Discover Financial Services(DFS) - 2022 Q4 - Annual Report

Part I Item 1. Business Discover Financial Services operates as a digital bank and payment network, offering consumer lending, deposits, and transaction processing Introduction and Operating Model The company operates two segments: Digital Banking for consumer lending and deposits, and Payment Services for payment network processing - The company operates through two main segments: Digital Banking (consumer lending and deposits) and Payment Services (PULSE, Diners Club, Network Partners)[15] - As of December 31, 2022, Discover had $112.1 billion in loan receivables and $70.5 billion in deposits, primarily sourced through direct-to-consumer channels[12] Digital Banking Products The Digital Banking segment offers credit cards, private student loans, personal loans, and home loans, funded by diverse deposit products - Interest earned on revolving credit card balances constituted approximately 83% of the company's total interest income for the year ended December 31, 2022[19] - The company offers a range of consumer loans: unsecured credit cards, private student loans, personal loans, and secured home loans[18][22][27][29] - Funding is sourced through direct-to-consumer and brokered deposits, including savings accounts, certificates of deposit (CDs), money market accounts, and checking accounts[31] Payment Services The Payment Services segment includes PULSE, Diners Club, and Network Partners, providing transaction processing and settlement services - PULSE network's primary revenue comes from transaction fees for switching and settling ATM and debit transactions[35] - Diners Club operates on a licensee model, earning royalties for brand usage and fees for processing cross-border transactions[38] - The Network Partners business leverages the Discover Global Network to process payments for financial institutions, technology firms, and commercial service providers[40] Credit Risk Management and Operations The company employs rigorous credit risk management, using analytical tools for customer acquisition and portfolio management, alongside fraud prevention - New customer acquisition involves a rigorous screening process using proprietary analytical tools and credit scoring systems to assess creditworthiness[45][46][47] - Existing credit card accounts are regularly assessed using statistical models to manage credit risk, leading to actions such as credit limit adjustments[49] - Fraud prevention relies on machine-learning models and rules-based logic to screen and authorize transactions, aiming to identify and halt fraudulent activity[63] Competition Discover faces intense competition across consumer lending, payment services, and direct-to-consumer deposits from diverse financial institutions - Key competitors in the credit card business include American Express, Bank of America, JPMorgan Chase, Capital One, and Citibank[72] - The Discover and Diners Club networks' primary competitors are Visa, MasterCard, and American Express. PULSE's main competitors include Visa's Interlink and MasterCard's Maestro[76] - In the direct-to-consumer deposits business, competitors include Ally, American Express, Barclays, Capital One, Goldman Sachs, and Synchrony[77] Human Capital As of December 31, 2022, Discover employed approximately 20,200 individuals, with a focus on a people-first culture and diversity - The company employed approximately 20,200 individuals at December 31, 2022, with 100% of customer service agents based in the U.S[79] - As of December 31, 2022, the U.S.-based employee population was composed of 64% Women and 44% People of Color[84] - A third-party pay equity analysis found that women and minorities at Discover earn, on average, between $0.99 and $1.03 for every $1 earned by men and non-minorities, after adjusting for factors like role and tenure[86] Risk Management Discover utilizes a comprehensive enterprise-wide risk management framework across three lines of defense to manage various financial risks - The enterprise risk management framework is built on five key principles: Comprehensiveness, Accountability, Independence, Defined Risk Appetite, and Transparency[89] - The governance structure operates on a three-lines-of-defense model: business units (1st line), corporate risk management (2nd line), and internal audit (3rd line)[91][93] - The company identifies and manages seven major risk categories: credit, market, liquidity, operational, compliance, legal, and strategic risk[111] - Stress testing is used to assess material risks and vulnerabilities, informing business strategy, risk appetite, and capital planning decisions[130] Supervision and Regulation Discover is extensively regulated by federal and state authorities, including the Federal Reserve, FDIC, and CFPB, as a Category IV institution - The company is a bank holding company regulated by the Federal Reserve, while its subsidiary Discover Bank is regulated by the Delaware Commissioner and the FDIC[137][138] - Under the tailoring rules, DFS is a Category IV institution, subject to the least stringent category of enhanced prudential standards for large bank holding companies, including supervisory stress tests every other year[144] - The Consumer Financial Protection Bureau (CFPB) has broad supervisory, examination, and enforcement authority over Discover's consumer financial products and services[163] - The Dodd-Frank Act includes provisions relevant to the PULSE debit network, requiring merchants to control transaction routing and mandating that interchange fees be 'reasonable and proportional'[167] Item 1A. Risk Factors The company faces significant risks from economic conditions, evolving regulations, intense competition, and operational challenges like cybersecurity Current Economic and Regulatory Environment Discover's business is highly sensitive to economic conditions and a complex, evolving regulatory landscape, impacting operations and costs - Adverse economic conditions can reduce credit card usage and increase delinquencies, impacting interest income, which was 80% of net revenues in 2022[183][184] - As a Category IV institution, DFS is subject to tailored enhanced prudential standards, including biennial stress tests, but many core Dodd-Frank Act provisions remain in effect[185][186] - Heightened regulatory expectations and an increased volume of regulatory changes may generate additional expenses and require significant resources to maintain compliance[189] Strategic Business Risk The company faces intense strategic competition in lending and payments, with success dependent on global network acceptance and student loan stability - The consumer financial services business is highly competitive, with rivals including traditional banks and non-traditional fintech firms[190] - The rewards rate (rewards cost divided by Discover Card sales volume) has increased from less than 1% in 2013 to 1.41% in 2022, reflecting intense competition[191] - The payments business faces substantial competition from larger, well-established networks like Visa and MasterCard, which have greater merchant acceptance and global brand recognition[196][197] - The success of the student loan business is challenged by economic weakness, potential legislative changes, and competition from non-traditional lenders[207] Credit, Market and Liquidity Risk Discover is exposed to credit risk from loan repayments, liquidity risk from funding sources, and market risk from interest rate fluctuations - At December 31, 2022, $1.3 billion (1.14%) of loan receivables were non-performing, highlighting the inherent credit risk in the lending business[212] - The company's primary funding sources are customer deposits and securitization of credit card receivables. As of Dec 31, 2022, it held $70.5 billion in direct/affinity deposits and $21.1 billion in brokered deposits[214][218] - An early amortization event in credit card securitizations, triggered by factors like insufficient cash flows, would materially and adversely affect liquidity[224] - Changes in interest rates can materially affect earnings, as rising rates increase funding costs and may lead to higher consumer delinquencies[229][231] Operational and Other Risks Operational risks include model effectiveness, cybersecurity threats, fraud, third-party reliance, reputational damage, and regulatory limitations on capital actions - The company's digital banking and network operations rely on the secure processing of sensitive information, making it a target for cyber-attacks[236] - Fraudulent activity is a significant risk, with fraud losses and other charges totaling $149 million in 2022, up from $92 million in 2021[251] - The company depends on third-party service providers for key operations; failure by these providers could negatively impact business operations and customer service[256] - The ability to pay dividends and repurchase stock is subject to the discretion of the Board of Directors and regulatory limitations imposed by the Federal Reserve[273] Item 1B. Unresolved Staff Comments The company reports no unresolved staff comments - None[281] Item 2. Properties The company's principal U.S. properties, including headquarters and call centers, are considered suitable and adequate for current needs - The company's main properties are in the U.S. and include its corporate headquarters, call centers, and a processing center, which are deemed adequate for its needs[282][283] Item 3. Legal Proceedings Information regarding legal proceedings is detailed in Note 19 to the consolidated financial statements - For a description of legal proceedings, see Note 19: Litigation and Regulatory Matters to our consolidated financial statements[284] Item 4. Mine Safety Disclosures The company reports no mine safety disclosures - None[285] Part II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Discover's common stock trades on the NYSE, with a $4.2 billion share repurchase program approved in April 2022, resuming in November - In April 2022, a new share repurchase program was approved, authorizing up to $4.2 billion of share repurchases through June 30, 2023[288] - Share repurchases were suspended in July 2022 due to an internal investigation into student loan servicing practices and resumed in November 2022 upon its completion[289] Q4 2022 Share Repurchases | Period | Total Shares Purchased (Repurchase Program) | Average Price Paid Per Share | | :--- | :--- | :--- | | Oct 1-31, 2022 | — | $ — | | Nov 1-30, 2022 | 850,874 | $107.77 | | Dec 1-31, 2022 | 5,031,837 | $101.08 | | Total Q4 2022 | 5,882,711 | $102.04 | Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations In 2022, net income decreased to $4.4 billion due to higher credit loss provisions, despite 20% loan growth, with continued growth expected in 2023 2022 Highlights and Outlook In 2022, net income decreased to $4.4 billion, while total loans grew 20% to $112.1 billion, with continued loan growth and rising charge-offs expected 2022 Key Performance Indicators (vs. 2021) | Metric | 2022 | 2021 | Change | | :--- | :--- | :--- | :--- | | Net Income | $4.4 billion | $5.4 billion | -18.5% | | Diluted EPS | $15.50 | $17.83 | -13.1% | | Total Loans | $112.1 billion | $93.7 billion | +20% | | Credit Card Loans | $90.1 billion | $74.4 billion | +21% | | Credit Card Net Charge-off Rate | 2.05% | 2.09% | -4 bps | | Credit Card 30+ Day Delinquency | 2.53% | 1.66% | +87 bps | | Direct-to-Consumer Deposits | $70.5 billion | $61.9 billion | +14% | - The company expects continued loan growth, a modest increase in net interest margin, and an increase in the total net charge-off rate for the upcoming year[305] Regulatory Environment and Developments Discover operates under stringent regulations, including biennial CCAR stress tests, LIBOR to SOFR transition, and CFPB scrutiny on consumer fees - Following the 2022 CCAR exercise, the Federal Reserve set Discover's new Stress Capital Buffer (SCB) at 2.5%, the lowest possible requirement, effective October 1, 2022[304] - The company is transitioning away from LIBOR. As of December 31, 2022, LIBOR-indexed loans comprised 39% of the private student loan portfolio and will convert to a SOFR index in 2023[310][311] - The CFPB's priorities under Director Chopra include increased enforcement with a focus on consumer fees, UDAAP, fair lending, and student loan servicing[316] Results of Operations Consolidated net income decreased 19% to $4.4 billion in 2022, driven by higher credit loss provisions and equity investment losses in Payment Services Consolidated Earnings Summary (2022 vs. 2021) | Metric | 2022 ($M) | 2021 ($M) | % Change | | :--- | :--- | :--- | :--- | | Net Interest Income | 10,999 | 9,517 | +16% | | Provision for Credit Losses | 2,359 | 218 | +982% | | Other Income | 2,338 | 2,570 | -9% | | Other Expense | 5,236 | 4,805 | +9% | | Net Income | 4,392 | 5,449 | -19% | - The Digital Banking segment's pretax income decreased to $5.7 billion in 2022 from $6.5 billion in 2021, largely due to a higher provision for credit losses[327] - The Payment Services segment's pretax income fell to $9 million in 2022 from $533 million in 2021, primarily due to net losses on equity investments[332] Loan Quality Total loan receivables grew to $112.1 billion, with the allowance for credit losses increasing due to loan growth and rising delinquency rates Loan Portfolio and Allowance for Credit Losses (in millions) | Metric | Dec 31, 2022 | Dec 31, 2021 | | :--- | :--- | :--- | | Total Loan Receivables | $112,120 | $93,684 | | Allowance for Credit Losses | $7,374 | $6,822 | | Net Loan Receivables | $104,746 | $86,862 | Key Credit Quality Metrics (2022 vs. 2021) | Metric | 2022 | 2021 | | :--- | :--- | :--- | | Credit Card Net Charge-off Rate | 2.05% | 2.09% | | Credit Card 30+ Day Delinquency Rate | 2.53% | 1.66% | | Private Student Loan Net Charge-off Rate | 1.00% | 0.63% | | Personal Loan Net Charge-off Rate | 1.25% | 1.73% | - The allowance for credit losses build of $552 million in 2022 was primarily driven by loan growth. The macroeconomic forecast used in the estimate included a peak unemployment rate of 4.68%[359][360] Liquidity and Capital Resources Discover maintains strong liquidity and capital, funded primarily by deposits and securitizations, with a CET1 ratio of 13.3% and active capital returns - Primary funding sources include direct-to-consumer and brokered deposits, which totaled $91.6 billion at December 31, 2022[389][390] - Total liquidity portfolio and undrawn credit facilities increased to $67.3 billion at year-end 2022, up from $52.9 billion at year-end 2021[422] Capital Ratios (DFS) as of Dec 31, 2022 | Ratio | Actual | Minimum Requirement | | :--- | :--- | :--- | | Common Equity Tier 1 (CET1) | 13.3% | ≥4.5% | | Tier 1 Capital | 14.3% | ≥6.0% | | Total Capital | 16.0% | ≥8.0% | - In 2022, the company repurchased approximately 21.5 million shares for $2.3 billion and increased its quarterly common stock dividend to $0.60 per share[438][442] Item 7A. Quantitative and Qualitative Disclosures About Market Risk The company's primary market risk is interest rate fluctuations, managed through portfolio mix and derivatives, with a modestly asset-sensitive position - The company's main market risk is interest rate risk, which affects net interest income[444][445] Net Interest Income Sensitivity to Interest Rate Changes (as of Dec 31, 2022) | Basis Point Change | Estimated Impact on NII ($M) | Estimated Impact on NII (%) | | :--- | :--- | :--- | | +100 | $183 | 1.40% | | -100 | $(190) | (1.45)% | - The company's current short-term interest rate risk position is modestly asset-sensitive, which management considers prudent in a rising rate environment[452] Item 8. Financial Statements and Supplementary Data This section presents the consolidated financial statements, auditor's report, and notes, with the Allowance for Credit Losses as a critical audit matter Report of Independent Registered Public Accounting Firm Deloitte & Touche LLP issued an unqualified opinion on financial statements and internal controls, identifying Allowance for Credit Losses as a critical audit matter - The independent auditor, Deloitte & Touche LLP, issued an unqualified opinion on the financial statements and internal control over financial reporting[455][462] - The critical audit matter identified was the Allowance for Credit Losses, due to the high degree of auditor judgment required to evaluate management's significant estimates and assumptions, particularly regarding the macroeconomic outlook[466][467][471] Consolidated Financial Statements Total assets grew to $131.6 billion, driven by net loan receivables, with total liabilities increasing due to deposits, and net income at $4.4 billion Consolidated Statement of Financial Condition Highlights (in billions) | Account | Dec 31, 2022 | Dec 31, 2021 | | :--- | :--- | :--- | | Total Assets | $131.6 | $110.2 | | Net Loan Receivables | $104.7 | $86.9 | | Total Deposits | $91.6 | $72.4 | | Total Liabilities | $117.0 | $96.8 | | Total Stockholders' Equity | $14.6 | $13.4 | Consolidated Statement of Income Highlights (Year Ended Dec 31, in billions) | Account | 2022 | 2021 | | :--- | :--- | :--- | | Total Interest Income | $12.9 | $10.7 | | Net Interest Income | $11.0 | $9.5 | | Provision for Credit Losses | $2.4 | $0.2 | | Total Other Income | $2.3 | $2.6 | | Total Other Expense | $5.2 | $4.8 | | Net Income | $4.4 | $5.4 | Notes to the Consolidated Financial Statements Notes detail accounting policies, allowance for credit losses, securitizations, capital adequacy, litigation, and segment financial data - The allowance for credit losses is estimated using models that consider probability of default, exposure at default, and loss given default, incorporating macroeconomic forecasts over a reasonable and supportable period (Note 4)[504][509] - Credit card and student loan securitizations are accounted for as secured borrowings, with the related trusts consolidated. As of Dec 31, 2022, $25.8 billion of credit card receivables were in the trust (Note 5)[394][594] - The company is subject to a 2020 consent order with the CFPB regarding private student loan servicing practices, which required a $25 million civil money penalty and at least $10 million in consumer redress (Note 19)[680] - The Digital Banking segment generated $5.7 billion in pretax income in 2022, while the Payment Services segment generated $9 million (Note 22)[720] Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure The company reports no changes in or disagreements with its accountants on accounting and financial disclosure - None[738] Item 9A. Controls and Procedures Management concluded disclosure controls and internal control over financial reporting were effective as of December 31, 2022 - The CEO and CFO concluded that the company's disclosure controls and procedures were effective as of December 31, 2022[739] - Management concluded that internal control over financial reporting was effective as of December 31, 2022, based on the COSO framework[741] - A new general ledger system was implemented in Q1 2022 to modernize technology, resulting in modifications to the control environment[743] Item 9B. Other Information The company reports no other information - None[745] Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections This item is not applicable to the company - Not applicable[746] Part III Item 10. Directors, Executive Officers and Corporate Governance Information on directors, executive officers, and corporate governance is incorporated by reference from the 2023 proxy statement - Information regarding directors and corporate governance is incorporated by reference from the company's 2023 proxy statement[748] Item 11. Executive Compensation Information regarding executive compensation is incorporated by reference from the company's 2023 proxy statement - Information regarding executive compensation is incorporated by reference from the company's 2023 proxy statement[750] Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Information on equity compensation plans and beneficial ownership is incorporated by reference from the company's 2023 proxy statement - Information regarding security ownership and equity compensation plans is incorporated by reference from the company's 2023 proxy statement[750][751] Item 13. Certain Relationships and Related Transactions, and Director Independence Information on related transactions and director independence is incorporated by reference from the company's 2023 proxy statement - Information regarding related transactions and director independence is incorporated by reference from the company's 2023 proxy statement[752] Item 14. Principal Accounting Fees and Services Information on principal accounting fees and services is incorporated by reference from the company's 2023 proxy statement - Information regarding principal accounting fees and services is incorporated by reference from the company's 2023 proxy statement[752] Part IV Item 15. Exhibits, Financial Statement Schedules This section lists the consolidated financial statements and an index of all exhibits filed with the Form 10-K - This section contains the index to the consolidated financial statements and a list of all exhibits filed with the Form 10-K[753][757] Item 16. Form 10-K Summary The company reports no Form 10-K summary - None[767]