the capital ratio and then the capital ratio if the AOCI were excluded or included. When you think about capital return over the next year, which one of those are you using as your base?

Yes, Moshe, it's Andrew. We look at a number of things as we are considering our capital actions. And so I've been saying for a couple of quarters now, we've seen an increased level of uncertainty in the economic environment, wide ranges around growth opportunities and everything that's happened over the last 1.5 months has increased that level of uncertainty. And so we continue to believe that it's prudent to operate above our 11% long-term target, both until we have more clarity, both not only on the economic front, but to the potential regulatory changes that may be coming down the pike, which could very well include treatment of AOCI in capital. But of course, we don't know that yet. And so for now, we're continuing to operate above that long-term target. But suffice it to say, we have substantial capital generation capacity, and we regularly evaluate our plans in light of the economic changes in light of regulatory changes, we have the ability to pivot quickly in our deployment and certainly we'll do so when we feel like the time is right.

Our next question comes from Richard Shane with JPMorgan.

Andrew, I'd like to talk a little bit about the impact of the surge in deposits. When we look at the impact, it appears that it primarily runs through the corporate and other line in terms of where the NIM impact is. But the other change that I think we see is that it looks like the transfer pricing on deposits went down modestly. When we think about things going forward, should we assume that there's a continued drag at the corporate line from the elevated deposits and that because the reinvestment rate is lower, that the transfer pricing is going to be a little bit lower as well.

Well, Rick, let me just clarify first. And I'm assuming you're just looking at the net interest income trends in other, which does serve as a clearing house for FTPs, but happy to talk to you offline in more detail about this. But the basic tenets of the FTP process or there's an arm's length transaction between corporate and other and deposits. And so they're getting a prevailing rate, which shows up in the revenue of either the Consumer Banking segment or the commercial banking segment. And so there isn't a subsidy or drag going on there. There's just a number of other clearing factors that happen in other.

Understood. But actually, we've figured out a way over the years to calculate the NII on the transferred deposits through the consumer bank and it looks like they were down, and it's been very accurate over a long time. It looks like the transfer deposit rate was down about 8 basis points -- so at the consumer bank. So I'm curious, it looks like there was a drag in terms of corporate and other and actually the benefit of the bank was a little bit less attractive from an NII perspective as well.

Rick, it's Jeff. I don't think we can comment on a calculation that you're doing that we don't fully understand. Why don't you and I take that offline?

Okay, terrific. Thank you, guys.

Our next question comes from Arren Cyganovich with Citi.

Maybe talk a little bit about credit card purchase volumes look like they inched up a little bit during the quarter. We've heard that from others that they're seeing slowdown in purchase volume in March and into April. What are you seeing within your portfolio? And are there kind of any differences between different income demographics that you're seeing within your customers?

So Aaron, yes. Let's just talk about purchase volume. So -- in Q1, our card purchase volume was up 10% year-over-year. And this grows while it's very solid, has decreased from the first part of 2022. But I think it's striking to separate out spend per active account and then like the growth of accounts and some of the benefits of our recent origination efforts. So if we look at spend per active account, now it was sort of -- it just really surge from the doldrums of the deep pandemic, then it really surged into the levels it was a year ago. We see spend per active account is pretty flat to a year ago. And it is -- and we can watch it on a typically, over the last few months, it has been sort of declining on that coming down to basically a sort of net result of being flat for a year ago or I think maybe it's actually in the last couple of months a little bit under where it was a year ago, if I remember the graph that I was looking at. Now initially, it's a funny thing how so often we see effects that start on the lower income, lower credit score side and then make their way up. I mean, pretty much the whole way credit has played out both on the improving side in the pandemic and then on the normalizing side, that's happened. But on spend, this slowing down happened in lower income segments first, but now it's more broad-based across income bands and really segments of our card business. So we, of course, are having very nice growth in accounts, and that's continuing to power purchase volume even as the spend sort of levels out. Now in the spirit of what are we rooting for, it seems to me to be a pretty rational thing for consumers to sort of level off this pretty strong spend that they have had. So I think what we see, we're pretty pleased with -- and then when we look at things like discretionary and nondiscretionary spending, both of them have slowed significantly over the last year. Well -- no, the growth rates have slowed significantly, but the category mix of spend, the more things change, the more they stay the same because basically pretty much across all the categories, things have returned to the pre-pandemic level.

And just following up. I appreciate the commercial office disclosures you put in your slide deck. It looks relatively small comparative to the overall commercial and overall loan portfolio total together. Maybe you could just talk a little bit about your commercial real estate business. Is this -- I know you acquired several kind of smaller banks, North Fork and Hibernia and Chevy Chase. Are these predominantly portfolios from around those regions? Or do you also have a national lending business that deals in larger commercial real estate as well?

Yes. Let me start by talking about kind of what isn't in the disclosure that we provided because I know there's differences across various organizations. I mean as you know, Arren, that it's a little less than $4 billion and represents about 1% of our total loans, but this is our commercial office space. It is excluding, as you probably saw in the footnote, medical office and REIT and REIF medical office just has very different characteristics and so 2 does that's REIT and REIF. So in terms of the commercial office portfolio on our books, it's roughly 2/3 concentrated in New York, D.C. and San Francisco. It is roughly 60% B, C and obviously, 40% Class A. And so it has been accumulated over time, but it also was a business that up until a few years ago, we were active in, but we haven't had any new originations for the past few quarters and reduced our exposure to this segment over the past year by a little north of I think it's 10%. But given right now just the uncertainty that we see with office vacancies being elevated and utilization rates significantly below pre-pandemic levels and increasing debt service burdens despite the fact that we are getting 100% payment on principal and interest just in light of the continued uncertainty that I described just in terms of utilization and other factors. We decided to increase the coverage ratio quite a bit this quarter, and that's what you see in the disclosure in the back.

Our next question comes from Ryan Nash with Goldman Sachs.

Maybe I know there's been a lot of questions on credit, but maybe just to follow up on another one, Rich. So can you maybe just talk about where the credit performance was worse or where it deteriorated. And also I'm surprised by the comment that you're reaching normal levels despite continued elevated payment rates and lower revolve rate. So how do you think about from here balancing growth versus the risk of credit continuing to not only normalize but get worse?

So yes, Ryan, I think the best net impression despite the fact that when we look at all our credit metrics, the -- some of them, like half of them aren't sort of back to pre-pandemic levels, and half of them are. My gut feel is it's a better net impression to view them as back. And I just think the underlying effects of continuing to lean into spenders, not only at the very top of the market, but within our segments and just the emphasis that we put on spend and some of the products, the marketing, the way we manage accounts, the kind of -- the people we raise lines to, et cetera. I just think there's been a subtle shift a little more towards the spending side. So I think that might explain why a few of these metrics are behind, but behind in terms of the -- but I think I walk around with the perception that things are pretty much at the levels of where they were a few years ago. So now we feel very comfortable with respect to the choices that we're making, and let's just talk about why that is. I've already said, we underwrite to assumed worsening. So let's go back to back when the behavior of the consumer was at levels we've never seen in the whole history of the company. The credit performance was so good. We just assumed that was unsustainable. We underwrote to much higher levels of losses. So as things normalize, that's not really sort of changing anything at Capital One. So we -- but at the same time, you see the noise all over the place on the horizon. So we obsessively look for -- we not only use all of our modern and machine learning-based monitoring tools to identify little pockets that might be gapping out from expected performance or prior performance or anything like that. And by the way, we have seen that in some pockets and then we dialed that back. We also hunt around and think about where would most intuitively the vulnerabilities be to where the economy is going. And we even anticipatorily kind of dial back around the edges there. But as I said earlier, I'm kind of struck by the number of new opportunities that are originating in terms of driven by the tech transformation of the company, new channels, new ways to succeed with customers that for kind of -- for every dial back that's happened, we seem to have had opportunities open up, and so we lean into those. And so it leads to my sitting in here and saying with respect to the card business, we feel, and I want you to walk away with that same net impression, the same level of optimism about our growth opportunities and our marketing and really the opportunity to create value in this part of the -- where we are in the cycle with card to be very strong. Now even as that happens, just to -- it's always striking to talk about the fact that the sibling of the card business, which is our auto business has been in a striking pullback mode over the very same period that we've been leaning in here and I partly point that out just to say that we don't at the top of the house, say there's just a green light out there. This is all very much one part of the business at a time, 1 segment, 1 business area, but that pullback in auto has been a minority of the pullback, but still an important part of the pullback has been credit driven in the sense of looking at things in the card business and trying to get ahead of any effects that we think might happen from a credit point of view, but the majority of the effects have been margin related, as we've talked about with the some of the marketplace not passing through into their pricing, the higher interest rates. And so the -- and so we have dialed back quite a bit in auto. But given that most of that dial back or certainly the majority of it is really more margin related and not so much credit related. We -- if things change and normalize a little bit more on the pricing side, we might be able to open up more opportunity in auto. But what I'm pleased about is the combination of the -- walking around with an intuitive model about how the marketplace works. And as I shared in the earlier answer, thinking about the ways customers -- credit can worsen and customers can do perform not as well as it might appear as we obsess about that, that informs our choices and then by monitoring at the margin and incredibly granularly to look for effects and then having the technology to move so quickly with respect to the identification, the diagnosis of what's going on, the root causes of it and then taking the action, which is a cycle that's way faster than it used to be before our tech transformation. All of these contribute to the ability to be able to move with confidence in a changing environment and probably has contributed to why the vintage curves sort of keep coming back -- coming in on top of each other despite a changing environment. And all of that finally leads to why we feel confident about our opportunities to lean into growth because every opportunity has a limited window, and we're the company that when we see those opportunities, we go after them.

Our next question comes from Bill Carcache with Wolfe Research.

As a follow-up for you, Andrew, on your allowance commentary, just to make sure I have the mechanics right. If macro conditions do indeed worsen from here as you expect? And each new quarter, that comes on reflects the worse outlook than each old quarter that rolls off. Is it reasonable to expect that your reserve rate would drift higher in future quarters given that dynamic?

It would, Bill. I was responding to what I interpreted to be Betsy's question of just individual vintages being the same, similar to what Rich just described. That in and of itself if you have a consistent growth rate wouldn't add to allowance. But if we're updating our assumptions a quarter from now and our economic view changes that will likely change our estimation of the loss content of the portfolio at that time.

Understood. That's super helpful. And then separately, Rich, I wanted to ask you about the CFPB [ lengthy ] proposal. We know it's less significant for you than it is for others who are more deeply involved in the partnership business. But as we try to think through how this may play out across the industry, can you give any perspective on the extent to which you'd expect some merchants to possibly push back against efforts by their issuing partners to renegotiate economic terms following the proposed reduction in late fees, particularly in cases where merchants expect their sales to come under pressure?

So Bill, I don't really -- I don't really have a -- I don't have a prediction about what exactly happens in the partnership business relative to merchant -- partnership agreements and then something as significant as the change in late fees comes and therefore, what do the collective -- the merchant and the issuer sort of do about that, I don't really have a prediction on that one. I just -- I wouldn't want to let your opening comment go just when you say, well, it's obviously much more probably for the people with partnerships than others because this -- where this legislation to come into effect, it has a significant impact on Capital One. So now there's a lot of miles to go before maybe everything works out. But just to comment on this for a second. First of all, with respect to the proposal, it's not final, and we -- the CFPBs will get lots of public comments. And we'll have to see how the rule-making process plays out. Late fees play in a very important role in the system because they provide a direct and clear incentive for customers to pay on time and avoid running into delinquency. And it's also a way that issuers can sort of price for risk, and all this leads to greater access to credit and a lower cost of credit on average. So we certainly have a point of view on this one. A change in -- a significant change in late fees could affect consumer payment behavior and delinquencies, it could affect access to certain parts of the population. So there's kind of a lot at stake. But what I wanted to say for Capital One, this is -- it's an important revenue source for Capital One. And we obviously are working on thinking about those impacts, what might be mitigating measures. And so we're early into our thinking about it, but I think not only for partnership-based companies. But for Capital One and maybe some other players as well, this is an important development that we're going to all have to take very seriously.

Our next question comes from John Hecht with Jefferies.

Actually, all my questions have been asked and answered, but something came up to me and Rich, I apologize, it's somewhat nebulous. But in the past, you've given us some good metaphors to think about the environment. I think during the pandemic and stimulus zone, you talked about it, you're boring through a mountain because of stimulus, which helped avoid some level of loss content. We're in this unique world where we have inflation. Many of us haven't really lived or at least analyzed the equity markets in a period like this. And then we've got a lot of other factors going on as well, both good and bad. I'm wondering whether it's a metaphor or not, you -- with stepping back, how do you describe the overall environment? You're advancing in certain categories, pulling back and others. Is there some context you can give us or a comparison to a previous time or how you think about it in comparison to previous times?

Well, thank you, John. I'd forgotten all about. I know you've been around me for quite a while. I love metaphors, and sometimes metaphors, I think, can be pretty striking ways to think about things that otherwise are complex to talk about. But going back to the boring through the mountain. Remember, we were talking back then each quarter, we'd say, well, we're in -- what could be very whopping losses that come from the tremendous upheaval of the pandemic every quarter, we are boring through the mountain and with the government stimulus and so on. If we think back, we got all the way through the mountain to the other side. And it was better from a credit point of view than anything that we can kind of imagine. So if I pull up and just say, where am I just -- how do I feel about where we are. When I think about the health of the consumer, the U.S. consumer remains a source of relative strength in an uncertain economy. The savings accumulated over the pandemic remain a positive for many consumers, that servicing burdens remain low by historical standards. The labor market, which is usually the most important economic driver of consumer credit performance remains strikingly strong, although we have seen some indications of some softening. Now you -- on the other hand, home prices have been falling a little bit. Inflation, I really believe none of us know really the effects of inflation, so we're going to be needing to manage intuitively here. We can't pull out PhDs to figure this one out. But -- so we assume the inflation is going to -- here's an interesting thought on inflation versus unemployment, John. Unemployment affects a small number of people terribly. Inflation affects all of us somewhat. And so from a credit point of view, I believe the reason unemployment has been the biggest driver is that because charge-offs happen at the tail of the distribution and the tail moves when the economy moves, so what is the effect of all of us losing a little bit of our purchasing power. My gut feel is it's just something that is slow in its effect. It's cumulative. It doesn't have the sort of precipitous effects that the unemployment does. But I still believe on little cat feet, there's another metaphor for you, John. I think it will play out. The other one, and it's almost -- I want to go back. I don't have a perfect metaphor for it, but I do want to say, again, I -- I've been around this business long enough to kind of know that extreme effects with respect to credit for a period of time, create the opposite effect on the other side, just -- it does with respect to markets and competition, but that's not even what I'm talking about here. I just -- I believe in life, let's just say there's always a certain percentage of consumers that are living on the edge, they're vulnerable and they don't have much of a buffer to absorb shock. So then when the global financial crisis came along, it was like a tsunami wave coming in and everyone who was -- I feel just so many people that were in a somewhat vulnerable situation got sort of washed over from that, that it was followed by this period where we had trouble keeping up with our own forecast of the losses. We -- in a good way in the sense that we finally said, this is the survivorship effect. The Great Recession accelerated so many charge-offs that at some point were statistically probably going to happen that we had a survivorship effect going on that anybody can survive that probably not charging off anytime soon, and that's why you sort of had there for the reverse of that effect. And I believe intuitively, I have no way to prove it and we'll never be able to quantify it, but just intuitively thinking about it when there were still vulnerable people all during the period of the pandemic, so many of them got lifelines that I think you can -- it doesn't mean there are lives necessarily changed. And I think you have sort of the reverse survivorship effect or maybe the sort of the catching-up effect from very, very low losses. And this is something that I believe is a real effect. And so if I pull up, I think the consumer is in a great shape. You're going to have sort of on little cat feet, the inflation effect and the catching-up effect and then you have a wildcard of a quite uncertain economy that creates greater volatility than usual in terms of where things might go. But in the context of all of that, and the opportunities we see -- one of the things -- sorry, it's a long answer to your question. But one of the things that you may remember my saying back when the credit was just unsustainably good a couple of years ago. I remember saying that there will be real consequences in the competitive marketplace if this abnormal environment continues for too low. And we really already saw it happen in the period of the extraordinary credit. What you saw is a tremendous inflow of FinTechs, you saw a huge expansion of credit, primarily in the subprime and even below sort of where we play in that space. We were worried that the underwriting that any of them were doing would be -- it's based on data, would definitionally not have a rear view, it would have a rearview mirror that is extremely unreliable. So I think when I would pull back this sort of great normalization that's happening even with some cat feet effects that are still probably going to play out is a very healthy thing to happen in terms of credit environment, competitive environments in the marketplace over time. So all in all, I feel really good about where we are. And if you detect optimism in my voice, you're getting the right read there.

Our next question comes from Dominick Gabriele with Oppenheimer.

Almost to piggyback on that last question a little bit. There have been a lot of new card issuers and types of cards and payment types like P2P, debit rewards, FedNow is coming out. Could you talk about the evolving of both debit and credit card space? And how you expect the competition and offerings could change over time, not just versus, let's say, Discover Synchrony or American Express, but other payment types and how Capital One is positioned as payment preferences among consumers might change.

Yes. Well, the -- we've seen a lot of innovation over the last number of years. I'd add one to your list, one that really was quite a made quite a flash, which is buy-now pay-later that came into the marketplace. Let me really sort of start with that one. With buy-now pay-later came out, I remember having sort of saying this is kind of ironic because the original and still extraordinary buy-now pay-later product is called the credit card. So what is this new one that says, you can buy-now and pay-later. But anyway, it was riding on the back of some very, very clever technology sort of modern tech stacks and really good merchant relationships that made quite an impact on there. Now it was hailed as a revolution in payments from everything that we saw early on. I think it was, by the way, a very clever payment -- a very clever innovation, but it turned out to be more of a credit access play than necessarily. I'm not saying it isn't a revolution. Well, I'm saying that when we look at who flop there, it was a credit from looking at our bank customers and card customers, everything else, it was a credit access play and I think it's running into some challenges with respect to merchant discount rates and some credit challenges and other things, but it was certainly quite innovation. If you look at debit cards, anyone innovating in the debit card space that has access to the differential interchange that came from the law that created, tried to advantage smaller players versus bigger and networks other than -- well, different choices for different networks and different sized players. Anyone who has the fortune to ride on the back of that. I think that's a promising opportunity for them. And so payments -- the payment space will continue to evolve. One other thing about payments that when you look pull way up and say in what areas have FinTechs or major tech companies have the biggest impact on banking. It was -- we, of course, worried that all aspects of banking would get affected. But the biggest -- I think the biggest single area that has really been impacted is payments itself which -- when you think about it, that it's kind of the holy grail from a tech company's point of view because it's where the money is, and it's a real-time kind of customer experience activity. And importantly, it's not heavily regulated. For what it's worth the other play that I think the tech companies enduringly have had the greatest impact is in the platforms space, either payments platforms or other kind of platforms, building on modern tech stack. So those are some thoughts in the marketplace. But -- so just a reminder, Capital One has got to stay on the forefront of innovation or we can be yesterday's news.

Our next question comes from Sanjay Sakhrani with KBW.

I've got some follow-up questions for Andrew and some of the comments. Maybe just first on the 11 basis points drag from the excess cash. Does that persist over the course of the year? Or does that go away at some point?

Well, as I said in my talking points, Sanjay, I think that is something that we do expect to remain at least elevated compared to pre-pandemic levels. So yes, I would -- that's probably where I would leave that.

Okay. And then secondly, just the comments on capital levels and capital return. Should we assume like you're going to maintain CET1 inclusive of sort of AOCI or work your way up to that level and then consider any moves with capital return? Or maybe you can just help us think through how we should read into some of your comments there. And then -- at what rate does AOCI accrete over the course of the year? Just would love to get some color on that.

Yes. Why don't I start with the second one first, which is -- if you look at our AFS AOCI, about 40% of that will pull to par between now and the end of '24. In terms of capital targets, I absolutely would not say it's a mechanical linkage that we are thinking about our capital targets inclusive of AOCI. There's a lot of uncertainty of regulatory treatment. It is not included in our regulatory ratios at this point. I just referenced that, that is one thing that we look at in addition to a number of other factors inclusive of just economic uncertainty and our growth opportunities. And so for now, we've been operating above our target. We're going to keep an eye on those things. And as we have more certainty of the future, we have a lot of flexibility with how we return capital to shareholders, if that's appropriate.

Our final question comes from John Pancari with Evercore ISI.

On the net interest margin front, I wanted to see if you could possibly give us some color on how you see the margin trajectory here from the 660 level just given what you said about cash balances likely to remain elevated? And then maybe how deposit pricing plays into that and how you're thinking about through cycle deposit beta at this point.

Well, I'll go in reverse order on that one, too, because the beta will feed into the NIM response there. I'll remind you of my comments from a quarter ago, where I talked about cumulative deposit beta for the overall company could be somewhat higher than the last rate cycle, which was 41%. I think a quarter ago, our cumulative beta was in the mid-30s, where we sit today, it's 44. It is hard to predict how much further deposit betas will increase from here. There's a number of unique factors, especially following the events of the last month that makes predicting betas a challenge. Everything from product mix to the market in competitive pricing, if there's really intense competition from more insured deposits and just the sheer magnitude and pace of Fed fund hikes is unprecedented and what happens to on the other side when the Fed eventually starts lowering rates, and all of this is happening in the context of a Fed that's executing QT. So where we go from here is going to be impacted by a number of factors, customers' appetite for different deposit products, our focus on customer relationships, industry competition, funding needs. But I will say, given deposit pricing tends to lag asset yield resets. I wouldn't be surprised if there's at least some upward pressure on beta from where we were in the first quarter. So as I then pull that into thinking about NIM over time, that is likely a potential headwind for us, particularly in the near term given the lag of deposit pricing, where wholesale funding costs go could also be a headwind. And as credit continues to normalize, we could continue to see revenue suppression. So those are a few things that will potentially provide a headwind to NIM from where we sit today. But on the other hand, there's definitely some tailwinds even though my response to Sanjay's question in the real near term, I would think our average cash position will stay elevated relative to pre-pandemic levels, not necessarily relative to what we saw in the first quarter. But over a longer period of time, that will almost assuredly come back down and eventually be a tailwind for NIM. We also could see a growing percentage of revolving card balances and in the immediate term, keep in mind, we'll have one more day in the second quarter. So I know that that's a lot of headwinds and tailwinds, but just wanted to give you a sense of all of the forces that play there.

That's very helpful. And then just secondly, we've seen some headlines regarding the Walmart partnership. And I don't know if you can provide a little bit of color there and where that stands, maybe can you confirm the discussions, the timing of when any change could be? And then lastly, if you can update us on any other upcoming negotiations or maturities of other types of partnerships on that front?

Okay. Thank you, John. So -- we are, of course, in the middle of litigation. So there's only so much -- I'm going to share in an earnings call about the various legal arguments being made by each side. But at a high level, Walmart has sued us trying to terminate the deal early, and we deny that they have a contractual right to an early termination. Walmart points to some service failures that we cured in 2022 and which had no impact on the value of the portfolio. Now in the meantime, we are committed to meeting our contractual commitments while we defend ourselves in court. And we will keep you updated on the litigation in our periodic SEC filings. With respect to timing of any potential impacts there are a lot of unknowns. There's the -- of course, the question of whether Walmart will win their litigation seeking early termination. And if so, when that will occur. We, of course, deny that they have a right to terminate early. Then there's a question of how long it will take for Walmart to transfer the portfolio to a new issue. We currently expect that the transfer of the Walmart portfolio to a new issuer would occur no earlier than January 2025, even if they win their litigation. So we will keep you updated if our timing expectation changes.

Well, that concludes the earnings call for this evening. Thank you for joining us on this conference call, and thank you for your interest in Capital One. The IR team will be here later this evening to answer any questions that may remain. Have a good night, everybody.

This concludes today's conference call. Thank you for participating. You may now disconnect.