Capital One Financial Corp

NYSE:COF

Earnings Call Transcript 2018-Q1

[Operator]

Welcome to the Capital One Q1 2018 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. [Operator Instructions] Thank you.

I would now like to turn the call over to Mr. Jeff Norris, Senior Vice President of Finance. Sir, you may begin.

[Jeff Norris, Senior Vice President of Global Finance]

Thanks very much, Leanne, and welcome, everybody to Capital One's first quarter 2018 earnings conference call. As usual, we are webcasting live over the Internet. To access the call on the Internet, please log on to Capital One's website at capitalone.com, and follow the links from there. In addition to the press release and financials, we've included a presentation summarizing our first quarter 2018 results.

With me this evening are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer; and Mr. Scott Blackley, Capital One's Chief Financial Officer. Rich and Scott will walk you through this presentation. To access a copy of the presentation and the press release, please go to Capital One's website, click on Investors, then click on Quarterly Earnings Release.

Please note that the presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion in the materials speak only as of the particular date or dates indicated in the materials.

Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. And for more information on these factors, please see the section titled Forward-looking Information in the earnings release presentation and the Risk Factors section in our Annual and Quarterly Reports accessible at the Capital One website and filed with the SEC.

And now I'll turn the call over to Scott.

[Scott Blackley, Chief Financial Officer]

Thanks, Jeff. I'll begin tonight with Slide 3. Capital One earned $1.3 billion or $2.62 per share in the first quarter. We had one adjusting item in the quarter, which was $19 million of restructuring costs. Net of this item earnings per share were $2.65. A slight outline in adjusting items can be found on Page 13 of the slide deck.

Pre-provision GAAP earnings increased 3% on a linked quarter basis and 8% on a year-over-year basis to $3.3 billion. Provision for credit losses decreased 13% on a linked quarter basis and 16% year-over-year primarily driven by smaller allowance builds in our Domestic Card business.

Let me take a moment to explain the movements in allowance across our businesses, which are detailed in Table 8 of our earnings supplement. In our Domestic Card business, we built $59 million of allowance in the quarter reflecting seasonally adjusted growth and the moderating impacts of growth math.

The allowance in our Consumer Banking segment increased $11 million driven by growth in our Auto business and net reserves in our Commercial Banking segment decreased $33 million primarily due to paydowns in an improved risk profile. Our effective tax rate in the quarter was 19.2%. We have refined our estimate of the impact of the new tax law and we now expect our 2018 corporate annual effective tax rate to be around 20%.

Turning to Slide 4, you can see that reported net interest margin decreased 10 basis points from the fourth quarter, primarily driven by day count and an increase in rate paid for deposits, which was only partially offset by higher asset yields in mix.

Net interest margin was up 5 basis points on a year-over-year basis resulting from a higher mix of card assets on the balance sheet. As of the end of the quarter, our net interest income was modestly liability sensitive to implied forwards and a flatter yield curve would create a modest headwind to earnings.

Turning to Slide 5, our common equity Tier 1 capital ratio on a Basel III standardized basis was 10.5%. Last quarter, I shared that we expected our CET 1 ratio which is our binding capital constraint to trend back towards the mid 10% range. Since then there have been several developments that have affected our capital requirements. These developments include a more severe 2018 CCAR assumptions that were provided by the Federal Reserve in its stress scenarios.

More severe Federal Reserve CCAR loss models are coming for a card and subprime auto, and of course, the impacts of both of these developments are compounded by the associated incremental disallowed DTA resulting from the loss of the NOL carry back.

Giving these developments, we now believe that our CET 1 ratio will trend up to around 11%. In the first quarter, we repurchased approximately 200 million of common stock and in light of our updated view of capital. We do not expect to use any of the remaining authorization for the 2017 CCAR approval window, which ends June 30, 2018.

Importantly, this view does not incorporate any of the potential impacts from CECL implementation in 2020. With respect to CECL, we were pleased to see bank regulators acknowledge in their MPR that the initial challenges of CECL implementation, but they didn't go far enough.

Our current capital regime was built around incurred loss allowance model and under CECL we will shift to a lifetime loss allowance, but we've seen no comments or shift in capital frameworks. We view the potential increase and allowance from CECL, as simply capital in another form and since the MPR doesn't allow for Tier 1 capital relief, it will all else equal simply cause banks to hold more capital.

In addition, CECL has the potential to be very procyclical and we will discourage loan growth, especially in recessionary periods and will make financial statements less comparable and less useful. We will continue to advocate the bank regulators and the FASB to carefully consider all of the impacts of CECL.

So with that, I'm going to be turning the call over to Rich. Rich?

[Richard Fairbank, Chairman and Chief Executive Officer]

Thank you, Scott. I'll begin on Slide 8 with our Credit Card business. We posted strong year-over-year growth in both revenue and pretax income driven by the performance of both our domestic and international Card businesses. Credit Card results also benefit from the absence of any additions to our U.K. PPI reserves in the quarter, which adversely impacted the first quarter of last year.

On Slide 9, you can see the first quarter results for our Domestic Card business. As a reminder, Domestic Card results and metrics now include the impacts of the Cabela's portfolio, which are playing out as expected. Ending loan balances were up $7.4 billion or about 8% compared to the first quarter of last year. First quarter purchase volume increased 18% from the prior year. Revenue for the quarter increased 6% from the prior year. Revenue margin for the quarter was 15.9% down 36 basis points from the first quarter of 2017.

Strong net interchange revenue partially offset the expected margin pressure from Cabela's. Non-interested expense increased 7% compared to the prior year quarter. The charge-off rate for the quarter was 5.26%, up 12 basis points year-over-year. The 30 plus delinquency rate at quarter end was 3.57% down 14 basis points from the prior year, both metrics include the benefit from adding the Cabela's portfolio.

The competitive marketplace remains intense, but generally rational. Supply of card credit is on the high side, although it is settled out a bit. We continue to see good opportunities to grow card loans and purchase volumes with a watchful eye on the marketplace.

Slide 10 summarizes first quarter results for our Consumer Banking business. Ending loans grew about 1% compared to the prior year, while average loans were up about 2%. Growth in auto loans was partially offset by planned mortgage runoff.

Ending deposits were up 3% versus the prior year with a 23 basis point increase in average deposit interest rate compared to the first quarter of 2017. We expect further increases in average deposit interest rate driven by higher market rates and increasing competition for deposits.

The Auto business continues to grow. First quarter auto originations were strong and ending loans were up 10% year-over-year, competitive intensity in auto is increasing, but we still see attractive opportunities to grow. Consumer banking revenue for the quarter increased about 4% from the first quarter of last year driven by growth in auto loans and deposit.

Non-interest expense for the quarter decreased 4% compared to the prior year quarter driven by our ongoing efforts to tightly manage cost and the exit of the mortgage origination business last quarter, partially offset by continuing growth in auto. Provision for credit losses was down from the first quarter of 2017 primarily as a result of lower auto charge-off rate and a smaller allowance build. In auto, we remain cautious about used car prices and our underwriting assumes that prices decline. As the cycle plays out, we continue to expect that the auto charge-off rate will increase gradually.

Moving to Slide 11, I'll discuss our commercial banking business. First quarter ending loan balances decreased about 2% year-over-year and average loans decreased 3%. Both trends were driven by our choice to pull back in several less attractive business segments in the second half of 2017. With many of these choices behind us, ending loan balances increased about 2% from the sequential quarter.

First quarter revenue was roughly flat year-over-year as strong non-interest income in capital markets and agency offset the decline in average loans and the effect of the lower tax rate on tax equivalent yields. Excluding the net impacts of the new tax law, revenue would have grown about 4%. Non-interest expense was up 3% primarily as a result of technology investments and other business initiatives.

Provision for credit losses was actually a benefit of $14 million in the quarter driven by lower charge-offs and a larger allowance release as compared to the first quarter of last year. The charge-off rate for the quarter improved to 11 basis points. The commercial bank criticized performing loan rate for the quarter was 3.7%, down 40 basis points from the fourth quarter. The criticized non-performing loan rate was 0.5%, up 10 basis points from the fourth quarter.

Last quarter, we shared with you that we had moved the vast majority of our Taxi Medallion portfolio to held for sale, which drove most of our fourth quarter commercial provision expense. During the first quarter, we sold most of this portfolio and realized the small gain. We have just over $40 million in remaining Taxi Medallion loans and assets on the balance sheet, which are carried at a valuation comparable to the recently completed portfolio sale.

In the first quarter, Capital One delivered year-over-year growth in loans, deposits, revenues, and pre-provision earnings. We tightly managed costs even as we continue to invest to grow and to drive our digital transformation. Total company ending loan balances grew 3% year-over-year and we still see opportunities to book attractive and resilient loans in our card, auto, and commercial banking businesses. We expect marketing in 2018 will be higher than 2017.

First quarter efficiency ratio improve year-over-year as revenue growth outpaced the growth in non-interest expense, while efficiency ratio can vary in any given year. Over the long-term, we continue to believe that we will be able to achieve gradual efficiency improvement driven by growth in digital productivity gains. As always, marketing expense will continue to be driven by the opportunities and requirements of the competitive marketplace.

We expect long-term improvements and total efficiency ratio will mostly come from improving operating efficiency ratio. We continue to expect a majority of the tax benefit will fall to the bottom line this year, while it's still early to have a definitive observations and conclusions, we continue to believe markets behave in predictable ways. A surge in tax benefits has a way of working its way into the marketplace through increasing competition, including higher levels of marketing and lower prices.

Responding to these actions, we will likely consume a growing portion of the tax benefit over time. In addition, we will also continue to lean into our investment in talent, technology, innovation, brand, and growth. We are bullish about the long-term benefits of our investments.

Taking all of this into account, we continue to expect that our current trajectory coupled with the new tax law will enable us to accelerate full-year 2018 EPS growth compared to full-year 2017 EPS growth, net of adjustment and assuming no substantial adverse change in the broader economic or credit cycles.

Pulling up, we continue to build an enduringly great franchise with the scale, brand, capabilities, and infrastructure to succeed as the digital revolution transforms our industry and our society. Our digital and technology transformation is accelerating. We are growing new customer relationships and deepening engagement with new and existing customers, and we are strengthening our position to succeed in a rapidly changing marketplace and create long-term shareholder value.

Now Scott and I will be happy to answer your questions.

[Jeff Norris, Senior Vice President of Global Finance]

Thank you, Rich. We'll now start the Q&A session. As a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to one question plus a single follow-up. If you have any follow-up questions after the Q&A session, the Investor Relations team will be available after the call.

Leanne, please start the Q&A.

[Operator]

Thank you. [Operator Instructions] And we'll take our first question from Moshe Orenbuch with Credit Suisse.

[Moshe Orenbuch, Credit Suisse]

Great. Thanks. Rich, I was hoping that you could, I mean you alluded to this in your prepared remarks, you talked a little bit about seeing opportunities for growth in a market that you kind of defined is still rational. Maybe if you could kind of flesh that out a little bit kind of where within the credit spectrum, what have you seen in terms of both the supply of credit and the ability to if your borrowers to support it in the market and how has that influenced to your thought process?

[Richard Fairbank, Chairman and Chief Executive Officer]

Okay. Thanks Moshe. Good afternoon. So if I calibrate, so we had a big surge of growth in 2014 through 2016. And as you know, Moshe we are very sensitive about what is the supply demand situation in the marketplace being so cautious about oversupply. And we saw a window that we said at the time gave us I think an exceptional opportunity to grow and get the kind of performance that we wanted and we went all in on that.

Starting in 2016 and sort of into 2017, we saw a big surge in industry supply. Well it actually started before that, but there was a big surge in the industry supply. In early 2016 we started making our cautionary sounds about look that will probably have ripple effects on some of the performance metrics in the business, the credit performance metrics in the business, and sharing off those performance changes. I mean that's nothing overly alarming to those performance changes we saw in our own and in industry metrics in 2016.

And so we dialed back to more moderate growth rate. Dial back basically around the edges, across our revolver programs and you see the slower growth in 2016 and you can see growth has been pretty slow at this - to this quarter that we're reporting today. I think I would describe the generally things have kind of settled out in the environment not in a huge way, but just in a moderate way. You can see supply has little bit settled out even though supply is still on the high side, and clearly the supply, the growth of revolving credit is well above the growth of the economy et cetera.

So certainly we'll call that one on the high side, but kind of settling out. If you look at industry practices, pricing and various things I think there is a rationality and a stability to things. Competition is fairly intense especially on the very high end of the marketplace. But I would call it kind of a settling out period. I think we see an opportunity for attractive growth in this environment, not like a big surge like before, but I think that we still feel optimistic about the ability to have appropriate attractive growth in this environment, not like a big surge like before.

But I think that we still feel optimistic about the ability to have appropriate attractive growth in this environment. You talked about where across the credit spectrum that we see that would really say that across the areas that we tend to invest in, we see some attractive growth opportunities.

We continue to be going very hard at the top of the marketplace has a very competitive there. I think that the people who will succeed and are succeeding there are those who invest for years in building a brand and sort of the benefits of staying power in that particular area, but we continue to like our results there and you can see we printed them some pretty good purchase volume growth metrics.

In the revolver space, across the credit spectrum I think you know there is an opportunity, kind of medium size opportunity there. So we'll be very vigilant along the way as we read the market conditions and act appropriately, but I think that we do see some opportunity for growth.

[Moshe Orenbuch, Credit Suisse]

And just the last part of that it was whether you can ever see anything in the kind of customer base from employment or income standpoint that would make you kind of more or less enthused?

[Richard Fairbank, Chairman and Chief Executive Officer]

Yes, I think for the consumer, things look pretty strong in the near-term. I think they're benefiting from job growth and wage increases maybe a bit from Tax Cuts. And so I think the consumer and the economy sort of in which the consumer is a big part is in the near-term in a pretty strong and stable place.

Now when you look out a little bit farther, there are a number of things that are still considered can concerning like growing consumer indebtedness, growing the government deficits and a number of issues, but almost all the issues are a bit farther out.

So all of that adds up to a view in our case that there is a. Kind of middle of the cycle field to where we are right now. I think that we have some attractive opportunities to grow, but one has to I think bring a very careful and wary eye to work every day because there are a number of factors out there that could get a lot worse from here.

[Jeff Norris, Senior Vice President of Global Finance]

Next question please.

[Operator]

And our next question comes from Sanjay Sakhrani with KBW.

[Sanjay Sakhrani, Keefe Bruyette & Woods Inc.]

Thanks. When I look at the monthly progression of the U.S. card credit metrics, they paint a pretty positive story, delinquencies are down year-over-year, the charge-off rate seem to be trending down year-over-year now. Could you maybe help us reconcile your expectations for the charge-off rate to be up this year given this phenomenon?

[Scott Blackley, Chief Financial Officer]

Well, Sanjay, first I don't think we've given any guidance about the 2018 full-year charge-off rate. I think that we've historically been telling you that we expected that the increasing pressure year-over-year basis from growth math was moderating and that's what we've talked about. I mentioned that that is having a modest impact on the allowances we've seen that the income down. But Rich, I don't know if you want to make any other comments about that?

[Richard Fairbank, Chairman and Chief Executive Officer]

Well, maybe it's appropriate to kind of just seize the moment and just talk about growth math and where we are on that. If we kind of pull back over - our journey of the last several years, the reason we talked about growth math was to highlight the impacts of our outsized growth relative to the rest of the card industry.

And that surge turned out to be from 2014 through 2016 and since then our growth has been moderate. If you combine our vintages of outsized growth, 2014, 2015 and 2016, their losses have stabilized and now actually started to improve. And our newer vintages 2017 and forward are in the early seasoning phase with increasing losses. And this is a natural way that seasoning works in the Card business.

When you net these two effects, the result is the small tail of growth math we have spoken off, but pulling way up we're near the end of the growth math story, and from here we expect our credit will be impacted more by the economy, the competitive cycle, and other industry effects.

And these factors are more likely upward than downward and they will - on our portfolio will ultimately be a blend of all of these effects, but I think the thing we wanted to point out is that the surge if you will from 2014, 2015, and 2016 those vintages actually have turned to the positive.

[Sanjay Sakhrani, Keefe Bruyette & Woods Inc.]

Thank you. I mean I guess just a follow-up on that. I mean do we think that now the charge-off rate could then come down for the year relative to last year? And then just one question on the CCAR comment, Scott. Could you maybe just talk about how the more onerous expectations affect you are ask this time around, I mean in terms of just dimensionalizing that? Thank you.

[Richard Fairbank, Chairman and Chief Executive Officer]

Sanjay, we're not - it's been our norm over the 20 some years we've been a public company, not to give specific credit guidance. And I think our view is since now we're kind of beyond the growth math story and our credit is going to be driven mostly by industry factors.

We give you a little bit of a window into what's happening along the way with that thing I'll call that the surge over the three-year period. But I think we're now - it's probably less of a Capital One specific story and more about industry factors, but we will have a bit of the beneficial impact of the surge being a very gradual.

All other things being equal, a very gradually beneficial and again, everything being precisely equal something that is over the rest of it life sort of having being a modest good guy as opposed to the “bad guy” it has been for several years as the losses have been so frontloaded.

[Scott Blackley, Chief Financial Officer]

Sanjay, on the CCAR. So I obviously can't give you much information about our 2018 CCAR submission. I will kind of just pull up and first talk about the whitepaper that the Fed released on its modeling. We don't have any more information about how that's going to impact us than you do. We've made assumptions about that in terms of dimensioning the 11% that I've told you that we're going to be trending towards. So I'll just make a couple comments about what I think looking ahead for capital.

I think that we're going to be trending up towards the 11%. I would think that we'll get there over the next 12 months or so for sure. I would think that when I look at our earnings capacity, I think that we have their earnings capacity to have support growth to support our capital trending up and for the opportunity for some continued capital distribution along the way. So we're looking at all components of that as part of our dynamic management of our capital levels.

[Jeff Norris, Senior Vice President of Global Finance]

Next question please.

[Operator]

And we'll take our next questioner from Don Fandetti with Wells Fargo.

[Donald Fandetti, Wells Fargo Securities, LLC]

Yes. Good evening. I was just wondering if you could talk a little bit about sort of your view on industry card loan growth. If you look around a lot of the issuers are tightening up underwriting on the edges, yet the consumer is in very good shape. Can you talk a little bit about the outlook there and also the competitive dynamic you've got the Fed continuing to raise rates? You've got corporate tax rates that have been cut, are you seeing any changes in the competitive behavior from some of the banks?

[Richard Fairbank, Chairman and Chief Executive Officer]

Right. Don, I'm not sure that the industry is pulling back as much as it's kind of settling out. It was clear that the growth in the Card business, the growth of supply was surging over the last couple of years. It seems to have settled out around 6%, subprime growth rate surged quite a bit higher than that and it's now come down, but it's still a little bit higher than the prime rate.

So again, my characterization of that would be supply is on the high side, but kind of settling out relative to the pace it was going one in two years ago when we were raising some alarm bells. At the top of the market, there is tremendous competition at the top of the market, and the top competition shows up in rewards offerings that not only our card players actively putting some pretty aggressive things out there, but retailers are kind of jumping into the fray there's been a lot of competition on rewards themselves. Intense marketing associated with those and my expectation is that that will continue. I see nothing abating about that.

You asked the question about the impact of taxes. Both intuitively and in any retro studying we have done when a windfall happens to come to companies. Intuitively and empirically, it seems those windfalls end up making their way into the marketplace. Now one of the frustrating things will be and I'll say it in advance now.

We won't be able to measure it and we won't be able to ever attribute any particular thing to that in the same way when the windfall from bankruptcy reform that happened in the [indiscernible] ended up making its way. I would argument to a pretty unhealthy way into the Credit Card marketplace, again, who can attribute cost to all of these things, but the striking thing in the wake of that sort of the industry got a little bit overheated and competitive in some unnatural ways.

But my points are even kind of larger than a card industry point, I think as a corporate America point, where the big windfall is my expectation over the course of say the first year, most of that I'd certainly speak for Capital One. When I look at our own actions, I think that this thing looks like it had to default to the bottom line, but I think my cautionary words to all of us is, I would expect in little ways here and little ways there this will make its way into the marketplace in the form of more investment, more spending, pricing in various ways such that it kind of gets competed away which is a good thing from a societal point of view and how in the end giving a break to corporations has a way of making it self broadly available into the marketplace.

So although we won't be able to measure it, we are assuming over time in our own planning that the marketplace will get more competitive and those are my cautionary comments. And in the end, the one thing we'll know is we don't really be able to measure that effect. So if I pull way up though, I still a pretty bullish about the opportunity in the Credit Card business. I think it's a reasonably stable time in the industry. We know which direction in the credit cycle things are moving, but I think there's a window of opportunity to still have some good growth.

[Donald Fandetti, Wells Fargo Securities, LLC]

And just a quick clarification. If I look at your funding cost on securitized debt and senior and subordinate notes, it looks like they went up a lot the yield quarter-over-quarters, so anything to call out there was just sort of normal progression?

[Richard Fairbank, Chairman and Chief Executive Officer]

Yes. Most of our wholesale funding is actually swapped out to three-month LIBOR, so it's really reflective of kind of the great moves and we saw a little bit of disconnect in the three month LIBOR, which run through that for most of those items.

[Jeff Norris, Senior Vice President of Global Finance]

Next question please.

[Operator]

And our next question comes from Rick Shane with JPMorgan.

[Richard Shane, JP Morgan Chase & Co.]

Hey guys. Thanks for taking my question this afternoon. I just wanted to talk a little bit about the impact of higher deposit costs and higher rates on funds transfer pricing. I realize it's a net - it's a zero sum between corporate in the consumer bank, but I am assuming that is rates rise, the bank would be more profitable at the expense of the corporate another one and just like to go through that a little bit?

[Richard Fairbank, Chairman and Chief Executive Officer]

I think as a really broad principle, I think you're right. I think that the - we transfer funding costs from the other segment into the retail bank and its rates rise that spreads going to be more beneficial. And so all things being equal, I think that's likely going to be true.

[Richard Shane, JP Morgan Chase & Co.]

Scott and how often do you reprice that just so we understand think about the dynamic in a right way?

[Scott Blackley, Chief Financial Officer]

Yes, we do that on more or less a monthly basis is the process that we follow.

[Richard Shane, JP Morgan Chase & Co.]

Okay, great.

[Jeff Norris, Senior Vice President of Global Finance]

Next question please.

[Operator]

And we'll take our next question from Ryan Nash with Goldman Sachs.

[Ryan Nash, Goldman Sachs & Company, Inc.]

Hey, good evening, guys. So I just wanted to ask a follow-up to one of the questions that was asked earlier regarding credit note. We've obviously seen two straight months of improving charge-offs in delinquencies Rich? Do you talk about the 2014 through 2016 vintage - vintages are starting to have some gradual improvement. So given that we're now a couple months into the year with both losses and delinquency down on a year-over-year basis and seemingly we should have more tailwinds from this.

[Scott Blackley, Chief Financial Officer]

I guess what would we need to see from - if I'm assuming the environment is going to be stable, what would we need to see for losses in delinquencies to actually start going up over the course of the year. I think the point that there's no full-year guidance, but I'm just trying to understand unless it there's a big change in the operating environment why would losses start to go up?

[Richard Fairbank, Chairman and Chief Executive Officer]

So I think small changes in the environment can very easily happen. They can come on little cat feet. I'll give you an example of just what happened in 2016. Now in 2016 we were just beginning to - we were in the last year of our growth surge, but we started raising alarm bells about some of the supply things we saw going on and sure enough when you look back and by the way at that time one can't really see things particularly on origination programs and things like that.

But if you look back at the period where I would say the card industry worsened of it, starting in the second quarter of 2016 particularly on the origination side where the industry, vintages from that period started gapping out.

There was a worsening there and then we also saw that over the 2016 and 2017 period that the good guy the back book had been for so many years we'd almost all forgotten, where the back book not only was stable, it actually was getting better and better that that moved to stable, and then actually for several quarters and you can see this is an industry phenomenon. It was Capital One and you can see it in the securitization trust for the industry, actually worsen.

Now both that the origination effect that that we noticed in the second quarter of 2016 and this back book effect that went from good guide neutral to even a worsening that seems to have settled out a little bit, but those are things that that can happen very easily and while there are always can be economic effects that cause them.

The thing that I most focus on those things can happen very easily by competitor actions in the marketplace extra supply, changes in underwriting at various things. So my only point is that this is why we're not really in the credit guidance business because what we want to do is be in the credit guidance business when we have unique things to talk about - about our portfolio that wouldn't just fall of the industry things. So look, I think the most important thing that I have to share with you is that our 2014 to 2016 surge has turned into a gradual good guy.

So whatever thing that happens from there whether the industry gets worse or better or whatever, we will have that little benefit on our own portfolio and it may be beneficial relative to other card players. And put another way as we've talked about it is we're farther along in the later innings kind of growth math and some of the other players. So I think Capital One will carry that particular benefit whether losses go up or not for us in the industry I think is something we'll have to see.

[Ryan Nash, Goldman Sachs & Company, Inc.]

Got it. And I guess if I could ask one follow-up, Rich you've been spending heavy on tech for the past five years, but we still managed to see 330 basis points of efficiency improvement in the last two years. However, I think over half came from lower marketing and lower amortization. So as you continue to get more benefits from these analog cost saves and maybe we start to see some of the investments sun setting, could we actually start to see the savings that you're seeing coming through on the expense side accelerating and maybe we could see a little bit lower expense growth going forward? Thanks.

[Richard Fairbank, Chairman and Chief Executive Officer]

I think we have one growing benefit and one less benefit than we had on something like efficiency ratio relative to the last few years and not even counting by the way your point on amortization. But I think the benefit that will grow over time is the relative meter between the increased investment in technology, which has been going on for years and the meter of the savings that we get because we're investing in technology. And what I've been saying for a long time is Capital One was way out there from the beginning, saying well some banks are saying they're going to sell fund their tech investment.

I want to make one thing clear, we're not self-funding this thing. It's going to cost more before it costs less. So we have continued to invest heavily in technology and we will continue to invest heavily in technology and there are many benefits that come from that. And cost to me isn't even at the top of the list and we're not doing it primarily for cost benefits. However, with respect to cost, there are two growing good guys to offset the continued investment in technology.

One is tech savings on tech spend, so a bunch of that that we're spending a lot in technology and is starting to actually create some tech savings. The other thing is really helping to grow the meter of sort of one minus tech spend across the company. And this is a gift that will keep on giving over time. And so what I've always said is I'm not ready to predict whether it could be that tech spends will grow as far out as we can see because at some point we all become just tech companies that's all we are.

But the thing that is clearly going on is our - that tech is starting to save on itself and one minus tech spend that the savings meter is starting to grow, and I think that's going to be a gift that gives for a bunch of years. Now the one thing that's not as helpful to us over the next few years relative to what we had as our efficiency ratio is pretty steadily marched down over the last few years is basically the growth rate of the company. We were able to have the - it was really nice to have a pretty rapid growth rate and just not grow cost as much.

So we've got our work cut out for us more with more moderate growth rates that's going to be a bit harder work, but we believe that. And a very important way our investors will be paid and an important manifestation of the benefits of really transforming the company into a tech company that does banking instead of a bank that you like I think, so many in the industry bank that use this technology is that we should be able to have the benefit in the operating cost over time.

In any particular year, we're not really into the near-term guidance on that. The only other thing that I wanted to say just about efficiency ratio and you may have noticed the distinction that I made that what we believe over the longer-term overall efficiency ratio will be a good guy over time.

I think that marketing, we've already said we expect to increase marketing over time. We had earlier questions on this call about the very competitive card marketplace et cetera as we look around. We expect to continue to invest heavily in marketing. I think it's really important to the growth opportunities of the company and for the brand and ultimately where we need to go as a company. But even in spite of higher marketing spend, we are very hopeful for the continuing benefit of operating cost through technology savings to carry the day.

[Jeff Norris, Senior Vice President of Global Finance]

Next question please.

[Operator]

And we'll take our next question from Betsy Graseck with Morgan Stanley.

[Betsy Graseck, Morgan Stanley]

Hi, good afternoon.

[Richard Fairbank, Chairman and Chief Executive Officer]

Hi, Betsy.

[Betsy Graseck, Morgan Stanley]

Couple questions. One, I just want to understand - make sure I understand what you said about the CET 1 ratio, the capital ratio. So I think you said that over the course of next three, four quarters you expect you can get it back - you can get it to around 11%. Do I take that to mean that from there you anticipate holding it at 11%? I just want make sure I understand the drivers behind why you feel the need to go there and how we should expect a trajectory and what kind of leverage you're planning on pulling to either maintain or to get there?

[Richard Fairbank, Chairman and Chief Executive Officer]

Hey, Betsy. Thanks for the question. So I did say that I would expect that we would get to around 11% over the next 12 months or so from here. I think that we've got the earnings power that's going to allow us to accrete to those levels and at the same time support growth and the potential for some capital distribution as well. As we think about kind of where we need to be, I think 11% is kind of where I see the company needing to be with our current mix of business.

The one thing that is out there that we're going to need to keep a close eye on a CECL and it's kind of the way CECL and its implementation comes out. We're likely to at some point going to have to take and adjust that 11% for what we see and what we learn about kind of how CECL is going to be implemented in stress testing and the day one effect at CECL. So those are all the things that I think that I have to say on that topic.

[Betsy Graseck, Morgan Stanley]

Okay. Just because the timing doesn't have to do in part with what the CCAR test was like this quarter. Is it at all around Fed parallel run on Basel II? Is it a function of what your outlook is for credit losses, just trying to understand the timing of this currently around 11%?

[Richard Fairbank, Chairman and Chief Executive Officer]

Yes. Well the timing is mainly - I'd previously mentioned that that we thought we need to be around 10.5%, and since then we've gotten additional information from the Fed about them incorporating updated models in card and in subprime auto which are two big businesses for us. So we're trying to make sure that we don't get caught behind the April on any of those items.

[Betsy Graseck, Morgan Stanley]

Thank you.

[Jeff Norris, Senior Vice President of Global Finance]

Next question please.

[Operator]

And we'll take our next question from Eric Wasserstrom with UBS.

[Eric Wasserstrom, UBS Investment Bank]

Thanks very much. Rich if I may, I'm just trying to sort of aggregate the responses to several other questions that have come before, so I can sort of understand where the real pivot points in the income statement exist. So is this a fair characterization, I mean what we're going to see is sustained, but relatively low growth a little bit of margin benefit as asset yields outpace changes in cost of funds and operating and provision benefits relative to the prior year as the primary drivers of EPS growth, is that basically correct?

[Scott Blackley, Chief Financial Officer]

Hey, Eric, I think that when it comes to margin, I think that what I would say is, if you look at our sensitivities to further rate changes. We're basically neutral to imply forward. So I don't anticipate that you should expect a benefit with Capital One from further rate.

In fact, we're slightly liability sensitive and so that that can be that's again - that's in a shock scenario. So we're slightly liability sensitive there and then I would also add that we are sensitive to the shape of the curve. So if we were to see a slightly flatter curve that also can create a headwind perhaps to net interest margin.

And then I think when it comes to operating efficiency, as Rich just said that's something that we've given guidance that we believe over time that's a metric that we will see trend down. We've mentioned that we anticipate increasing our marketing spend versus 2017.

And then on the growth side, I think I would just characterize that as we think that we've got a pretty good competitive environment to compete, and so we're not going to see kind of the same growth rates that we were able to kind of in the 2014, 2015, 2016. We think that there's an opportunity for us to have healthy and reasonable growth.

[Eric Wasserstrom, UBS Investment Bank]

Thanks and if I can just follow-up on one point. I was trying to calculate the marginal cost of deposits and it looks like the delta there in cost was about 33 basis points and Fed funds were up about 34 over the course of the quarter. Is that - is my math is in the ballpark?

[Scott Blackley, Chief Financial Officer]

I think that you're in the ballpark in terms of total costs. Certainly, we had a number of - we talk a little bit about the wholesale funding going is being indexed to the short end of the curve three month LIBOR. So that picked up all of the change there. So basically a data one and then we also had some higher rates moving up in our commercial business as well as some of the more competitive aspects of savings in CDs. So those were all the things that contributed to that that move up in average deposit pricing.

[Jeff Norris, Senior Vice President of Global Finance]

Next question please.

[Operator]

And our next question comes from Kenneth Bruce with Bank of America Merrill Lynch.

[Kenneth Bruce, Bank of America Merrill Lynch]

Thank you and good evening. I'd like to ask a question on credit and look I understand you're trying to get out of giving any direct guidance and so I won't ask for that. But if we look back at the last couple years of growth and you pointed out that there was inflated growth continue through 2016.

There is also a pretty significant shift in the mix of Capital One's business towards [sub 650 FICO], and that has come off pretty dramatically off - over the last few quarter. So is it fair to assume that as we look forward that slower growth in that subprime portfolio should begin to accelerate the - if you will the improvement or the downward pressure from there kind of reverse growth math over the next call it 18 months?

[Richard Fairbank, Chairman and Chief Executive Officer]

Ken, I probably - I mean mechanically what you say would be the way things would work at the subprime mix, goes down and we have seen the subprime mix has declined recently, I do want to say Cabela's is a pretty significant contributor to that impact.

These are also numbers that are like rounded off to the nearest integer kind of thing and I wouldn't want you to take away that things have changed relative to the mix of Capital One business. I think things are very similar to how they've been for a long period of time most of our pull back around the edges was like you all are revolver business is in a way just trying to be cautious in the context and industry getting a little bit carried away.

While continue into pretty intensely go after the top of the marketplace. So I think things are going to be pretty consistent from the mix point of view as a general observation, but that number will bounce around and Cabela's has brought it down relative to the highs from a couple of quarters ago.

[Kenneth Bruce, Bank of America Merrill Lynch]

Great. And our math would support that just the growth that you had in 2016 in particular is going to actually start to give you some of downward pressure on loss rates into 2018, so we're bit more optimistic about that that maybe you, my follow-up question is on the…?

[Richard Fairbank, Chairman and Chief Executive Officer]

Ken, answer, can I? The one thing I wouldn't take to the bank because I don't take it to our bank is the vintage, vintages in general I think the way to think about vintages is that for a couple of years there are very clearly sort of bad guys and then there's kind of a stabilization and then there's this kind of over the rest of its life all other things being equally very gradual kind of positive right. So one thing that I've always been struck by is each vintage has a different personality that where it actually peaks the exact timing of when they turn.

So I wouldn't lean in too hard to any particular vintage and count on that being a big contributor. But all of that said, the physics - number one, when I've come out with this growth math term, I've said look I can't be precise about exact timing at magnitude of things, but it's sort of physics.

The physics works as you're saying. I just wouldn't lean in too hard on any one vintage really being a significant contributor to this year's performance, particularly 2016, which is the youngest of the three that I talked about in the surge. Anyway, sorry go ahead I interrupted.

[Kenneth Bruce, Bank of America Merrill Lynch]

Yes. No, caution noted. I guess that my follow-up is just if CECL is going to create this potential capital event, would do you think about changing the mix of business that you were willing to do based on the potential like a loan loss expectations that had to go into that math?

[Richard Fairbank, Chairman and Chief Executive Officer]

Yes and the one thing I would just say about CECL. I think CECL is going to have an impact on a number of different asset classes. I don't think this is just something to be worried about with whether it's card or auto for us. When I look at it's really going to have an impact on any type of asset that has a long life where you're going to have to extend your coverage from what's a one or two year coverage window to a life time window.

I think with card, one of the challenges with card is because it's a revolving asset and with CECL you're setting an allowance based on the outstanding balance. We may see that card isn't the asset class that's most impacted by CECL. But I think that the biggest challenges for CECL that I see are if you're going in and out of a cycle, it's really going to be pro cyclical and it's going to really put a challenge for all banks, not just Capital One for all banks. I think it's going to disincentive wise loan growth in tough times. Sorry to carry on there, but I think those are - they're broader impact than just in Capital One.

[Scott Blackley, Chief Financial Officer]

But Ken I actually want to follow-up on the strategic spirit of your question. If you pull up on frankly the Credit Card business in general, subprime cards in particular. The tax on them if you will over time is pretty striking the capital requirements that have continued to build the stress test, modeling about that business, because it's a higher loss business, the front loading and then with FAS 166/167 bringing all that into front loading, the impact of a rapid growth in the business then you bring the CECL effect. This is a lot of tax on the business.

What is clear to us we have to make sure that that we are risk adjusted return in the business like this is robust and resilient to all of this. I'm hopeful over time that that a rational industry incorporates these things I mean these things should show up in the form of higher required returns, higher pricing for the risk and things like that.

One thing it does do is scare off a lot of players who dabble in this space and so I think it's pretty clear that people are going to have to really - I think that that people are going to have to really be good at this in order to do it and be very successful.

But I think it is worth taking note on how much the tax on really most consumer lending in general has gone up in the banking business and now look in the end as markets equilibrate over time, I feel that that in the nature of our potential competitive advantage is the same.

But we can't get there by just going in and doing the same thing and making the same assumptions we've done that we used to do and we ourselves have to ask it to deliver even more given the tax on it.

[Jeff Norris, Senior Vice President of Global Finance]

Next question please.

[Operator]

And our final question tonight comes from Chris Brendler with Buckingham Research Group.

[Chris Brendler, Buckingham Research Group]

Hi, thanks. Good evening. Thanks for taking my question. I think just focus on the non-interest income in the Card business for a moment, I think you mentioned the strong net interchange growth, but I think you've had some FX in this one and before anything to call out in that strong double-digit growth, the interchange either on the interchange reward side that's driving that.

And as well that the service line, service fees and that statement as well sort of speeds are up for the first time in a long time I think you can pulling back on some of those credit products other to a non-leading related fees in the Card business and looks like that may reflected as well if you just had any insights on those to be the great things?

[Richard Fairbank, Chairman and Chief Executive Officer]

Yes, why don't I just start up on service charge? The service charges when you're looking at that on the year-over-year basis just remember that last year, we had a UK PPI charge that was around 37 million that impacted Q1 2017. So that's impacting that period-over-period and I just also mentioned that as part of the new accounting standard that we adopted.

We reclassified about $18 million of FX related fees that used to run at the contrary to the service and got moved down into the operating expenses and so that's impacting Q1, but not in any of the prior period. So that's - it's really just some of the mechanical things that are impacting that trend line as opposed to core business things.

Chris on the interchange side, we - as you've seen for years really the growth in purchase volume has well outstripped the growth in interchange revenues. Second thing I think has been very striking and it's what's behind your question is this number bounces all over the place and it's almost in any one quarter and especially be looking at growth rates any one quarter not only does that quarter bounce, but we're comparing it to a year-ago quarter that had its own bouncing dynamics to it.

So I think it's kind of structural in the marketplace that the interchange growth is less than the growth in purchase volume because of the growing competitiveness of the marketplace and the growing penetration of great rewards products to all the players including Capital One, broader customer bases.

But I also pleased to see though that even in the tremendously intense interchange race that we are - I mean the rewards competition that we see that it is the case if you pull way up from this bouncing ball. You see that year-after-year Capital One's been posting pretty solid net interchange growth in the face of all of this competition and all the moves to extend into broader parts of our customer base, and I think that that's a manifestation of the fact that.

While we're competing very intensely, we keep our pencils very sharp and to make sure that's a collective economics of what we're booking is something that can really reward us over time. And we continue to believe in the economics of this franchise, we're investing so heavily in this top of the market spender business. And I think that - while this is a particularly high quarter and I wouldn't take that one to the bank. I think that the fact that there is real interchange growth is real.

[Chris Brendler, Buckingham Research Group]

Great. Thanks. If I could ask one follow-up on credits in a different way and so looking at the loss rate, looking at the provision expense and reserve building, subprime loans in the mix you mentioned is actually - they are actually down on a dollar basis, so it's includes the Cabela's as a fact. Subprime is gone negative, our delinquencies are negative, loss rates are improving, and growth is slow. Any reason why reserve building shouldn't continue to slow from here in the card business?

[Scott Blackley, Chief Financial Officer]

Chris thanks for the question. Look, I would just say that when it comes to the reserve that's a really dynamic process. You know that a small changes in expectations, given that we've got $100 billion card portfolio, a 10 basis point move. There's a $100 million of allowance, and so I think that there are a number of forces. Rich talked about all the dynamics that will impact our overall loss rate. And those are really the things that I think we'll be looking for to drive the allowance going forward as well as just the amount of growth that we're putting on the balance sheet.

[Jeff Norris, Senior Vice President of Global Finance]

That concludes our call and our Q&A session for this evening. Thank you very much for joining us on this conference call today. And thank you for your continuing interest in Capital One. Remember, if you have further questions, the Investor Relations team will be here after the call. Have a great night.

[Operator]

And that does conclude today's conference. Thank you for your participation. You may now disconnect.