NEW YORK--(BUSINESS WIRE)--Fitch Ratings has today 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. A full list of rating actions follows at the end of this rating action commentary.
Today's rating actions have been taken as part of Fitch's periodic review of U.S. consumer-focused internet banks, which comprises four publicly rated firms.
KEY RATING DRIVERS
VRs, IDRs, AND SENIOR DEBT
The rating affirmations and Stable
Outlook reflect DFS's strong franchise supported by its owned payments
network, peer-superior credit performance, strong and consistent
financial performance over time, diverse funding base, ample liquidity,
strong risk-adjusted capitalization, robust risk frameworks, and
seasoned management team.
Rating constraints include DFS's concentrated and cyclical business model, potential funding sensitivity associated with wholesale and internet deposit funding sources, the likelihood of asset quality reversion from current levels, and continued elevated regulatory and legislative risk.
Furthermore, ratings remain constrained by DFS's weaker relative market position within the increasingly competitive payments industry, as evidenced by its smaller market share compared to payment network peers (e.g. Visa, MasterCard and American Express) and general purpose credit card issuers (JPMorgan Chase, Bank of America, and Citigroup).
Fitch views DFS's ability to generate strong and consistent operating performance over time as a rating strength. Net income for 1H16 increased 0.5% to $1.2 billion, which included a non-recurring tax benefit of $44 million. Excluding non-recurring items, Fitch estimates net income would have declined versus the prior year period driven primarily by a 35% increase in provision for loan losses in 2Q16. Return on equity in 1H16 remained strong at 21%.
Fitch expects DFS's financial performance to remain relatively stable over the near term, although with greater volatility within specific line items. Fitch expects net interest income growth to improve as a result of strategies being undertaken to increase market share in the credit card business through targeted marketing initiatives, new product introductions, innovative rewards programs, and highly regarded customer service. Loan growth and modest net interest margin expansion should be at least partially offset by further loss reserve building and elevated reward costs..
Credit performance is expected to remain relatively stable in 2H16, although charge-offs and delinquencies will likely start to normalize from historically low levels. Fitch expects the loan loss provision to increase further in 2016 driven primarily by the seasoning of balances stemming from new account growth in recent years, as well as some modest deterioration in credit metrics. Nonetheless, DFS maintains a relatively seasoned credit card portfolio, with only 18% of the portfolio having a tenure of less than three years. Credit card net charge-offs increased three basis points (bps) to 2.37% in 1H16, and remained well below other top credit card issuers and the industry average. Reserve coverage for credit card loans remained strong at 2.80% of loans and 172% of loans past due at June 30, 2016.
DFS is well-positioned for further increases in U.S. interest rates. At June 30, 2016, assuming an immediate 100 bps increase in interest rates, DFS estimates that net interest income over the following 12-month period would increase by approximately $230 million, or 3%. However, the interest rate sensitivity of the online deposit channel remains untested during periods of rising interest rates.
Despite high levels of capital distributions to shareholders in recent years, Fitch believes DFS remains well-capitalized. At June 30, 2016, DFS's common equity Tier 1 capital ratio (CET1) was 14.3% on a Basel III transitional basis, or an estimated 14.2% on a fully phased-in Basel III basis. DFS's tangible common equity/tangible assets ratio was 12.0% at June 30, 2016. These metrics compare favorably to peers. Additionally, DFS performed well relative to peers 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 2016. Fitch expects DFS's CET1 ratio to gradually decline over time before normalizing at a level in the low double digits. In this scenario, Fitch believes DFS would remain adequately capitalized relative to existing ratings.
DFS maintains adequate liquidity with strong risk oversight. At June 30, 2016, DFS's liquidity portfolio amounted to $13.5 billion (or 15.5% of tangible assets), and excluding deposits, the company has a very manageable $400 million in unsecured debt maturities over the next twelve months. Fitch views DFS's liquidity position as strong and, when combined with future asset repayments, provides adequate sources to fund growth and meet its upcoming debt obligations.
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 for 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 rated one notch higher than their
respective IDRs because U.S. 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
The Stable Outlook reflects Fitch's view
that positive rating momentum is relatively limited over the outlook
horizon. Longer term, rating momentum could be driven by consistent
market share gains in card-based payments, increased revenue diversity,
and sustained strong credit performance in non-card loan categories
through the credit cycle. Other factors that could support positive
rating actions include further clarity on regulatory and legislative
issues (particularly as it relates to the student loan sector) and
enhanced funding flexibility. In particular, the durability of DFS's
internet-based deposit platform in a rising interest rate environment
will be a key consideration in evaluating the strength of the company's
funding profile.
Negative rating action could be driven by a steady decline in profitability resulting from slowing loan growth, yield compression, a severe degradation in credit performance, 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 earnings prospects 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 rated 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+';
--Senior unsecured debt at 'BBB+';
--Short-Term
IDR at 'F2';
--Preferred stock at 'BB-';
--Support Rating at
'5';
--Support Rating Floor at 'NF'.
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'.
The Rating Outlook is Stable.
Additional information is available on www.fitchratings.com.
Applicable Criteria
Global Bank Rating Criteria (pub. 15 Jul 2016)
https://www.fitchratings.com/site/re/884135
Global
Non-Bank Financial Institutions Rating Criteria (pub. 15 Jul 2016)
https://www.fitchratings.com/site/re/884128
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