Fitch Ratings has maintained the Rating Watch Positive on Discover Financial Services' (DFS) and its subsidiaries' ratings including their Long-Term Issuer Default Ratings (IDRs) of 'BBB+' .

The Ratings were placed on Rating Watch Positive on Feb. 21, 2024 following the announced deal with Capital One Financial Corporation.

Key Rating Drivers

The Rating Watch Positive on DFS and its operating subsidiary reflects Fitch's view that the purchase by Capital One Financial (COF; IDR, A-) will likely result in a stronger company than DFS on a standalone basis. Fitch expects to resolve DFS's Rating Watch upon the completion of the transaction with COF, which is expected in late 2024 or early 2025. The transaction is subject to customary closing conditions, including regulatory approvals and approval by the shareholders of each company.

DFS's ratings reflects its strong franchise supported by its owned payments network, above average ROAs through cycles, diverse funding mix, ample liquidity, and solid risk-adjusted capitalization. Rating constraints include DFS's concentrated and cyclical business model, unsecured credit profile, above average interest rate sensitivity associated with online savings accounts, threats from disruptive technologies in the payments space and elevated regulatory and legislative risk.

The ratings also reflect Fitch's expectation that DFS's common equity Tier 1 (CET1) ratio will decline toward management's long-term target of 10%-10.5% while DFS's above average profitability and strong liquidity levels are maintained.

DFS has had heightened senior management turnover following the resignation of CEO Roger Hochschild and the announcement of the COF transaction. Additionally, there is increased regulatory scrutiny amid several compliance matters over the last year, including the disclosure of a long-occurring merchant misclassification issue and the reception of an FDIC consent order related to DFS's compliance management system.

DFS has announced that it will explore the sale of its student loan portfolio, and Fitch would view positively the exit from a lending segment in which DFS had previously made operational missteps resulting in a 2015 CFPB consent order related to loan servicing practices. The sale would provide DFS with additional liquidity, proceeds would provide an earnings boost, and the reserve release related to the long duration student loans as well as risk-weighted asset contraction would be accretive to capital ratios.

Faster Credit Deterioration Reflects Higher Risk Appetite: DFS's asset quality has normalized over the past year at a faster pace than its peers, and net chargeoffs (NCOs) have surpassed pre-pandemic levels as of 3Q23. Fitch believes the increase in DFS's chargeoffs are a function of looser underwriting standards relative to the pre-pandemic period and the seasoning effects from elevated credit card account growth over the last several years, as recent vintages have displayed more rapid delinquency formation than typically expected.

Although DFS has strong pre-provision pretax earnings, loss reserves and excess capital to absorb further degradation in credit losses, a sharp and sustained increase above historical levels would reduce rating headroom and could result in negative rating actions.

Above Average Profitability: DFS has demonstrated above average profitability relative to traditional banks through multiple cycles. Strong loan growth drove a 19% yoy increase in net interest income, and non-interest income was up 20% yoy, but DFS's operating results moderated in 2023 from exceptionally strong levels in 2021 and 2022, driven primarily by a provision expense reflecting weakening credit quality, as well as rising funding costs.

Excess Capital to Moderate: Fitch views DFS's capital ratios as strong and supportive of its overall rating. The company's stated CET1 ratio declined to 11.3% at 4Q23 from 13.1% at 4Q22, primarily reflecting accelerated loan growth. Discover announced it would pause share buybacks in June 2023 in relation to an ongoing internal compliance review, but continues to return capital to shareholders via quarterly dividends. Fitch expects DFS's CET1 ratio to decline over the longer term, driven by continued loan growth, but remain at or above the company's long-term target.

Strong Liquidity Coverage: Fitch believes DFS maintains a conservative liquidity profile and views its continued shift toward more stable deposit funding in recent years favorably. The company's direct deposit funding as a proportion of total funding, 65% at 4Q23, was approximately flat yoy, and brokered deposits were flat at 18% of total funding over the same time period.

DFS held a fairly conservative liquidity portfolio at 4Q23, with cash, treasuries and agency mortgage-backed securities (MBS) equating to approximately 15.4% of total assets. The company had a relatively small amount of securities categorized as held-to-maturity, and its unrealized losses on securities were immaterial to its tangible common equity. Fitch believes the company still has ample liquidity and contingent liquidity sources to meet its near-term debt maturities and maintain sufficient flexibility through a stress scenario.

DFS's IDR and VR are equalized with those of its bank subsidiary, reflecting its role as the bank's 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.

Rating Sensitivities

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

An increase in DFS's net chargeoff rate above 6% for several quarters, a reduction in DFS's CET1 ratio below 10% for several quarters, a significant reduction in operating profit as a percentage of risk-weighted assets over multiple years and a weakening liquidity profile or dramatic shift in funding mix that constrains the company's ability to meet obligations under a stressed scenario could pressure its ratings.

Negative rating momentum could be driven by an inability of DFS to maintain its competitive position and market share in an increasingly digitized payments and consumer lending landscape.

Negative rating action could also be possible if the Capital One transaction is terminated, which could prove a distraction from DFS's own strategic plans and key personnel retention. The ratings would be pressured if focus on the transaction interfered with Discover's efforts and investment towards sufficiently addressing compliance failures that have cropped up over the last year, or if additional compliance problems emerged.

Should the bank holding company (BHC) begin to exhibit signs of weakness, demonstrate trouble accessing the capital markets or have inadequate cash flow coverage to meet near-term obligations, Fitch could notch the BHC's IDR and VR from the ratings of the bank subsidiary.

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade

DFS's ratings will likely be upgraded and equalized with those of COF provided all necessary approvals are received.

Given that the sale is expected to close in late 2024 or early 2025, Fitch expects the resolution of the Rating Watch will occur more than six months in the future, which is outside of Fitch's normal Rating Watch time horizon.

Fitch believes that, independent of successful execution on the Capital One transaction, upward rating momentum is unlikely in the near term. In the longer term, upward momentum could result from consistent market share gains in credit card-based payments, a meaningful increase in revenue/earnings diversity from its unsecured consumer lending business and enhanced funding flexibility in the form of retail deposits, particularly a meaningful expansion of checking account balances as part of its overall deposit mix.

OTHER DEBT AND ISSUER RATINGS: KEY RATING DRIVERS

Fitch's baseline approach is to rate the senior unsecured debt of banks and BHCs in line with the respective entity's Long-Term IDR. This reflects the fact that default on senior obligations equates to the default of the bank/BHC (as captured by the IDR) and usually average expected recoveries upon default.

DFS's Short-Term IDR at 'F2' reflects good intrinsic capacity for timely payment of short-term financial commitments. While a Long-Term IDR of 'bbb+' also corresponds with a short-term IDR of 'F1' under Fitch's 'Bank Rating Criteria,' the 'F2' Short-Term Rating is assigned because DFS's funding and liquidity score of 'bbb+' is below the 'a' minimum threshold for an 'F1' Short-Term Rating.

DFS's subordinated debt rating is one notch below the entity's VR of 'bbb+'. In accordance with Fitch's 'Bank Rating Criteria,' this reflects alternate notching to the base case of two notches due to Fitch's view of U.S. regulators' resolution alternatives for an entity such as DFS, as well as early intervention options available to banking regulators under U.S. law.

The preferred securities rating is four notches below DFS's VR, encompassing two notches for nonperformance and two notches for loss severity.

Discover Bank's long-term uninsured deposit rating is one notch higher than the bank's IDR because U.S. uninsured deposits benefit from depositor preference in the U.S. Fitch believes depositor preference in the U.S. gives deposit liabilities superior recovery prospects in the event of default. Discover Bank's short-term uninsured deposit rating of 'F2' is equalized with the bank's Short-Term IDR.

DFS and Discover Bank have Government Support Ratings of 'ns'. In Fitch's view, the probability of support is unlikely.

IDRs and VRs do not incorporate any support.

OTHER DEBT AND ISSUER RATINGS: RATING SENSITIVITIES

The senior unsecured debt rating is equalized with DFS's IDR, and these ratings would be expected to move in tandem with any changes to the IDR.

The Short-Term IDRs are directly linked to the Long-Term IDRs, and these ratings would be expected to move in tandem. Secondarily, the Short-Term IDRs are sensitive to improvements in DFS's funding and liquidity factor score.

The subordinated debt and preferred security ratings are directly linked to DFS's VR, and these ratings would be expected to move in tandem with any changes in the VR.

The deposit ratings are primarily sensitive to any change in Discover Bank's Long-Term and Short-Term IDRs.

VR ADJUSTMENTS

The Business Profile score of 'bbb-' has been assigned below the 'a' category implied score due to the following adjustment reason: Concentrated (unsecured consumer lending) business model (negative).

The Earnings and Profitability score of 'a-' has been assigned below the 'aa' category implied score due to the following adjustment reasons: Revenue diversity (negative) and earnings stability (negative).

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Discover Financial Services has an ESG Relevance Score of '4' for Customer Welfare - Fair Messaging, Privacy and Data Security due to its exposure to compliance risks that include fair lending practices, debt collection practices and consumer data protection. This has a negative impact on the credit profile and is relevant to the rating in conjunction with other factors.

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/topics/esg/products#esg-relevance-scores.

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