Discover Financial Services (DFS) Q3 2022 Earnings Call Transcript

Discover Financial Services (NYSE: DFS) Q3 2022 earnings call dated Oct. 25, 2022

Corporate Participants:

Eric Wasserstrom — Head of Investor Relations

Roger Hochschild — Chief Executive Officer

John Greene — Chief Financial Officer

Analysts:

Ryan Nash — Goldman Sachs — Analyst

Moshe Orenbuch — Credit Suisse — Analyst

Sanjay Sakhrani — KBW — Analyst

John Hecht — Jefferies — Analyst

John Pancari — Evercore — Analyst

Betsy Graseck — Morgan Stanley — Analyst

Robert Napoli — William Blair — Analyst

Don Fandetti — Wells Fargo — Analyst

Mihir Bhatia — Bank of America — Analyst

Rick Shane — JPMorgan — Analyst

Bill Carcache — Wolfe Research — Analyst

Kevin Barker — Piper Sandler — Analyst

Mark DeVries — Barclays — Analyst

Bill Ryan — Seaport Research Partners — Analyst

Dominick Gabriele — Oppenheimer — Analyst

Presentation:

Operator

Good morning. My name is Katie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter 2022 Discover Financial Services Earnings Conference Call. All lines have been placed on mute to prevent any background noise. [Operator Instructions]

I will now turn the call over to Mr. Eric Wasserstrom, Head of Investor Relations. Please go ahead.

Eric Wasserstrom — Head of Investor Relations

Thank you, Katie, and good morning everyone. Welcome to today’s call. I’ll begin on Slide 2 of our earnings presentation, which you can find in the financial section of our Investor Relations website, investorrelations.discover.com.

Our discussion today contains certain forward-looking statements that are subject to risks and uncertainties and that may cause actual results to differ materially. Please refer to our notices regarding forward-looking statements that appear in our third quarter’s earnings release, press release and presentation.

Our call today will include remarks from our CEO, Roger Hochschild; and John Greene, our Chief Financial Officer. After we conclude our formal comments, there will be time for a question-and-answer session. During the Q&A session, you will be permitted to ask one question followed by one follow-up question. After your follow-up question, please return to the queue.

Now, it’s my pleasure to turn the call over to Roger.

Roger Hochschild — Chief Executive Officer

Thanks, Eric, and thanks to our listeners for joining today’s call. I’m very pleased with our results this quarter. Against a fluid macroeconomic backdrop, we generate strong financial performance while continuing to advance our strategic priorities.

Let’s start with a summary on Slide 3. For the third quarter, we reported net income of $1 billion after tax or $3.54 per share. Over the past three months, as Fed policy has become more restrictive, it has made fears of a recession more acute. Against this backdrop, the key narratives of the third quarter results are the strength of our balance sheet and the quality of our earnings.

Our increase in revenues this year has been largely driven by our strong receivables growth with loans up 17% year-over-year. This growth was driven largely by elevated sales volume and the increased number of new accounts we’ve added since mid-2021. We continue to use a through-the-cycle approach to underwriting, which considers all stages of a credit cycle, including downturns.

As part of our conservative credit management, we marginally tightened our new account underwriting criteria this quarter. Given these factors, we consider our growth to be consistent with current macroeconomic conditions. Naturally, discussion of — session of elicits concerns about credit quality, but the credit performance of our loan portfolio at this stage does not suggest anything other than gradual normalization. Nonetheless, a late-cycle environment requires a particular awareness of changing conditions and underscores the importance of our strong financial condition.

We also continue to advance our strategic priorities. As a few examples, in August, we expanded our global presence with the signing of Woori Card of the largest issuers in South Korea. The extension of this relationship as well as the number of new network partnerships we’ve announced this year highlight our focus on expanding our international presence. We continue to demonstrate the value of our network and our growing relationships with fintech partners. As an example, we announced in October that we will facilitate payments for TYDEi’s new healthcare vendor management system, which will digitize and streamline payments in an industry where legacy purchasing is still primarily manual.

Finally, this summer, we announced the opening of our new Advanced Analytics Resource Center at our downtown Chicago location. The first cohort of 75 individuals, which we selected from over 1,000 applicants has already started, and we intend to grow the program with an additional cohort in 2023. This follows the grand opening of our customer care center in the South Side neighborhood of Chatham earlier this year and underscores our commitment to bring additional jobs to Chicago while supporting great customer experiences.

I’ll now turn the call over to John to review our results in more detail.

John Greene — Chief Financial Officer

Thank you, Roger, and good morning, everyone. I’ll start with our financial summary results on Slide 4. There were three important trends in the quarter: strong asset growth, net interest margin expansion, and modest credit normalization. The strength in asset growth, combined with a NIM rate improvement increased revenue by 8% sequentially and 25% year-over-year. Asset growth resulted in an increase in our reserves under CECL of $304 million, but our reserve coverage ratio declined slightly. So while our reported net income was down 8% year-over-year, adjusting for the reserve change, our net income would have been 28% higher on a year-over-year basis.

Let’s review the details starting on Slide 5. Net interest income was up $438 million year-over-year or 18%, driven by higher average receivables and improved net interest margin. We achieved a record-high NIM rate of 11.05%, up 25 basis points from the prior year and 11 basis points sequentially. On both a year-over-year and sequential basis, the increase in net interest margin primarily reflects the higher prime rate, partially offset by higher funding costs and increased promotional and balance transfers.

Receivable growth was driven by card, which increased 19% year-over-year, reflecting continued strong sales and the contribution from new accounts growth last year and into this year. Sales growth was 15% in the period, a deceleration from the 20% growth we experienced in the first half of the year.

As anticipated, the sales decline was partially mitigated by a decrease in the payment rate, which fell 70 basis points in the quarter. Nonetheless, it remains more than 400 basis points over 2019 levels. We expect the payment rate to continue to decline through the back half of 2023, which should help support receivable growth.

Turning to our non-card products, organic student loans increased 4% as a result of peak season originations. Personal loans were up 11%, the growth reflects our disciplined approach to marketing, underwriting, and pricing of this product, which we believe has created an attractive competitive position for us in the market, particularly relative to some non-bank originators.

In terms of funding mix, our customer deposit balances were up 4% year-over-year and 2% sequentially. So far, deposit pricing has been in line with what we expected in a rising rate environment. As we mentioned last quarter, our strong asset growth has caused deposits to various proportions of our funding mix, but we continue to target 70% to 80% deposit funding over the medium term. We also issued $2 billion of card ABS fixed notes in the quarter and booked $5 billion of broker deposits. We maintain broad access to a variety of funding sources, enabling us to confidently fund our asset growth.

Looking at other revenue on Slide 6. Non-interest income increased $264 million or 71%. This was partially due to a $157 million loss on our equity investments in the prior year quarter compared to a $4 million loss this quarter. Adjusting for these, our non-interest income was up 19%. This was driven by higher net discount and interchange revenue, which was up $47 million or 16%, reflecting strong sales and a favorable sales mix, partially offset by higher rewards costs.

Similar to last quarter, we estimate that inflation contributed between 200 basis points and 250 basis points of sales growth in the period. The strong sales also drove higher reward expenses. Consistent with the prior quarter, our rewards rate increased 3 basis points year-over-year, driven by substantial growth in new accounts, increasing the cost of our cash-back program. Year-to-date, our rewards rate is up 2 basis points, consistent with our expectation of 2 basis points to 4 basis points of annual reward rate inflation.

Moving to expenses on Slide 7. Total operating expenses were up $198 million or 17% year-over-year and up 13% from the prior quarter. Compensation costs were up primarily due to increased headcount. Our servicing organization is a key component of our value proposition. We expect to grow this as our accounts and assets expand. This will contribute to an increase in salary and wages through the end of this year and into next year.

Marketing expenses increased $66 million or 31% as we continue to invest for growth in our card and consumer banking products. We grew new card accounts by 22% from last year’s third quarter. Professional fees increased $43 million or 22% as a result of investments in technology and increased consulting costs. We also had additional fraud costs in the consumer bank, driven by increased volumes as well as some legal expenses elevating our other expense category in the quarter.

Moving to credit performance on Slide 8. Total net charge-offs were 1.71% or 25 basis points higher than the prior year, but down 9 basis points from the prior quarter. Total net charge-off dollars were up $114 million from the prior year and only up $10 million sequentially. In the card portfolio, the net charge-off rate of 1.92% was 27 basis points higher than the prior year and 9 basis points lower sequentially.

Similar to our commentary from last quarter, we are not seeing evidence of emerging credit stress beyond normally expected normalization. Delinquencies among our lower prime segment have been normalized, but in the upper prime delinquencies and charge-offs remain below pre-pandemic levels. This is consistent with our baseline expectation that credit will continue to normalize over the next several quarters’ absence of a change in macro conditions.

Turning to the discussion of our allowance on Slide 9. This past quarter, we increased our allowance by $304 million due to higher receivable balances. Our reserve rate modestly declined to 6.7%. For us, changes through — to employment conditions pose the most significant risk to loss levels. As part of our reserving process, we have considered the prospects of higher unemployment among a range of macroeconomic scenarios which is reflected in our reserve balance.

Looking at Slide 10. Our common equity Tier 1 for the period was 13.9%. The strong asset growth was a primary driver of the approximate 30 basis point decline from the prior period. Our long-term target remains 10.5%. In terms of capital return, we declared a quarterly common dividend of $0.60 per share and repurchased $212 million of common stock in the period before we decided to temporarily suspend our buyback activity.

Concluding on Slide 11. As we look at the last quarter of the year, our prospects for 2022 remain favorable, and we are once again improving elements of our expectations. We are revising our view on loan growth to high teens, continued strong sales, new account acquisitions through the third quarter and some recent improvements in the payment rates to support our confidence in the outlook.

In terms of NIM, we expect the full year to be mildly above the high end of our expected range with sequential margin improvement in the fourth quarter based on rate hikes that happened in late September. We are revising our expense outlook to be up high single digits versus the prior year, driven by increased marketing and compensation costs. In line with previous communications, we still expect marketing costs to come in above 2019 levels as we’ve discussed.

We expect to add headcount, which will elevate salary and wages as well as benefit expenses. Excluding these two categories, expenses are expected to increase by low single digits. We now expect net charge-offs to be between 1.8% and 1.9% for the full year, driven by lower-than-expected credit losses through this point in the year. Our temporary pause on share repurchases remains in place, but we hope to resume share repurchases before year-end.

In summary, receivable growth accelerated as we continue to benefit from elevated sales, strong new account acquisitions, and improvements in the payment rate. NIM continues to benefit from prime rate increases. Funding costs are consistent with expectations and credit performance is slowly normalizing, reflecting our disciplined approach to underwriting and credit management. These results demonstrate the resiliency of our integrated digital banking and payments model. Our earnings power, coupled with our strong balance sheet and capital position, keeps us well-positioned for continued profitable growth through a range of economic conditions.

With that, I’ll turn the call back to our operator, Katie, to open the line for Q&A.

Questions and Answers:

Operator

Thank you, sir. [Operator Instructions] We’ll take our first question from Ryan Nash with Goldman Sachs. Your line is now open.

Ryan Nash — Goldman Sachs — Analyst

Hey, good morning guys.

Roger Hochschild — Chief Executive Officer

Good morning.

Ryan Nash — Goldman Sachs — Analyst

So maybe to start on the net interest margin John, you commented that it implies another uptick given the rate hikes that we saw at the end of the quarter. Can you maybe just talk about where we go from here on the margin? I think last quarter; you talked about it potentially peaking out. I’m just curious; do you think you can continue to hold their line around these levels? And maybe what is incorporated within that in terms of deposit betas and the like?

John Greene — Chief Financial Officer

Great. Okay. Thanks for the question, Ryan. There’s a lot there. So, let me start with the fundamentals that we’re seeing. So the liability side of the balance sheet is certainly subjected to increases in deposit funding costs as a result of competitive actions and general needs across the market to attract some deposits. With that said, the 11% plus we delivered in the third quarter; we do expect some upside from that as a result of the Fed hikes in September. So certainly, sequentially into the fourth quarter, we’ll see further improvement.

Now, beyond the — excuse me, beyond into the fourth quarter — we’ll see improvement. Beyond the fourth quarter at this point, we’re going to reserve any commentary. But what I would say is, we don’t expect any specific, I’ll say, seismic changes to net interest margins in 2023 based on the stability of our funding base and turn access to multiple sources of funds.

Ryan Nash — Goldman Sachs — Analyst

Got it. Thanks for the color. Roger, maybe one for you. You mentioned you guys are marginally tightening on account acquisition. Can you maybe just give additional color regarding some of the changes you’re making to underwriting? And what do you think this might mean for growth over the intermediate term? Thanks.

Roger Hochschild — Chief Executive Officer

Sure. So, I would start by saying, in general, it remains a very good environment. We’re seeing cost per account on the prime side below what we had last year. The value proposition is resonating well. For the new account space at the margin, we tightened some of those segments that will be most volatile in a downturn. So, I think the lower end of prime. And we’re ready to take further action on new accounts or the portfolio side. But again, I’d say overall, a very good environment, and that’s part of why you’re seeing such strong growth.

Ryan Nash — Goldman Sachs — Analyst

Got it. Appreciate the color.

Operator

Thank you. Our next question will come from Moshe Orenbuch with Credit Suisse. Your line is now open.

Moshe Orenbuch — Credit Suisse — Analyst

Great. Thanks. I was hoping maybe you could talk for a little bit of a different tack. Maybe talk a little bit about the competitive environment and what you’re seeing from a credit standpoint and from a competitive marketing standpoint, kind of, in your two installment loan businesses, both in the personal loan business and the student loan business, and maybe talk about that and the outlook there for a moment?

Roger Hochschild — Chief Executive Officer

Yeah, so it is hard Moshe to know what individual competitors are doing. I would say in general, most of them are much broader spectrum lenders than we are. And so my guess is we’d be seeing some stress at the lower ends of their books. For us, a rising rate environment creates a lot of focus on debt consolidation, which is the primary use of our personal loans. So, we’re maintaining very disciplined credit criteria by seeing strong originations in that segment.

Moshe Orenbuch — Credit Suisse — Analyst

Got it. Thanks. It is interesting. I mean, I think we’ve seen that for others that are at the higher end of the credit spectrum where the stress you’re talking about we do see at the lower end. The follow-up question that I had is, you talked about hoping to restart the buyback by year-end or so, a little bit of growth kind of causing a 30 basis point downtick in your capital, but you’re still well above. Just talk about, I guess, the appetite for that given — and does the kind of macro environment figure into that? Just talk about the appetite for the buyback once that restarts? Thanks.

John Greene — Chief Financial Officer

Yeah sure. Moshe, I’ll take that. So from an overall capital level, we are very well-capitalized, right? So, we’re 13% approaching, 14% on the CET1. Our target is 10.5%. The credit book has been very, very stable. It’s normalizing, but overall, very, very stable. So the capital allocation priorities through the firm remain in place. So first is to invest in strong organic growth, second would be a return of capital, and then third, perhaps a bolt-on acquisition, and we’re going to do that will likely be in the Payments segment. So overall, those priorities didn’t change. So the suspension remains in place, but we’re hopeful that it will resume — buybacks will resume here in the fourth quarter.

Moshe Orenbuch — Credit Suisse — Analyst

Thank you.

Operator

Thank you. Our next question will come from Sanjay Sakhrani with KBW. Your line is now open.

Sanjay Sakhrani — KBW — Analyst

Thanks. Good morning. John, I wanted to just walk through the expense guide increase. You mentioned it’s a blend of marketing and comp costs. Could you just parse apart what part is — how much of each sort of contributing to the increase? And I’m just trying to put the marketing comments to slightly pull back the credit box. And then as far as like the headcount increases, was that related to the growth? I’m just trying to figure out what changed in terms of the comp cost?

John Greene — Chief Financial Officer

Yeah. Yeah, happy to help with that, Sanjay. So let me provide some context upfront here. So year-to-date total expenses are up 7%. Comp expense is up 5%, and excluding marketing, our expense base year-to-date is up 2%. So actually really, really what I’ll say the first half of the year and into this quarter are some strong fundamentals. Now, we did have significant growth in the asset base, which of course, means that there are accounts that we’re going to have to service. And you might have seen a press release that came out that indicated we were hiring about 2,000 servicing agents through the balance of this year and into next year depending on the balance sheet and our customer value proposition and metrics.

So overall, the strong growth and the strong acquisition have necessitated investments in our people. We’ll continue to do that. We’ve also made specific investments in information technology, specifically around resources and advanced analytics in order to further position us to be able to grow profitably and then also enhance underwriting and customer targeting. So, we believe all those investments make perfect sense for the long term. And what you’re seeing here in the third quarter is a combination of what I’ll say is a tough comp as a result of some turnover last year. And then us coming on with backfilling resources, what I’ll say is salaried resources as well as the investments I talked about in terms of customer service. So hopefully, that provides some context and color to your question.

Sanjay Sakhrani — KBW — Analyst

Okay. That’s very helpful. And then I know we’re trying to read between the lines in terms of the student loan servicing inquiry or investigation that’s going on. But just to be clear, there is no change to how you guys are thinking about it relative to last quarter. And as far as the expenses are concerned, it seems like things are progressing as you expected it to and it’s just a matter of timing. Is that a correct statement?

John Greene — Chief Financial Officer

Yes, that is a correct statement. So no change. Obviously, when we have some news to share, we’re going to share it. The expense guidance we provided and the updates reflect those items I discussed in your previous question and no specific changes related to expenses related to the buybacks as mentioned.

Sanjay Sakhrani — KBW — Analyst

Okay. Great. Thank you.

Operator

Thank you. Our next question will come from John Hecht with Jefferies. Your line is now open.

John Hecht — Jefferies — Analyst

Good morning guys. Actually, most of my questions have been asked, and I was going to ask one about marketing. But maybe since you addressed the spending patterns, maybe can you talk about — just because it’s a topic that we haven’t really talked about in detail recently your perspective on rewards and the competitive environment around rewards and what that means for the intermediate term?

Roger Hochschild — Chief Executive Officer

Yeah. Sure. So a lot of the most intense competition on rewards is in the super prime segment, and we’ve talked over the last year or two, about how we think some of the propositions issuers are putting out aren’t necessarily sustainable in the long run. As John mentioned, our rewards costs are moving up exactly as we forecast. We haven’t felt the need to make any structural changes to our program. So as you can see from the growth in the new accounts, our value proposition competes very well in that prime revolver segment. And so while the market is always competitive, we bring a differentiated value proposition that resonates well with consumers.

John Hecht — Jefferies — Analyst

Okay. And then the second question is maybe thinking about like a 2021 cohort, and I know it’s probably early for the 2022 cohort, but what can you tell us in terms of how they’re seasoning utilization rates and kind of delinquency seasoning? Is there — is it back to what it looked like in 2019? Or is there something different that’s worth pointing out with respect to more recent vintages?

Roger Hochschild — Chief Executive Officer

Yeah. I would say more recent vintages are performing exactly in line with our expectations, right? I mean every vintage got distorted during the pandemic. So you saw it cut across the curves. But again, we feel very good about the performance.

John Hecht — Jefferies — Analyst

Okay. Thank you, guys.

Operator

Thank you. Our next question will come from John Pancari with Evercore. Your line is now open.

John Pancari — Evercore — Analyst

Good morning.

Roger Hochschild — Chief Executive Officer

Good morning.

John Pancari — Evercore — Analyst

The efficiency ratio came in at around 40% for the third quarter. And just given the commentary that you gave around the investments that you’re making and your expense expectations, can you maybe help us think about how that could shape up for the fourth quarter, and more importantly into 2023, how we could think about the trajectory there? Thanks.

John Greene — Chief Financial Officer

Yeah, John thanks for the question. So, what we said in the past and what we’ve told our Board and what we’re targeting is an efficiency ratio in the high [Indecipherable]. And through this year, we’ve done a pretty good job in terms of being able to deliver that. Certainly the really strong growth and the great performance through the first half on expense — on the expense base. And then the third quarter reflects some investments and despite those investments, still below 40%. We’re going to continue to make investments where we see an opportunity to drive great returns for our shareholders.

And as we approach 2023, we are aware that the economic environment is a little tougher. We do feel like we have remaining tailwinds in terms of asset growth and we do have investments we’re going to continue to make. So, I would say for 2023 specifically, we will come out in January to give more specific details. But the overall commitments remain in place, commitment to positive operating leverage and efficiency ratio south of 40% and expense discipline while investing for growth.

John Pancari — Evercore — Analyst

Okay. Thank you. That’s helpful. And then on the reserve front, just wanted to get your take on how you see that trajectory here? I know you allowed the reserve to bleed a bit in terms of the ratio this quarter. But now as you’re seeing some of the normalization that you indicated and some of the pressure on delinquencies, how should we think about the reserve as you look here, particularly as you factor in the economic conditions and how you’re looking at the economy, the impact on the economy plays out? Thanks.

John Greene — Chief Financial Officer

Yeah, great. Thanks for that question. So a little bit of context there. So, we put on about $5.5 billion to $5.6 billion worth of assets in the quarter. Our reserves increased by $304 million. So, as we look at the portfolio and the macro environment, we’re seeing the portfolio continuing to be very, very stable but normalizing. The macro-environment indications of a recession are certainly increasing. Roger mentioned in his comments about some mild — in his comments about some mild tightening.

So in terms of expectations around reserves, we’ll continue to take a look at the macros. We’ll run multiple scenarios and then make sure the balance sheet, and the portfolio specifically continue to perform as anticipated and will make appropriate calls for reserves under GAAP. It’s really tough to give any specific guidance on that other than we’re going to be mindful of the macros, continue to watch the portfolio, and that prime revolver targeting we do, tends to add high-level stability.

As matter of fact one other point may be useful, not specific to reserves, but rather charge-offs. You have to go all the way back to the second quarter of 2011 to see charge-offs that — charge-off rates that is north of 4%. So, we’re seeing great stability this year, and we expect it to be stable next year as well.

John Pancari — Evercore — Analyst

Got it. Okay, thanks for taking my questions.

Operator

Thank you. Our next question will come from Betsy Graseck with Morgan Stanley. Your line is now open.

Betsy Graseck — Morgan Stanley — Analyst

Hi, good morning.

Roger Hochschild — Chief Executive Officer

Good morning.

Betsy Graseck — Morgan Stanley — Analyst

I just wanted to see if I could get you to unpack your statement on no seismic changes in 2023. Maybe we could speak a little bit about how you’re thinking — and I know you just detailed a little bit, but how you’re thinking about how the loan yield should traject. I know in the slide deck, you called out that the loan yield was driven by prime obviously, but with a partial offset from a higher promotional mix and the timing of pricing changes. Could you help us understand how that works? How much did the promo mix and the timing impact loan yields and how you’re thinking about that trajecting as we continue to go through a Fed rate hike period here?

John Greene — Chief Financial Officer

Okay. Yeah, so there’s a lot there. And as you know, it’s fairly complex Betsy, but I’ll do my best to create some transparency here. So — and let me start with the loan yields. So 80% of our book is the floating rate of the asset side. So as the Fed increases, that creates the opportunity to move the contract rate up with the Fed changes. And correspondingly, if the Fed were to come down, the contract rate would come down. So, what we’re seeing there is in a rising rate environment. We still expect 3 basis points to 5 basis points of yield improvement. So net interest margin yield improvement over a 12-month period.

So, we saw significant increases in September. It looks like based on the forward curve, there’s another maybe as much as 125 basis points of further Fed action this year, and then next year, depending on the economy, there could be a couple more or there’ll be a pause. I don’t think there will be much in the way of Fed rate reductions until maybe as late as 2024. So what that means is, we’re going to get the benefit from the Fed rate increases into the portfolio. We’re seeing deposit pricing continue to go up. We haven’t been a price leader on that. Certainly, we’ve been a follower to make sure we have a positive value proposition for our customer base.

And then the next question would be about betas and what do you think about betas. So, I’m going to try to address that right now. So as there’s a greater disparity between our rates from a deposit standpoint and the brick-and-mortar banks. It creates plenty of opportunity for us to market into those customers and they’ll find an attractive value proposition, which should help dampen the impact of further rate increases. So, we do think the combination of the Fed increases, us being able to manage the deposit book, but in a rising rate environment, stability from a credit standpoint, but normalization, which will create a bit of incremental interest reversals impacting net interest margin. And then ultimately, the pricing decisions we’re going to make where we have that flexibility to make sure we’re making good decisions for our customers and for our shareholders. So ultimately, it nets out that we expect relative stability over net interest margin through 2023.

Betsy Graseck — Morgan Stanley — Analyst

Okay. Got it. And I appreciate that. Thanks. My follow-up has to do with the buyback discussion that we had earlier. And I know you mentioned that you’re hoping it can resume in 4Q. Would you expect to put out an 8-K, that indicates that you can now resume buybacks? Or would we hear about buybacks only after you started, there’s no obligation to put a notification into the market that you can resume. Thanks.

John Greene — Chief Financial Officer

Correct. There isn’t an obligation, but we would likely put an 8-K out.

Betsy Graseck — Morgan Stanley — Analyst

Okay. No obligation, but you would likely do it [Indecipherable]. Thanks.

John Greene — Chief Financial Officer

Yeah.

Operator

Thank you. Our next question will come from Robert Napoli with William Blair. Your line is now open.

Robert Napoli — William Blair — Analyst

Yeah. Thank you and good morning. So, I am just following up on — it was good to hear about resuming the buybacks. I guess that would suggest that the review is behind you. But would you expect them to get you to go towards your 10.5% target capital ratio? And over what time frame would you like to do that? Or what kind of a buffer do you want above that 10.5%?

John Greene — Chief Financial Officer

Yeah, hey Bob, thanks for the question. I just want to be very specific about something you said. And our comments have consistently been here on this call that we hope to resume the buyback in the fourth quarter. So, we say that because we’re hopeful, but ultimately, it will be a decision that the Board helps with. So in terms of the 10.5% target, so we’ve been well north of that for quite some time, there’s — we have said that we want to step towards that, we intend to step towards that. So certainly, the earnings power that the firm has generated and the buybacks as well as dividends, have impacted our ability to get there. So we’re going to step towards that when throughout 2023 and 2024. What we said previously is, we hope to be around the 10.5% target, sometime in 2024 or 2025.

Robert Napoli — William Blair — Analyst

Thank you. And the follow-up is just on the normalization of credit losses. As we think about normalized credit losses there, looking back over history, credit cards, high-3s, I guess, or mid-3s to high-3s personal loans in the 4% range. Is that the way we should think? Is there anything that’s changed? Should we continue to think about normalized credit losses in that kind of area?

John Greene — Chief Financial Officer

Yeah. Yeah so, I would put two points out there. First, I would take a look at the historical trends and use that and make certain judgments. The other item here, I’m going to say is a matter of judgment. But certainly, I have a belief that credit cards have increased in the payment priority because folks can access the digital economy without a credit card — some folks with a debit card, but most specifically around a credit card. So that, I believe, helps prioritize the primary credit card among many other debt obligations that a consumer has. So could that impact the relative charge-off rates versus the historical trend? My belief is yes, but your judgment is, what I’d say you should apply when you’re working through your forward-looking outlook.

Robert Napoli — William Blair — Analyst

Thank you.

Operator

Thank you. Our next question will come from Don Fandetti with Wells Fargo. Your line is now open.

Don Fandetti — Wells Fargo — Analyst

John, personal loan growth was pretty strong this quarter. Just wanted to get your thoughts on the outlook there and growth. And also any updates on your home equity lending initiative?

John Greene — Chief Financial Officer

Yeah. Yeah, thanks for the question, Don. So certainly, nice growth there. On the personal loan front, you go back in a few quarters, and it was flat. And we said it was flat to down. Actually, if you go back three or four quarters as a result of some underwriting decisions we took. We’ve been — we set strength in the underwriting for that product, and it’s given us greater confidence to be able to market that product, and there’s been a high level of appeal to it. So, we’ll continue to be mindful of the product in the face of tougher economic conditions. But certainly, we feel like it’s a good product and it is meeting customer needs, and that’s helped drive the growth.

In terms of kind of forward-looking guidance, I’m not going to start to do that at a product level, all it would do is ensure that I was wrong more often. But if I go to the kind of the home equity loan, that portfolio is relatively small. So it’s actually not moving the dial at this point from an earnings standpoint. But what we’ve seen is a great level of interest in the second lien product, and we’re also originating a first lien product as well. So both products are performing well and nice appeal.

Don Fandetti — Wells Fargo — Analyst

Thanks.

Operator

Thank you. Our next question will come from Mihir Bhatia with Bank of America. Your line is now open.

Mihir Bhatia — Bank of America — Analyst

Good morning. Thank you for taking my question. Maybe I just wanted to start with — if you just take your guidance for NIM and loan growth, and I think that works out about four points effectively works out of fourth-quarter NIM of at least 11.2% and $3 billion-plus NII. Is that the right way to think about it and frame the exit rate for NIM? And then should NIM, NII just increases from there given loan growth and your comments about NIM stability? Am I thinking of that correctly?

John Greene — Chief Financial Officer

Yeah. So Mihir, thanks for the question. And I certainly appreciate the specificity. What I’ve said about NIM is probably as far as I’m going to go here on this call. We do expect sequential improvement, as I said. Beyond that, it will be tough to give specific details.

Mihir Bhatia — Bank of America — Analyst

Okay. And then just wanted to ask about losses normalizing. A little previously, you had talked about it being in 2H 2023 is when we get to a more normalized loss rate. But I think there was talk that it could maybe push into even 2024 later. Any update on that? Thank you.

John Greene — Chief Financial Officer

Yeah. So normalization through 2023 and the macro environment will help us determine whether it pushes 2023 into 2024. But where we’re sitting today, we’re very pleased with the portfolio performance and the only surprise is frankly, the pace of normalization on the upper end is a little slower than we expected, which helped drive the improved guidance that we gave on the charge-off rate.

Mihir Bhatia — Bank of America — Analyst

Thank you.

Operator

Thank you. Our next question will come from Rick Shane with JPMorgan. Your line is now open.

Rick Shane — JPMorgan — Analyst

Thanks, everyone for taking my question. Look, your customer base really represents a great sample of the domestic population. I’m curious when you look at spending on a category-level basis if there’s anything that you’re seeing that is a cause for concern, not asking if people are spending more of the [Indecipherable] that’s obvious with the inflationary pressures. But are there categories where you’re seeing people use their cards that are signals for something we should be thinking about?

Roger Hochschild — Chief Executive Officer

Yeah. Great question. So our base probably does skew a little upwards, so more in the prime, but we’re seeing continued strength in sales in October. So, I’d say, year-over-year in the low teens. Some of the trends you’ve heard about were picking up. So consumer durables softening in terms of year-over-year. But again, our households, by and large, they have the liquidity to absorb inflation. It causes some pain, and we’ll switch categories, we’ll downgrade within a category. But I would say travel is coming off some of the very, very strong growth we saw over the summer. So a little less strength in travel and consumer durables are probably the key trend.

Rick Shane — JPMorgan — Analyst

Got it. Thank you very much.

Operator

Thank you. Our next question will come from Bill Carcache with Wolfe Research. Your line is now open.

Bill Carcache — Wolfe Research — Analyst

Thank you. Good morning, Roger and John.

John Greene — Chief Financial Officer

Good morning.

Bill Carcache — Wolfe Research — Analyst

You mentioned that operating conditions are consistent with late-cycle expansion historically. Fed hiking cycles have typically ended in slowing loan growth, but you’re already exceptionally strong loan growth seems to be accelerating, and certainly, the whole industry is enjoying strong growth. Can you share any thoughts around how you’d expect the late-cycle expansion to end? And I’ll just layer in my follow-up now. And if you can give any commentary around what level of unemployment is implicit in your reserve rate and what a change in unemployment would mean for the reserve rate, that would be very helpful?

Roger Hochschild — Chief Executive Officer

Yeah, that is a great question. So, I mean, in terms of the late cycle, I think back pre-pandemic, we talked about it being late cycle for a couple of years, and then it ended in a way that I think no one expected. And so that’s part of why we tend to use a through-the-cycle loss rate and look to be disciplined in our credit management. So while I would be, it’s not a time probably to be widening credit. We’re seeing a lot of benefits from the investments in advanced analytics, in particular, around the personal loan product and on the card side, where the growth we’re achieving the growth while swapping in and swapping out different populations.

And again, with a policy that I think is appropriate for a late cycle. And it builds on some of the really strong new account production we had in 2021 and as those accounts mature. So again, we’ll continue to look at it, both in terms of our portfolio actions as well as new account originations across all of our products, but we feel good about the credit approach and just the traction our products are getting in the marketplace. And I’ll pass it to John for part two.

John Greene — Chief Financial Officer

Yeah, hey Bill, and in terms of kind of fundamental assumptions for kind of reserve setting. So, as I said earlier, we used a number of different scenarios, which included kind of non-recession scenario as well as the recessionary scenario. The recessionary scenario that we modeled. We certainly didn’t wait as much as the non-recession and also the view in terms of the unemployment rate, there’s pretty wide range right now, right? So some forecasted going north of 6% in a very, what I’ll say, a dark scenario. The more optimistic scenario is 4%.

And so we looked at a complete range of scenarios and weighted it more towards stability with increasing unemployment. GDP, not as big a driver, but certainly an indication for the economy. Today, we’re at about 1%, and in 2023 in a recessionary scenario; there would be mild contraction, not deep contraction. So we think, overall, there will be general stability despite a tougher macro.

Bill Carcache — Wolfe Research — Analyst

Thank you.

Operator

Thank you. Our next question comes from Kevin Barker with Piper Sandler. Your line is now open.

Kevin Barker — Piper Sandler — Analyst

Thank you for the comments regarding the unemployment rate, maybe some slight tightening on underwriting. That being said, are you seeing any minor shifts in consumer spending or payment patterns that may indicate certain pockets of stress, whether it’s the lower end of prime or other parts or maybe even certain vintages of customers that are on your books?

Roger Hochschild — Chief Executive Officer

Yeah, I mean all the vintages are performing well. As John said, I think we’re seeing the normalization occur faster and pretty close to fully normalized for the lower end of the prime. While the payment rate has softened a bit and come down by about 70 basis points, it remains 400 basis points higher than 2019 levels. And so I think that speaks to the fact that there’s still a very strong employment market out there, people can find jobs, can find extra hours. And so a good amount of liquidity that is supporting the deferred for our segment.

Kevin Barker — Piper Sandler — Analyst

Okay. And then I know it’s a fluid situation, but the student debt repayment is supposed to restart here maybe early next year or who knows, given what’s happening with the fighting in the courts, but do you expect any incremental impact to credit with a lot of student debt payments. Obviously, there’s the forgiveness is obviously a credit positive, but is there something that you could see as a potential headwind as student debt repayments restart here potentially in January?

Roger Hochschild — Chief Executive Officer

Not necessarily. We’ve watched it closely. I mean I think we have experienced an elevated payment rate, which has a dampening impact on loan growth as students have put more of their payments towards their private student loans. But we don’t see anything that would have a significant impact on credit.

Kevin Barker — Piper Sandler — Analyst

Okay, thank you for taking my questions.

Operator

Thank you. Our next question will come from Mark DeVries with Barclays. Your line is now open.

Mark DeVries — Barclays — Analyst

Yeah, thanks. How should we think about how you manage expense discipline if we start to see some revenue and credit weakness if the economy softens here?

John Greene — Chief Financial Officer

Yeah, I would just simply say that we will take a look at the opportunities we have in front of us, and we’ll make what I hope will be great long-term decisions for our shareholders. And we’re going to be very, very mindful around discretionary spending and around employment decisions. So overall, we hope we’re good stewards of the company.

Mark DeVries — Barclays — Analyst

Okay. Got it. And then just given where the rewards cost has trended so far this year in the guidance I think you said it was 2 basis points but guidance is 2% to 4%. Is it right to assume that 4Q is a relatively big quarter for expenses? Maybe you’ve got more of the 5% categories this quarter.

John Greene — Chief Financial Officer

Yeah, I wouldn’t necessarily assume that what is the point of the guidance between two and four is what we have said previously still within the range, and we wanted to keep it within the range. So that 2% to 4% is something that we’ve seen historically, and to an extent, managed to, and we’ll continue to do that. So I wouldn’t lean on any particular information to assume the fourth quarter is going to be extraordinarily high or low.

Mark DeVries — Barclays — Analyst

Okay, got it. Thank you.

Operator

Thank you. Our next question will come from Bill Ryan with Seaport Research Partners. Your line is now open.

Bill Ryan — Seaport Research Partners — Analyst

Thanks. Good morning and a couple of quick questions. Just following up on the personal loans business. Historically, it’s been heavily focused on your credit card base. And I was just wondering if that’s still the case. And you also had, I’d say, very, very strong credit checks in that business, paying off creditors directly. Has anything changed there as well?

Roger Hochschild — Chief Executive Officer

No. So, I would say it’s pretty balanced in terms of cross-hold to the card base versus broad market. Probably the biggest change has been just the continued advancement in analytics and the underwriting approach there but very, very conservative. So a lot of employment verification, et cetera, heavily manual processes just to make sure we get it right because as opposed to the card business where you can manage credit as you go, you get one shot in personal loans. But again, I would say that the performance remains very, very strong there and it’s a lot of it thanks to that disciplined approach.

Bill Ryan — Seaport Research Partners — Analyst

Okay. And just one follow-up on the promotional balances, that’s kind of been brought up on the card book for the last several quarters. Is it still increasing as a percentage of the overall card portfolio? Or is it kind of stabilized and maybe give us some historical perspective of where it stands to recent history? Thanks.

John Greene — Chief Financial Officer

Yeah, thanks. It is stabilized in the third quarter, and basically approaching stabilization into the second quarter and it’s very close to where it has been historically.

Bill Ryan — Seaport Research Partners — Analyst

Okay, thanks for taking my questions.

John Greene — Chief Financial Officer

You’re welcome.

Dominick Gabriele — Oppenheimer — Analyst

Thank you. Our next question will come from Dominick Gabriele with Oppenheimer. Your line is now open. Hey, thanks so much for taking my questions. Throughout the call and throughout other calls, you’ve kind of laid out your playbook and pieces in particular on the credit side for a slowing economy. But maybe, Roger, you can just provide us with a more holistic idea of what discover would change across various pieces of the businesses to protect profitability in a, of tougher economic environment? And then I just have a follow-up. Thank you.

Roger Hochschild — Chief Executive Officer

Yeah, I’d start by saying we don’t necessarily optimize on protecting profitability on a quarter-by-quarter basis. We focus on sort of delivering long-term value to the shareholders. And I think as I’ve been in this business a while, people who just totally got marketing in a downturn, miss out on what usually turn out to be some of the most profitable vintages. And so yes, you cut marketing mainly because as you tighten the credit box, there are fewer people to market, too.

But I think we try and operate our company almost like we’re always in a recession, always be conserved on credit or was be tied on expenses, there’s more you can do, especially around discretionary items. But that ability to keep momentum through a downturn has really distinguished us in previous cycles, and we would try and do that again.

Dominick Gabriele — Oppenheimer — Analyst

Okay. Great. Thank you. And I think it’d be really helpful to understand what your — both of your views are on the normalization of the personal loan portfolio net charge-offs versus the credit card portfolio. Consensus has such a huge ramp on the personal loan side versus credit cards for 2023 and — not looking for specific guidance, but is there any reason why there would be such a difference in faster normalization on the personal loan side versus credit card as far as basis point movement as a percentage of loans? Thanks so much, guys.

Roger Hochschild — Chief Executive Officer

Yeah, I mean we haven’t put out product-by-product guidance. But I would say that given how we underwrite the personal loans, I’m not sure why our portfolio would jump much faster than the card book. In general, we have a higher FICO for the personal loans business. They do tend to be a little more volatile than card in a recession. But I wouldn’t — that isn’t necessarily behavior I would expect.

Dominick Gabriele — Oppenheimer — Analyst

Great. Thanks so much.

Eric Wasserstrom — Head of Investor Relations

All right. Well, thank you everyone for joining us. And thank you, Katie. And if there are any additional follow-ups, please reach out to the IR team. We’ll be here and looking forward to speaking with you. Thanks, and have a great day.

John Greene — Chief Financial Officer

Thank you.

Operator

[Operator Closing Remarks]