Earnings Call Transcript - COF Q3 2023

Jeff Norris, Senior Vice President of Finance

Thanks very much, Amy, and welcome, everyone to Capital One's third 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 at capitalone.com and follow the links from there. In addition to the press release and the financials, we have included a presentation summarizing our third 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, then click on quarterly earnings release. Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion and the materials speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. For more information on these factors, please see the section titled Forward-Looking Information in the earnings release presentation and the Risk Factors section in our annual and quarterly reports accessible at Capital One's website and filed with the SEC. Now I'll turn the call over to Mr. Young. Andrew?

Andrew Young, CFO

Thanks, Jeff, and good afternoon, everyone. I will start on Slide 3 of tonight's presentation. In the third quarter, Capital One earned $1.8 billion, or $4.45 per diluted common share. Pre-provision earnings of $4.5 billion were up 7% compared to the second quarter and 17% compared to the year-ago quarter. Both period end and average loans held for investment increased 1% relative to the prior quarter, driven by growth in our domestic card business. Period end deposits increased 1% in the quarter, while average deposits were flat. Our percentage of FDIC insured deposits ended the quarter at 80% of total deposits. We have provided additional details on deposit trends on Slide 18 in the appendix. Revenue in the linked quarter increased 4%, driven by both higher net interest and noninterest income. Non-interest expense increased 1% in the quarter, as higher marketing expense was partially offset by lower operating expense. Provision expense was $2.3 billion with $2 billion of net charge-offs and an allowance build of $322 million. Turning to Slide 4, I'll cover the allowance balance in greater detail. The $322 million increase in allowance brings our total company allowance balance up to $15 billion as of September 30. The total company coverage ratio is now 4.75%, up 5 basis points from the prior quarter. I'll cover the drivers of the changes in allowance and coverage ratio by segment on Slide 5. Relative to last quarter's assumptions underlying the allowance, the baseline forecast in this quarter for most key economic variables improved. However, we continue to assume several key economic variables worsened from today's levels. In our Domestic Card business, the allowance balance increased by $349 million. The coverage ratio was largely flat at 7.79%. The predominant driver of the increased allowance was the growth in loans. The positive impact from the modestly improved economic outlook was largely offset by the impact of replacing the lost content of the third quarter of 2023 with a 12-month reasonable and supportable period that now includes the third quarter of 2024. In our Consumer Banking segment, the allowance balance declined by $136 million. The improved economic outlook and a decline in loan balances drove the release. In our Commercial Banking business, the allowance increased by $97 million. This build reflected the impact of rising interest rates and other factors on certain commercial real estate and corporate borrowers, including our commercial office portfolio. We have included additional details on the office portfolio. In the third quarter, we completed the sale of approximately $900 million of loans from our commercial office portfolio that were previously marked as held for sale. The coverage ratio in the Commercial business increased by 12 basis points and now stands at 1.74%. Turning to Page 6, I'll now discuss liquidity. Our preliminary average liquidity coverage ratio during the third quarter was 155%, up from 150% last quarter and 139% a year ago. Total liquidity reserves in the quarter were largely flat at $118 billion. Higher cash balances were offset by a decline in the market value of our investment securities portfolio. Our cash position ended the quarter at approximately $45 billion, up about $3 billion from the prior quarter. Turning to Page 7, I'll cover our net interest margin. Our third quarter net interest margin was 6.69%, 21 basis points higher than last quarter and 11 basis points lower than the year-ago quarter. The quarter-over-quarter increase in NIM was largely driven by higher card yields, a continued mix shift towards card loans and one additional day in the quarter, partially offset by higher rates paid on deposits. Turning to Slide 8, I will end by discussing our capital position. Our common equity Tier 1 capital ratio ended the quarter at 13%, approximately 30 basis points higher than the prior quarter. Net income in the quarter was partially offset by an increase in risk-weighted assets, common and preferred dividends, and the share repurchases we completed in the quarter. With that, I will turn the call over to Rich. Rich?

Richard Fairbank, CEO

Thanks, Andrew, and good evening, everyone. Slide 10 shows our third quarter results in the credit card business. The performance of this segment is primarily influenced by our domestic card results and trends illustrated on Slide 11. Our domestic card business had another strong quarter with year-over-year growth. Purchase volume for the third quarter increased by 6% compared to the same quarter last year. Ending loan balances rose by $19 billion, or about 16% year-over-year, and third-quarter revenue was up 15% year-over-year, driven by growth in purchase volume and loans. The revenue margin declined by 31 basis points compared to the same quarter last year, yet remained robust at 18.24%. This decline was due to two main factors: first, the growth of loans outpaced that of purchase volume and net interchange revenue for the quarter, which supports revenue dollars but negatively affects revenue margin; second, charge-offs increased, leading us to reverse more finance charge and fee revenue. These impacts were somewhat offset by a rise in the revolve rate. On a sequential quarter basis, the revenue margin saw a seasonal increase of 48 basis points. The performance in domestic card credit continues to normalize from the historically strong results we experienced during the pandemic, aligning with our expectations. The charge-off rate for the quarter rose by 220 basis points year-over-year to 4.4%. The 30-plus delinquency rate at the end of the quarter grew by 134 basis points from the prior year to 4.31%. On a sequential quarter basis, the charge-off rate remained flat, while the 30-plus delinquency rate increased by 57 basis points. Both the monthly delinquency rate and charge-off rate are now slightly above 2019 levels. Our delinquencies serve as the best leading indicator of domestic card credit performance, and the normalization of the delinquency rate is slowing. Non-interest expenses were essentially flat compared to the third quarter of 2022. Our total marketing expense for the quarter was $972 million, which also saw little change year-over-year, although it increased by 10% compared to the sequential quarter. Decisions made in the domestic card segment are the primary driver of total company marketing. We continue to identify attractive growth opportunities in our Domestic Card business, bolstered by our technology transformation, and our marketing efforts are yielding strong new account growth. Therefore, we are increasing our marketing investment to promote resilient growth and strengthen our domestic card franchise. We remain vigilant regarding competitive actions and potential marketplace risks. We anticipate that fourth-quarter marketing expenses will be seasonally higher. Slide 12 presents the third quarter results for our Consumer Banking business. During the third quarter, auto originations declined by 10% year-over-year. Consequently, ending loans in consumer banking decreased by about $4.4 billion, or 5.4% year-over-year, although they were essentially flat on a linked-quarter basis. We experienced another robust quarter of year-over-year growth in retail deposits, with third-quarter ending deposits rising by about $34 billion, or 13% year-over-year. Compared to the previous quarter, ending deposits increased by about 2%. Average deposits were up by 12% year-over-year and 1% from the previous quarter. Our digital-first national direct banking strategy, powered by modern technology and leading digital capabilities, continues to yield strong results. Consumer Banking revenue for the quarter dipped by approximately 7% year-over-year due to the higher rate paid on deposits as well as lower auto loan balances and margins. Non-interest expenses declined by about 6% compared to the third quarter of 2022. The reduction in operating expenses was somewhat offset by increased marketing to support our National Digital Bank. The auto charge-off rate for the quarter was 1.77%, up 72 basis points year-over-year, while the 30-plus delinquency rate was 5.64%, up 79 basis points year-over-year. In comparison to the previous quarter, the charge-off rate increased by 37 basis points, and the 30-plus delinquency rate rose by 26 basis points; both increases were better than typical seasonal expectations. Slide 13 outlines the third quarter results for our Commercial Banking business. Compared to the previous quarter, ending loan balances were essentially flat, while average loans decreased by about 2%, primarily due to our decision earlier in the year to tighten credit. Similarly, both ending deposits and average deposits were down about 2% from the previous quarter, consistent with the trend we've observed over several quarters as we adjust our commercial deposit balances. Third-quarter revenue rose by 2% from the previous quarter. Non-interest expenses increased by about 6%. The commercial banking annualized charge-off rate for the third quarter fell by 137 basis points from the second quarter to 0.25%. The second quarter's charge-off rate was elevated due to charge-offs recognized when we shifted a portfolio of commercial office loans to held for sale, which we completed in the third quarter. Slide 17 provides additional information about the remaining commercial office portfolio, which constitutes less than 1% of our total loans. The criticized performing loan rate in Commercial Banking was 8.08%, up 135 basis points compared to the previous quarter, while the criticized nonperforming loan rate remained stable at 0.9%. In conclusion, we consistently delivered solid results in the third quarter, showcasing growth in domestic card revenue, purchase volume, and loans. The pace of normalization for domestic card delinquency rates has slowed. We saw growth in consumer and total deposits, and we added liquidity and capital to further enhance our strong, resilient balance sheet. Now, turning to operating efficiency, the operating efficiency ratio for the third quarter was particularly strong. This ratio can fluctuate from quarter to quarter, influenced by revenue timing and operating costs. We expect the annual operating efficiency ratio for 2023, net of adjustments, to be slightly lower compared to 2022. Overall, our advanced technology capabilities are creating a wider array of opportunities across our businesses. We are improving underwriting, modeling, and marketing as we increasingly leverage machine learning on a large scale. Our technology engine promotes growth, enhances efficiency, and fosters long-term value creation. We are well-positioned to deliver substantial long-term shareholder value and thrive in a variety of potential economic scenarios. Now, we are happy to take your questions. Jeff?

Ryan Nash, Analyst

Hey. Good evening, everyone. So Rich, you noted several times that delinquency normalization has slowed. It looked like September charge-off performance was better than we would have expected. But we are hearing from others that pressure is becoming broader, not just sub-prime, but it's also into prime. So can you maybe just talk about what you're seeing within your portfolio? What do you think about the pace of delinquency normalization? And do you have any line of sight when you think losses will inevitably peak? Thank you.

Richard Fairbank, CEO

Thanks, Ryan. So let's just pull up on the metrics here. Our third quarter domestic card charge-off rate was essentially flat from the prior quarter, up 2 basis points to 4.40%. Our 30-plus delinquency rate increased 57 basis points from the prior quarter to 4.31%. Both our losses and our delinquencies are modestly above their pre-pandemic levels. Now let's talk about sort of what's happening at the margin here. The trend of normalization in our credit metrics appears to be slowing. In August and September, the month-to-month movement in our delinquencies was essentially in line with normal seasonality for the first time since normalization began. We've also seen some stabilization in new delinquency entries, relative to normal seasonal patterns. So we are hopeful these stabilization trends continue. Now charge-offs, of course, are a lagging metric, so they have some months of catching up still to do. In auto, we have seen stabilization even longer. Our losses are modestly above pre-pandemic levels, but moving in line with normal seasonality for the past few quarters. So back to our card business for a moment. There's another stabilization trend that we see as well, which is our recovery rate. Our recovery rate had been falling for several years because of the low level of charge-offs through the pandemic. So we've had less inventory, if you will, to recover on. And this was a larger effect for Capital One than for most of our competitors because we tend to have meaningfully higher recovery rates than the industry average. And because we tend to work our own recoveries, so they come in over time and not all at once, like in a debt sale. We've now seen the recovery rates stabilize, although it remains at unusually low levels. Now recoveries, of course, don't impact our delinquencies, but they are a pretty significant factor when comparing our charge-offs to pre-pandemic benchmarks. Now another Capital One-specific point here. There's another factor sort of driving stabilization, but this has been going on for a long time and that's the stability of credit performance in our recent origination vintages. So looking ahead, the economy is, as always, a source of uncertainty. In our outlook, we still expect the unemployment rate to worsen over the coming year. And as always, we remain very focused on resilience in our underwriting and making sure that we build resilience, a lot of resilience into all of our choices.

Ryan Nash, Analyst

Maybe, Rich, as a follow-up question, Andrew, you mentioned that the domestic card allowance was relatively stable and highlighted three different factors. Can you remind us what is included from a macro perspective regarding unemployment? Considering what Rich said about delinquency slowing and charge-offs catching up a bit, do you think we are at a point where the replacement and the allowance will be less of a headwind going forward? Can we expect the allowance build to more closely align with loan growth? Thank you.

Andrew Young, CFO

Sure, Ryan. So to your economic assumption point, I'll focus on the unemployment rate, although recall that a whole lot more is considered a whole bunch more variables, but we are now assuming the unemployment rate moves into the mid-4s by the middle of '24 and basically hold there for a period of time. But it's not just the absolute level of unemployment; as we've talked about before, it's also the change that influences underlying credit performance. How that then plays through the allowance, though, like a number of factors are going into the allowance calculation. As Rich said, the projected loss rates are going to be by far the biggest driver. And as we've talked about many times, delinquencies are the best leading indicator of credit performance, particularly over the next couple of quarters. And I won't go through the reasonable and supportable and reversion process elements that we've discussed previously, but I will say beyond the credit forecast, it is worth noting that the allowance framework considers a range of outcomes and uncertainties, which are generally wider in periods of either worsening or improving transitions. So at the core of your question, even in a period where projected losses in future quarters may be lower than today and might otherwise indicate a release. We could very well see a coverage ratio that remains flat or only modestly declined, at least in the near term as we incorporate the related uncertainty into the allowance. And so we'll go through our process as we do every year to take all of those factors into account and roll forward the allowance each quarter.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Mihir Bhatia, Analyst

Hi. Good afternoon and thank you for taking my question. I was curious in terms of the health of the consumer; I was curious if you're seeing trends at all diverge between higher FICO and lower FICO scores, whether it's on credit performance or spending as we go through the recovery?

Richard Fairbank, CEO

Thank you for your question, Mihir. Let's discuss credit performance. Initially, we noticed that as credit began to normalize, this trend was more evident at the lower end of the market, whether measured by income or credit score. Notably, these segments showed the most significant improvement early in the pandemic, which was expected. Subsequently, we found that normalization had become more widespread. For several quarters now, every segment has been normalizing at a similar rate. In other words, when examining any segment's credit metrics, such as delinquencies relative to pre-pandemic levels, they have all caught up. Currently, we are observing that stabilization is occurring more rapidly in the lower end of the market. In fact, over the past few months, delinquencies in these segments have essentially stabilized on a seasonally adjusted basis, while the upmarket segments are slightly lagging behind. However, this is specific to what we see at Capital One and may not reflect the broader marketplace. Our performance has been supported by the underwriting changes we implemented over the past couple of years, particularly in anticipation of the impact of inflating credit scores due to an influx of FinTech companies. As we've discussed over the years, we have made adjustments in our originations and credit policy to address potential risks, which I believe has contributed to our current strength and stability. Regarding spending, after the surge following the pandemic, spending per customer has moderated. Year-over-year, Capital One has seen fairly flat growth in spend per customer for several months. The growth reflected in our metrics is primarily driven by new account origination. In terms of the various segments, spending at the lower end of the marketplace has seen the most moderation, and while we initially observed this trend, we've noted moderation across all segments. Nonetheless, the lower end of the market has experienced the greatest impact on moderating spend growth.

Mihir Bhatia, Analyst

Got it. Thank you. That’s quite helpful. And then maybe just turning to NIM very quickly. Can you just talk about some of the puts and takes on NIM in the near term, particularly on the deposit competition side? Any thoughts on where deposit betas go? What are you seeing from a competitive standpoint? Thank you.

Andrew Young, CFO

Yeah. With respect to beta, as we've discussed in previous calls, there's really a couple of key factors that are impacting betas. The first is product mix. Sort of the rotation of customers across products. And then, the second is competitive pricing. And within that, I would include the notion of just deposit pricing lags that we've talked about. And so for us, the quarter-over-quarter beta with that lag effect was something like 160%. Our cumulative beta now stands at $57 million. And so that getting factored into NIM as we look ahead on that dimension, particularly assuming if rates do stay higher for longer, I wouldn't be surprised if there continues to be some upward pressure on beta at least in the near term, driven by those factors that I described, the pricing and product mix piece. So beyond that then, in the NIM, we have seen spreads widen a bit here and wholesale funding costs are up a bit. And I think Rich talked about suppression in card, but depending on the path of credit, there's the potential at least for increased revenue suppression. So I would lump all of those three things together as potential headwinds. But from a tailwind perspective, we can continue to see growth in card and particularly revolving card balances as a percent of the balance sheet like you saw this quarter. And then the other thing that I would note, even though cash balances remain elevated relative to historical standards, I think we will see it settle out at a level that's higher than pre-pandemic, but ultimately lower than where we are today as you look ahead over multiple quarters. So those are really the primary factors that I would say are at play with respect to NIM.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Arren Cyganovich, Analyst

Yeah. Just touching on the last discussion on net interest margin. The card loan yields expanded, I think, 89 basis points and that was quite a bit higher than the base rate expansion for the quarter. You mentioned higher revolve rates; is that part of what you're seeing there? And how do the revolve rates compare today versus maybe where they were pre-pandemic?

Andrew Young, CFO

Part of it, Arren, is that if you're looking at yield instead of margin, there's a tailwind from changes in the Fed rate. However, a larger factor than the Fed changes is seasonality. Typically, we see revolve rates in the third quarter to be higher than the rest of the year, and we also notice an increase in late fees during that time. So, there's a seasonal aspect to the revolve rates going forward. I'll let Rich discuss the trends we're observing in the portfolio.

Richard Fairbank, CEO

Yes, Arren. So overall, in our Domestic Card business, revolve rates are basically where they were. So for example, third quarter 2023 revolve rates right on top of third quarter 2019, but it's very sort of very different within segments. The place that the revolver rate is quite a bit higher is in our partnerships business because we have the Walmart portfolio. We didn't have before the pandemic pretty much everywhere else across our branded book revolve rates are a little bit generally speaking a little bit to quite a bit lower than they were before. But the net impression I would leave with you, so our branded book overall is somewhat lower, and the partnerships have offset that.

Arren Cyganovich, Analyst

Got it. Regarding marketing, it appears to have decreased slightly year-over-year, but it's still nearly double what it was before the pandemic. Have you essentially reached a peak in marketing expenditures, and how do you anticipate these expenses will change moving forward?

Richard Fairbank, CEO

Marketing for the total company increased by 10% compared to the previous quarter and remained flat year-over-year. We're excited about the opportunities in the market, particularly in expanding channels and increasing our card product offerings. Our technology transformation allows us to utilize data effectively, enabling us to harness advanced machine learning models to deliver customized experiences for consumers. This strategy is gaining traction, and we are committed to pursuing it further. A key aspect of our marketing strategy involves targeting heavy spenders. Our focus on this demographic dates back to 2010 with the launch of our Venture card, marking the start of sustained strategic efforts. Winning over heavy spenders requires not only an attractive product but also exceptional service, outstanding customer experiences, and strong value propositions. This necessitates significant investment in promotions, marketing, and brand development. Observing the successes and challenges in this business over the years highlights that consistent investment is crucial in building a strong brand. We are also investing in creating properties and experiences that drive growth among high spenders. These investments encompass our travel portal, exclusive access to various properties and experiences, airport lounges, and Capital One shopping. Our sustained focus on the high-end market has boosted our overall spending business, particularly with the heaviest spenders, which we find very appealing. Beyond the growth in spending, this segment generates substantial revenue, shows low losses and attrition, and enhances our brand. Additionally, our marketing strategy is supported by our commitment to developing our National Bank. With a smaller branch presence, our growth relies on modern technology, a compelling digital experience, a café presence in busy locations across the country, and ongoing marketing investments. These compelling opportunities are driving our marketing levels, and we're seeing positive traction across the board. We plan to continue engaging with these opportunities, which is essential for creating long-term value for our shareholders.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Richard Shane, Analyst

Thank you for taking my questions this afternoon. I would like to discuss the depository franchise. There has been significant growth this year in the consumer banking franchise, especially in deposits. Can you explain what you are observing in the competitive landscape where you believe you are gaining market share?

Richard Fairbank, CEO

Thank you, Rick. One of the core strategic approaches of Capital One, which defines the company's founding idea and guides all our decisions, is to analyze the marketplace and the significant forces driving change within it. We aim to identify where success will be in the future, particularly how technology influences this change. In retail banking, we entered the sector in the mid-2000s primarily to transform our company's balance sheet by moving away from capital market reliance towards building a deposit-driven balance sheet and seeking a consumer deposit franchise. As part of our strategy, we strive to stay at the forefront of the evolution in retail banking, moving from a strong reliance on branches—although I believe branches will continue to be important in banking for the foreseeable future—to transforming the concept from a branch on the corner to a bank in the hand, and eventually to a bank that is an integral part of daily life, providing interactive, real-time, and customized services. The first step in our journey was establishing a national savings business that was crucial to our balance sheet strategy. However, we did not stop there; we aimed to build a national full-service bank. This involved more than just offering checking accounts. With our retail branches present in about 20% of the country and our extensive experience in banking, we understood that to be competitive in National Banking, we needed to digitize the entire customer experience and make everything available digitally. Over the years, we have developed a full-service digital national bank, leveraging our large customer base and brand recognition. This approach has allowed us to effectively market our national bank, leading to significant growth and increased recognition as consumers realize that Capital One, despite our branch presence, operates as a full-service national bank. This strategy has been our focus for years, and we continue to commit to it from a marketing perspective, as we strive to build our national bank, not solely through numerous acquisitions of branch-based banks. Thank you.

Richard Shane, Analyst

Thank you, Rich.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Donald Fandetti, Analyst

Yes. Rich, I was wondering, given your good trends in auto delinquency, are you inclined to be leaning a little harder into auto lending or do you need to see something before making that decision?

Richard Fairbank, CEO

Thank you for your question, Don. It's interesting how we've consistently gone our own way in the auto business. Our strategy focuses on objectively assessing the marketplace for opportunities. The auto sector tends to be more volatile in terms of growth strategies compared to the credit card industry, largely because of the dealer's role in auction settings, which impacts our growth strategies based on the credit and underwriting decisions of our competitors. This is quite different from the credit card business, which is more direct and stable in customer interactions. Over the last several years, we've experienced significant growth in the auto sector, driven by our technology investments, data capabilities, and strong dealer relationships. In recent years, we were concerned about margin pressures from rising interest rates, which some competitors were slow to address. However, lending margins have now stabilized, and even those who were late to adapt have raised their prices. We have also been cautious about credit risks, proactively adjusting our approach due to anticipated challenges and concerns regarding consumer credit data. As a result, our outstanding loans have decreased somewhat, but we have maintained solid credit performance with stability over the last two quarters. While we remain vigilant for new opportunities, I’m not predicting any immediate acceleration, though we are pleased with the current performance in both our new and existing portfolios.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Sanjay Sakhrani, Analyst

Thanks. First question just on the adjusted operating efficiency rate. You've seen some nice improvements over the last two quarters. And I know, Rich, you talked about sort of the year outlook. I'm just wondering, if we could see this type of level or trends sustain itself into next year?

Richard Fairbank, CEO

Sanjay, we aren't providing guidance at this moment regarding our operating efficiency. We are pleased with the progress we have made in our operating efficiency ratio, especially while continuing to invest in the business. We are witnessing two dynamics at Capital One: substantial investment in technology and the corresponding benefits and efficiencies that come from that investment. As a result, we have made significant advancements in technology while achieving efficiencies along the way. I wouldn't place too much emphasis on any single quarter, as these numbers tend to fluctuate. However, you likely observed that our guidance indicated a flat to modest decline in our efficiency ratio for the full year 2023, and we have adjusted that to now reflect a modest decline. We remain optimistic that our technology transformation will yield substantial operating efficiencies, which we believe is crucial for value creation for our investors. Additionally, we recognize ongoing opportunities in the business and will continue to invest in technology to leverage even greater prospects in the future. This encapsulates our approach to the operating efficiency ratio.

Sanjay Sakhrani, Analyst

Perfect. Then I have a follow-up question just on the leaning into growth in card. Where exactly is that happening? I mean, obviously, you talked about adjusting the risk parameters, and that's obviously flowing through in the credit numbers improving. Is it more on the transactor side that you're leaning into growth or is it balanced across all segments? I'm just curious sort of the implications on a go-forward basis? Thank you.

Richard Fairbank, CEO

Thank you. We are gaining traction across the board. I want to discuss growth, particularly the impressive loan growth we've seen. Initially, we viewed this as simply a recovery from the pandemic's impact. However, our loan numbers have exceeded previous levels. It's worth considering what has driven this. There’s a notable effect from Capital One, as we continue to see substantial new account growth, which significantly contributes to loan growth over time. Payment rates have declined considerably but not to the pre-pandemic levels. A part of this is due to our success in spending, and generally, payment rates remain higher than they were before the pandemic. While this includes some Capital One specific factors, it also reflects strong consumer behavior. Although payment rates have decreased, this has supported growth. It's hard to prove empirically, but I believe inflation is a factor. When costs rise, as long as consumer incomes keep pace with inflation, there are natural inflation-driven growth elements. We see considerable strength in this area, with some points specific to Capital One and others that are relevant to the industry as a whole.

Jeff Norris, Senior Vice President of Finance

Next question, please.

John Pancari, Analyst

Good afternoon. Regarding your comments about the slowing increase in delinquencies in card accounts and the stabilization you mentioned, I understand that charge-offs typically lag behind this. Could you provide some insight into how long you expect that lag to be? Are we looking at a two to three quarter period for losses to manifest? Thank you.

Richard Fairbank, CEO

I don't want to make a specific prediction on that. First, I want to point out that we monitor delinquencies because they are the first indicator. That's why we've been discussing not just quarterly but also looking at the last couple of months and noticing a more stable trend on the credit card side, which is quite encouraging. Delinquencies occur when customers fail to pay, leading to charge-offs about six months later. However, the time frame can vary; sometimes it’s quicker, sometimes slower. Often, customers do make their payments. We are talking about these trends being assessed over a couple of quarters, relating delinquencies to charge-offs.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Erika Najarian, Analyst

I apologize for asking this again, but many investors are particularly interested in this matter for the fourth quarter. Referring back to Ryan and John's question about net charge-offs, it seems that what may be affecting credit-sensitive financials is the potential for a recession. However, Rich, your comments have indicated a positive trend in the slowing of delinquency rate normalization and the stability of credit performance in recent vintages. Considering the card charge-off rate in September and the quarterly charge-off rates from the second and third quarters, can we conclude that for the fourth quarter, the net charge-off rate will be primarily influenced by seasonality instead of normalization, assuming that normalization has stabilized for the time being?

Richard Fairbank, CEO

Thank you for your question, Erika. I want to highlight a few points. One factor that complicates the business for those who study it, including those of us involved daily, is the seasonality and the associated volatility. To elaborate, we typically see improvements in card and auto delinquencies around tax refund season each year, which then trend negatively throughout the rest of the year. The second quarter is usually the lowest point for card delinquencies, while the fourth quarter is the peak. Card losses tend to lag behind delinquencies, reaching their seasonal low in the third quarter and high in the first quarter. In the last quarter, our domestic card delinquencies rose, which is noteworthy since we're discussing a potential stabilization when delinquencies actually increased by 57 basis points sequentially, compared to a typical seasonal change around 37 basis points. Most of the increase we saw this quarter appears to be seasonal. If we look closely at August and September, the month-to-month changes are nearing the usual seasonal trends. This may suggest that the normalization trend we've been tracking is stabilizing. However, I want to emphasize that despite my positive tone, I am not claiming a definitive turnaround. We have a couple of months of encouraging data, but we would prefer more data before drawing firm conclusions. In the auto sector and the lower end of the card business, we have observed a more consistent stabilization, while our upmarket card business is still catching up. I would like to see additional data for full confidence. Regarding charge-offs, especially in August and September, we won't see stabilized charge-offs in the fourth quarter. It generally takes a couple of quarters for charge-offs to align with delinquencies. We are not making predictions; we aim to be transparent about our observations. While we are seeing some positive trends, they could also turn out to be misleading and not as favorable as they may seem.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Dominick Gabriele, Analyst

Hey. Good afternoon. Thanks so much for taking my question. When you think about capital ratios and Basel end game and the need to build capital specifically for unused lines, how do you think about mitigating if at all, mitigating your unused lines and given your capital target of about 11% today, maybe you could just talk to us about the factor of Basel unused lines and the effect going over on your capital levels and the ROTCE target? And then I just have a follow-up, if you don't mind. Thanks.

Andrew Young, CFO

Yeah, I'm going to come back, Dominick, because the last half of your question. I wasn't sure I followed it. But in terms of unused lines, one of our long-standing strategies has been to start people with smaller lines and allow them to grow. And so, I would say, I wouldn't expect a meaningful shift in that strategy solely in the service of risk-weighted assets. So overall, though, as you look at the risk weightings that have come out in the end game proposal. For us, in aggregate, recall, we're not in mortgage or trading. So looking at the net of retail and commercial, inclusive of the gold plating, those are largely fighting to a draw in terms of overall risk-weighting impact, specifically on the asset side. Like everyone else, of course, we're going to have an impact from the operational risk RWA. But I didn't quite follow the second half of your question around ROTCEs. Could you just repeat that for me?

Dominick Gabriele, Analyst

Sure. I was wondering if you need to hold more capital now that you have to maintain additional capital for unused lines compared to drawn lines. Would this mean that your capital ratio has to increase and might that impact long-term returns in any way?

Andrew Young, CFO

Got it. Yeah, sorry, I didn't quite follow the second half of it. That was what I was trying to explain in my answer is, the net of all of that ultimately ends up being a wash, the part where we will be holding more capital on the denominator side, strictly for the risk-weighting assets again, I should highlight that it's in a comment period, a lot of industry focus on it and well, particularly as it relates to the opt risk calculation, there could be material impacts on the final outcome relative to what's proposed. But taking what is currently proposed, the asset side specifically outside of the operational risk ends up being roughly a draw for us, and it's really just the operational risk that's going to require us to hold more capital.

Jeff Norris, Senior Vice President of Finance

Dominick, you have a follow-up? Next question, please.

Bill Carcache, Analyst

Can you hear me?

Richard Fairbank, CEO

Yeah.

Bill Carcache, Analyst

Okay. Great. Thank you. Yeah. So I wanted to ask about the late fee proposal. The consensus view is that we'll get it very soon. It will be immediately litigated. Can you give us your view on the likely path that you would anticipate and possibly speak to any potential costs that might be associated with it?

Richard Fairbank, CEO

Okay. Thank you, Bill. So the CFPB's late fee proposal as currently contemplated would reduce late fees by approximately 75%. And while the CFPB's proposal has not yet been finalized, we expect the CFPB to publish a proposal soon, probably before the end of the year. Now once the CFPB publishes its final rule, we expect there to be industry litigation that could delay or block the implementation of this rule. And this litigation will likely delay the implementation of the rule until at least the second half of 2024 and maybe longer. If the proposed rule is implemented, there will be a significant impact to our P&L in the near term. However, we have a set of mitigating actions that we're working through that we believe will gradually resolve this impact a couple of years after the rule goes into effect. These choices include changes to our policies, products and investment choices. Some of these actions will take place before the rule change takes effect, many will come after the rule change takes effect.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Dominick Gabriele, Analyst

Hey. Sorry about that, I think I got cut off. Can you hear me okay?

Richard Fairbank, CEO

Yes, we can, Dominick.

Dominick Gabriele, Analyst

All right. Sorry about that, guys. I was actually just curious on the quarter-over-quarter increase in domestic card yield. I know that there's sometimes some seasonality in the third quarter, and we've also had a lot of rate hikes in previous years around the third quarter. I was wondering if you could just walk us through some of the dynamics in the quarter-over-quarter increase in domestic card? Thanks so much.

Andrew Young, CFO

Yeah, Dominick. I think you largely answered your own question. There is seasonality that is partly a result of the revolve rates influenced by some of the dynamics Rich mentioned throughout the year. We observed the Fed's movements and also experienced a bit of late fees, which I consider part of the seasonality aspect. Additionally, we had one extra day in the third quarter, which affects the total day count in an absolute sense, although not necessarily in comparison to peers. Those are the main factors that contributed to the quarter-over-quarter yield.

Jeff Norris, Senior Vice President of Finance

Well, thanks, everybody for joining us on the conference call this evening, and thank you for your continuing interest in Capital One. The Investor Relations team will be here later this evening to answer any questions that you may have. Have a great evening, everyone.

Operator, Operator

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