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Fitch Affirms Discover Financial Services at 'BBB+/F2'; Outlook Stable
September 8, 2017 / 8:52 PM / in 3 months

Fitch Affirms Discover Financial Services at 'BBB+/F2'; Outlook Stable

(The following statement was released by the rating agency) NEW YORK, September 08 (Fitch) Fitch Ratings has affirmed Discover Financial Services' (DFS) Long-Term Issuer Default Rating (IDR) at 'BBB+', Viability Rating (VR) at 'bbb+', and Short-Term IDR at 'F2'. The Rating Outlook is Stable. See the full list of rating actions at the end of this release. Today's rating actions have been taken as part of Fitch's periodic review of U.S. consumer-focused internet banks, which contains four publicly rated firms. KEY RATING DRIVERS VRs, IDRs, AND SENIOR DEBT The rating affirmation reflects DFS's strong franchise, supported by its owned payments network, peer-superior credit performance, strong and consistent financial performance over various economic and market cycles, diverse funding base, ample liquidity, strong risk-adjusted capitalization, and seasoned management team. Rating constraints include DFS's concentrated and cyclical business model, heavier reliance on wholesale funding, potential funding sensitivity associated with internet deposits in a rising rate environment, the likelihood of asset quality reversion from current levels, threats from disruptive technologies in the payments space, and elevated regulatory and legislative risk. Furthermore, ratings remain constrained by DFS's relatively weaker market position within the increasingly competitive payments industry, as evidenced by its smaller market share compared to payment network peers (e.g. Visa Inc., MasterCard Incorporated, and American Express Company) and general purpose credit card issuers (JPMorgan Chase & Co., Bank of America Corporation, and Citigroup Inc.). Fitch views DFS's ability to generate strong and consistent operating performance over time as a rating strength. While net income for 1H17 decreased 7%, due largely to a 47% increase in the provision for loan losses and a non-recurring tax benefit recognized in 2Q16, return on equity remained strong, at 20%, while return on assets was a robust 2.4%. Fitch expects DFS's financial performance to remain relatively stable over the near term, as an increase in interest income, stemming from higher interest rates and loan growth, is partially offset by higher credit and funding costs. Loan growth is expected to be fueled by targeted marketing initiatives, new product introductions, innovative rewards programs, and the firm's highly regarded customer service. DFS has exhibited strong growth in its student loan and personal loan portfolios, in particular, which should contribute to the company's strong earnings profile. However, DFS recently announced its intentions to tighten underwriting standards on personal loans, which will slow growth and reduce yields but will likely result in stronger credit performance. Credit performance is expected to continue its normalizing trend as charge-offs and delinquencies rise from what had been historically low levels. DFS recently increased its FY17 net charge-off guidance to 2.7%-2.8%, (about 50bps higher than 2016 losses) due to higher loss severity on older vintages stemming from an increase in consumer leverage. Fitch expects the loan loss provision to increase further in 2H17 primarily driven by the seasoning of new account growth in recent years and lower recoveries on charged-off loans. Credit card net charge-offs increased 52bps year over year, to 2.89% in 1H17, but remained well below the industry average. Reserve coverage for credit card loans remained strong at 3.21% of loans and 160% of loans past due at June 30, 2017. Despite increasing levels of capital distributions to shareholders in recent years, Fitch believes DFS remains well-capitalized. At June 30, 2017, DFS's common equity Tier 1 capital ratio (CET1) was 13.0% on a Basel III transitional and fully-phased in basis. These metrics compare favorably to peers. Additionally, DFS performed well in the most recent Comprehensive Capital Analysis and Review (CCAR). As part of this review, DFS received a non-objection from the Fed on its capital plan in June 2017, which included a 16.7% increase in the quarterly dividend and $2.23 billion of share repurchase authority through 2Q18. The plan equates to a payout ratio greater than 100% of 1H17 annualized earnings compared to a payout ratio of 99% in 2016. Assuming continued strong loan growth and high payouts to shareholders, Fitch expects capital ratios will moderate over time, but that DFS will remain well-capitalized compared to peers. DFS's funding diversity serves as a ratings strength. At June 30, 2017, deposits represented 66% of total funding, with secured debt accounting for 21% and unsecured debt accounting for 13%. Fitch views a greater proportion of deposit funding positively as it reduces funding concentration risk and provides more flexibility in the event that wholesale funding sources (securitization and public debt markets) dry up or become cost prohibitive. Although deposit betas have been relatively modest to date, Fitch expects additional rate hikes by the Fed to result in more significant increases in deposit rates for online banks, including DFS. However, this should be at least partially offset by increasing asset yields. DFS maintains adequate liquidity with strong risk oversight. At June 30, 2017, DFS's liquidity portfolio amounted to $13.9 billion (or 14.9% of tangible assets). Long-term debt maturities consist of $750 million of unsecured holding company notes over the next 12 months, which Fitch believes is manageable. Fitch views DFS's liquidity position as strong and it is expected to remain relatively stable. The Stable Outlook reflects expectations for stable operating performance, strong capitalization and liquidity levels, and solid credit performance relative to the industry over the outlook horizon. SUBORDINATED DEBT AND OTHER HYBRID SECURITIES DFS's subordinated debt rating is rated one notch below the entity's VR of 'bbb+' in accordance with Fitch's assessment of each instrument's respective non-performance and relative loss severity risk profile. The subordinated note rating includes one notch for loss severity given the subordination of these securities in the capital structure, and zero notches of non-performance given contractual limitations on interest payment deferrals and no mandatory trigger events which could adversely impact performance. DFS's preferred stock ratings are rated five notches below DFS's VR of 'bbb+' in accordance with Fitch's assessment of each instrument's respective non-performance and relative loss severity risk profile. The preferred stock ratings include two notches for loss severity given these securities' deep subordination in the capital structure, and three notches for non-performance given that the dividends are non-cumulative and fully discretionary. LONG- AND SHORT-TERM DEPOSIT RATINGS Discover Bank's uninsured deposit ratings of 'A-/F2' are one notch higher than their respective IDRs because uninsured deposits benefit from depositor preference in the U.S. Fitch believes that this preference in the U.S. gives deposit liabilities superior recovery prospects in the event of default. HOLDING COMPANY DFS's IDR and VR are equalized with its bank subsidiary, reflecting its role as the bank holding company, which is mandated in the U.S. to act as a source of strength for its bank subsidiaries. Ratings are also equalized reflecting the very close correlation between holding company and subsidiary failure and default probabilities. SUPPORT RATING AND SUPPORT RATING FLOOR DFS has a Support Rating of '5' and Support Rating Floor of 'NF'. In Fitch's view, DFS is not systemically important, and therefore, the probability of sovereign support is unlikely. DFS's IDRs and VRs do not incorporate any support. RATING SENSITIVITIES VRs, IDRs AND SENIOR DEBT Positive rating momentum could be driven by consistent market share gains in card-based payments, increased revenue diversity, and sustained strong credit performance in all loan categories through the credit cycle. Positive ratings momentum could also be driven by enhanced funding flexibility in the form of retail deposits. In particular, the durability of DFS's internet-based deposit platform during a sustained period of rising interest rates will be a key consideration in evaluating the strength of the company's funding profile. Negative rating action could be driven by a significant decline in profitability associated with slowing loan growth and/or meaningful net interest margin compression, an outsized degradation in credit performance relative to peers, a weakening liquidity profile, significant reductions in capitalization, and/or potential new and more onerous rules and regulations. Negative rating momentum could also be driven by an inability of DFS to maintain its competitive position and profitability in an increasingly digitized payments and consumer lending landscape. The senior unsecured debt ratings are primarily sensitive to changes in the Long-Term IDRs of DFS and Discover Bank. SUBORDINATED DEBT AND OTHER HYBRID SECURITIES The subordinated debt ratings are directly linked to Discover Bank's VR and would move in tandem with any changes in the VR. The preferred stock ratings are directly linked to DFS's VR and would move in tandem with any changes in DFS's credit profile. LONG- AND SHORT-TERM DEPOSIT RATINGS Discover Bank's uninsured deposit ratings are one notch higher than the IDR. The deposit ratings are primarily sensitive to any change in DFS's Long- and Short-Term IDRs. HOLDING COMPANY Should DFS's holding company begin to exhibit signs of weakness, demonstrate trouble accessing the capital markets, or have inadequate cash flow coverage to meet near-Term obligations, there is the potential Fitch could notch the holding company IDR and VR from the ratings of the bank subsidiary. SUPPORT RATING AND SUPPORT RATING FLOOR Since DFS's Support and Support Rating Floors are '5' and 'NF', respectively, there is limited likelihood that these ratings will change over the foreseeable future. Fitch has affirmed the following ratings: Discover Financial Services -- Long-Term IDR at 'BBB+'; -- Viability Rating at 'bbb+'; -- Short-Term IDR at 'F2'; -- Support Rating at '5'; -- Support Rating Floor at 'NF'; -- Senior Unsecured Debt at 'BBB+'; -- Preferred Stock at 'BB-'. Discover Bank -- Long-Term IDR at 'BBB+'; -- Viability Rating at 'bbb+'; -- Short-Term IDR at 'F2'; -- Support Rating at '5'; -- Support Rating Floor at 'NF'; -- Long-Term Deposits at 'A-'; -- Short-Term Deposits at 'F2'; -- Senior Unsecured Debt at 'BBB+'; -- Subordinated Debt at 'BBB'. Contact: Primary Analyst Michael Taiano, CPA Director +1 646-582-4956 Fitch Ratings, Inc. 33 Whitehall Street New York, NY 10004 Secondary Analyst Jared Kirsch, CFA Associate Director +1 212-908-0332 Committee Chairperson Meghan Neenan, CFA Managing Director +1 212-908-9121 Media Relations: Sandro Scenga, New York, Tel: +1 212-908-0278, Email: sandro.scenga@fitchratings.com. 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