Annual Statements Open main menu

Discover Financial Services - Quarter Report: 2018 June (Form 10-Q)

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2018
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                    to 
                    
Commission File Number 001-33378
DISCOVER FINANCIAL SERVICES
(Exact name of registrant as specified in its charter) 
Delaware
 
36-2517428
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
 
 
2500 Lake Cook Road,
Riverwoods, Illinois 60015
 
(224) 405-0900
(Address of principal executive offices, including zip code)
 
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  x    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer  x
Accelerated filer  o
Non-accelerated filer  o (Do not check if a smaller reporting company)    
Smaller reporting company  o
 
Emerging growth company o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x
As of July 27, 2018, there were 342,658,270 shares of the registrant’s Common Stock, par value $0.01 per share, outstanding.
 



DISCOVER FINANCIAL SERVICES
Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2018
TABLE OF CONTENTS
 
 
 
 
 
Except as otherwise indicated or unless the context otherwise requires, “Discover Financial Services,” “Discover,” “DFS,” “we,” “us,” “our,” and “the Company” refer to Discover Financial Services and its subsidiaries.
We own or have rights to use the trademarks, trade names and service marks that we use in conjunction with the operation of our business, including, but not limited to: Discover®, PULSE®, Cashback Bonus®, Discover Cashback Checking®, Discover it®, Freeze ItSM, College Covered®, and Diners Club International®. All other trademarks, trade names and service marks included in this quarterly report on Form 10-Q are the property of their respective owners.


Table of Contents

Part I.
FINANCIAL INFORMATION
Item 1.
Financial Statements
DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Financial Condition
 
June 30,
2018
 
December 31,
2017
 
(unaudited)
(dollars in millions,
except share amounts)
Assets
 
 
 
Cash and cash equivalents
$
15,289

 
$
13,306

Restricted cash
630

 
81

Investment securities (includes $1,296 and $1,395 at fair value at June 30, 2018 and December 31, 2017, respectively)
1,522

 
1,568

Loan receivables
 
 
 
Loan receivables
84,789

 
84,248

Allowance for loan losses
(2,828
)
 
(2,621
)
Net loan receivables
81,961

 
81,627

Premises and equipment, net
874

 
825

Goodwill
255

 
255

Intangible assets, net
162

 
163

Other assets
2,058

 
2,262

Total assets
$
102,751

 
$
100,087

Liabilities and Stockholders’ Equity
 
 
 
Deposits:
 
 
 
Interest-bearing deposit accounts
$
61,068

 
$
58,165

Non-interest bearing deposit accounts
615

 
599

Total deposits
61,683

 
58,764

Long-term borrowings
26,252

 
26,326

Accrued expenses and other liabilities
3,927

 
4,105

Total liabilities
91,862

 
89,195

Commitments, contingencies and guarantees (Notes 8, 11 and 12)

 

Stockholders’ Equity:
 
 
 
Common stock, par value $0.01 per share; 2,000,000,000 shares authorized; 564,557,895 and 563,497,702 shares issued at June 30, 2018 and December 31, 2017, respectively
6

 
6

Preferred stock, par value $0.01 per share; 200,000,000 shares authorized; 5,700 shares issued and outstanding and aggregate liquidation preference of $570 at June 30, 2018 and December 31, 2017
563

 
563

Additional paid-in capital
4,089

 
4,042

Retained earnings
17,787

 
16,687

Accumulated other comprehensive loss
(162
)
 
(152
)
Treasury stock, at cost; 220,657,224 and 205,577,507 shares at June 30, 2018 and December 31, 2017, respectively
(11,394
)
 
(10,254
)
Total stockholders’ equity
10,889

 
10,892

Total liabilities and stockholders’ equity
$
102,751

 
$
100,087

 
 
 
 

The table below presents the carrying amounts of certain assets and liabilities of Discover Financial Services’ consolidated variable interest entities ("VIEs"), which are included in the condensed consolidated statements of financial condition above. The assets in the table below include those assets that can only be used to settle obligations of the consolidated VIEs. The liabilities in the table below include third-party liabilities of consolidated VIEs only and exclude intercompany balances that eliminate in consolidation. The liabilities also exclude amounts for which creditors have recourse to the general credit of Discover Financial Services.
 
June 30,
2018
 
December 31,
2017
 
(unaudited)
(dollars in millions)
Assets
 
 
 
Restricted cash
$
630

 
$
81

Loan receivables
$
30,151

 
$
31,781

Allowance for loan losses allocated to securitized loan receivables
$
(1,020
)
 
$
(998
)
Other assets
$
6

 
$
5

Liabilities
 
 
 
Long-term borrowings
$
16,365

 
$
16,536

Accrued expenses and other liabilities
$
17

 
$
16

 
 
 
 

See Notes to the Condensed Consolidated Financial Statements.
1


Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Income
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
 (unaudited)
(dollars in millions, except per share amounts)
Interest income
 
 
 
 
 
 
 
Credit card loans
$
2,139

 
$
1,916

 
$
4,229

 
$
3,792

Other loans
421

 
379

 
838

 
746

Investment securities
6

 
7

 
13

 
14

Other interest income
70

 
36

 
125

 
64

Total interest income
2,636

 
2,338

 
5,205

 
4,616

Interest expense
 
 
 
 
 
 
 
Deposits
287

 
199

 
549

 
390

Long-term borrowings
220

 
201

 
427

 
396

Total interest expense
507

 
400

 
976

 
786

Net interest income
2,129

 
1,938

 
4,229

 
3,830

Provision for loan losses
742

 
640

 
1,493

 
1,226

Net interest income after provision for loan losses
1,387

 
1,298

 
2,736

 
2,604

Other income
 
 
 
 
 
 
 
Discount and interchange revenue, net
263

 
278

 
517

 
511

Protection products revenue
50

 
56

 
103

 
114

Loan fee income
95

 
83

 
191

 
172

Transaction processing revenue
42

 
42

 
85

 
81

Other income
24

 
22

 
53

 
50

Total other income
474

 
481

 
949

 
928

Other expense
 
 
 
 
 
 
 
Employee compensation and benefits
400

 
367

 
805

 
730

Marketing and business development
224

 
192

 
409

 
360

Information processing and communications
86

 
77

 
168

 
157

Professional fees
161

 
156

 
316

 
303

Premises and equipment
24

 
23

 
50

 
48

Other expense
89

 
97

 
204

 
199

Total other expense
984

 
912

 
1,952

 
1,797

Income before income tax expense
877

 
867

 
1,733

 
1,735

Income tax expense
208

 
321

 
398

 
625

Net income
$
669

 
$
546

 
$
1,335

 
$
1,110

Net income allocated to common stockholders
$
663

 
$
532

 
$
1,309

 
$
1,083

Basic earnings per common share
$
1.91

 
$
1.41

 
$
3.73

 
$
2.83

Diluted earnings per common share
$
1.91

 
$
1.40

 
$
3.72

 
$
2.83

Dividends declared per common share
$
0.35

 
$
0.30

 
$
0.70

 
$
0.60

 
 
 
 
 
 
 
 

See Notes to the Condensed Consolidated Financial Statements.
2


Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Comprehensive Income
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
 (unaudited)
(dollars in millions)
Net income
$
669

 
$
546

 
$
1,335

 
$
1,110

Other comprehensive income, net of taxes
 
 
 
 
 
 
 
Unrealized (loss) gain on available-for-sale investment securities, net of tax
(1
)
 

 
(8
)
 
1

Unrealized gain on cash flow hedges, net of tax
7

 
5

 
26

 
10

Unrealized pension and post-retirement plan gain, net of tax

 

 
1

 

Other comprehensive income
6

 
5

 
19

 
11

Comprehensive income
$
675

 
$
551

 
$
1,354

 
$
1,121

 
 
 
 
 
 
 
 

See Notes to the Condensed Consolidated Financial Statements.
3


Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Changes in Stockholders’ Equity
 
 
 
 
 
 
 
 
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated Other Comprehensive Loss
 
Treasury
Stock
 
Total
Stockholders’
Equity
 
Preferred Stock
 
Common Stock
 
 
 
 
 
 
Shares
 
Amount
 
Shares
 
Amount
 
 
 
 
 
 
(unaudited)
(dollars in millions, shares in thousands)
Balance at December 31, 2016
575

 
$
560

 
562,414

 
$
5

 
$
3,962

 
$
15,130

 
$
(161
)
 
$
(8,173
)
 
$
11,323

Net income

 

 

 

 

 
1,110

 

 

 
1,110

Other comprehensive income

 

 

 

 

 

 
11

 

 
11

Purchases of treasury stock

 

 

 

 

 

 

 
(970
)
 
(970
)
Common stock issued under employee benefit plans

 

 
40

 

 
3

 

 

 

 
3

Common stock issued and stock-based compensation expense

 

 
988

 
1

 
32

 

 

 

 
33

Dividends — common stock

 

 

 

 

 
(232
)
 

 

 
(232
)
Dividends — preferred stock

 

 

 

 

 
(19
)
 

 

 
(19
)
Balance at June 30, 2017
575

 
$
560

 
563,442

 
$
6

 
$
3,997

 
$
15,989

 
$
(150
)
 
$
(9,143
)
 
$
11,259

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2017
6

 
$
563

 
563,498

 
$
6

 
$
4,042

 
$
16,687

 
$
(152
)
 
$
(10,254
)
 
$
10,892

Cumulative effect of ASU No. 2018-02 adoption

 

 

 

 

 
29

 
(29
)
 

 

Net income

 

 

 

 

 
1,335

 

 

 
1,335

Other comprehensive income

 

 

 

 

 

 
19

 

 
19

Purchases of treasury stock

 

 

 

 

 

 

 
(1,140
)
 
(1,140
)
Common stock issued under employee benefit plans

 

 
45

 

 
3

 

 

 

 
3

Common stock issued and stock-based compensation expense

 

 
1,015

 

 
44

 

 

 

 
44

Dividends — common stock

 

 

 

 

 
(248
)
 

 

 
(248
)
Dividends — preferred stock

 

 

 

 

 
(16
)
 

 

 
(16
)
Balance at June 30, 2018
6

 
$
563

 
564,558

 
$
6

 
$
4,089

 
$
17,787

 
$
(162
)
 
$
(11,394
)
 
$
10,889

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

See Notes to the Condensed Consolidated Financial Statements.
4


Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Cash Flows
 
For the Six Months Ended June 30,
 
2018
 
2017
 
(unaudited)
(dollars in millions)
Cash flows from operating activities
 
 
 
Net income
$
1,335

 
$
1,110

Adjustments to reconcile net income to net cash provided by (used for) operating activities:
 
 
 
Provision for loan losses
1,493

 
1,226

Deferred income taxes
(137
)
 
(46
)
Depreciation and amortization
216

 
188

Amortization of deferred revenues and accretion of accretable yield on acquired loans
(198
)
 
(195
)
Net loss on investments and other assets
22

 
27

Other, net
44

 
33

Changes in assets and liabilities:
 
 
 
Decrease in other assets
190

 
3

Decrease in accrued expenses and other liabilities
(141
)
 
(314
)
Net cash provided by operating activities
2,824

 
2,032

 
 
 
 
Cash flows from investing activities
 
 
 
Maturities of available-for-sale investment securities
86

 
104

Maturities of held-to-maturity investment securities
9

 
7

Purchases of held-to-maturity investment securities
(62
)
 
(36
)
Net principal disbursed on loans originated for investment
(1,639
)
 
(1,550
)
Proceeds from returns of investment

 
14

Purchases of other investments
(5
)
 
(23
)
Purchases of premises and equipment
(118
)
 
(103
)
Net cash used for investing activities
(1,729
)
 
(1,587
)
 
 
 
 
Cash flows from financing activities
 
 
 
Proceeds from issuance of securitized debt
2,184

 
2,952

Maturities and repayment of securitized debt
(2,337
)
 
(2,651
)
Proceeds from issuance of other long-term borrowings
844

 
1,050

Maturities and repayment of other long-term borrowings
(753
)
 
(401
)
Proceeds from issuance of common stock
3

 
2

Purchases of treasury stock
(1,140
)
 
(970
)
Net increase in deposits
2,900

 
858

Dividends paid on common and preferred stock
(264
)
 
(251
)
Net cash provided by financing activities
1,437

 
589

Net increase in cash, cash equivalents and restricted cash
2,532

 
1,034

Cash, cash equivalents and restricted cash, at beginning of period
13,387

 
12,009

Cash, cash equivalents and restricted cash, at end of period
$
15,919

 
$
13,043

 
 
 
 
Reconciliation of cash, cash equivalents and restricted cash:
 
 
 
Cash and cash equivalents
$
15,289

 
$
12,950

Restricted cash
630

 
93

Cash, cash equivalents and restricted cash, at end of period
$
15,919

 
$
13,043

 
 
 
 


See Notes to the Condensed Consolidated Financial Statements.
5


Table of Contents

Notes to the Condensed Consolidated Financial Statements
(unaudited)
1.
Background and Basis of Presentation
Description of Business
Discover Financial Services (“DFS” or the “Company”) is a direct banking and payment services company. The Company is a bank holding company under the Bank Holding Company Act of 1956 as well as a financial holding company under the Gramm-Leach-Bliley Act and therefore is subject to oversight, regulation and examination by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Company provides direct banking products and services and payment services through its subsidiaries. The Company offers its customers credit card loans, private student loans, personal loans, home equity loans and deposit products. The Company also operates the Discover Network, the PULSE network (“PULSE”) and Diners Club International (“Diners Club”). The Discover Network processes transactions for Discover-branded credit and debit cards and provides payment transaction processing and settlement services. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE network with access to ATMs domestically and internationally, as well as point-of-sale terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network of licensees, which are generally financial institutions, that issue Diners Club branded charge cards and/or provide card acceptance services.
The Company’s business activities are managed in two segments, Direct Banking and Payment Services, based on the products and services provided. For a detailed description of the operations of each segment, as well as the allocation conventions used in business segment reporting, see Note 15: Segment Disclosures.
Basis of Presentation
The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, the financial statements reflect all adjustments which are necessary for a fair presentation of the results for the interim period. All such adjustments are of a normal, recurring nature. The preparation of financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and related disclosures. These estimates are based on information available as of the date of the condensed consolidated financial statements. The Company believes that the estimates used in the preparation of the condensed consolidated financial statements are reasonable. Actual results could differ from these estimates. These interim condensed consolidated financial statements should be read in conjunction with the Company’s 2017 audited consolidated financial statements filed with the Company’s annual report on Form 10-K for the year ended December 31, 2017.
Recently Issued Accounting Pronouncements
In February 2018, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The ASU permits, but does not require, issuers to reclassify into retained earnings any tax effects that are stranded in accumulated other comprehensive income (“AOCI”) as a result of the change in the statutory federal tax rate enacted by the Tax Cuts and Jobs Act of 2017 (“TCJA”). Tax effects that are stranded in AOCI for other reasons, such as prior changes in tax law or changes in a valuation allowance, may not be reclassified directly through retained earnings. The guidance is effective for fiscal years beginning after December 15, 2018, with early adoption permitted. The Company early adopted the ASU as of April 1, 2018, resulting in a reclassification from AOCI to retained earnings that did not have a material impact to the Company's financial statements. See Note 7: Accumulated Other Comprehensive Income for additional details on the impact of adopting of this standard. The Company's policy is to adjust the tax effects of a component of AOCI in the same period in which the item is sold or otherwise derecognized, or when the carrying value of the item is remeasured.
In January 2017, the FASB issued ASU No. 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The purpose of this ASU is to simplify the test for goodwill impairment by eliminating Step 2 of the current impairment test. Under the current rules, if the reporting unit’s carrying value exceeds its fair value (Step 1), goodwill impairment is measured as the difference between the carrying value of goodwill and its implied fair value. To compute the implied fair value of goodwill under Step 2, an entity has to perform procedures to determine the fair value at the impairment testing date of its assets and liabilities (including unrecognized assets and liabilities) following the procedure

6

Table of Contents

that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Under the new standard, the Company will perform its annual goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. The Company should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The amendments in this ASU apply to the Company’s annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The amendments in this ASU apply on a prospective basis. All of the Company’s recorded goodwill is associated with its PULSE debit business. This ASU has no impact on cash flows, and its adoption is not expected to have any impact on the Company’s condensed consolidated financial condition or results of operations because the estimated fair value of the PULSE reporting unit is well in excess of its carrying value. The Company did not early adopt this standard, but is still evaluating whether it will prior to the 2020 effective date.
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. This ASU replaces the incurred loss model with the current expected credit loss ("CECL") approach. For loans carried at amortized cost, the allowance for loan losses will be based on management’s current estimate of all expected credit losses over the remaining contractual term of the loans. Upon the origination of a loan, the Company will have to record its estimate of all expected credit losses on that loan through an immediate charge to earnings. Updates to that estimate each period will be recorded through provision expense. The CECL estimate is to be based on historical experience, current conditions and reasonable and supportable forecasts. No specific method for estimating credit loss is mandated, permitting companies to use judgment in selecting the approach that is most appropriate in their circumstances.
The CECL approach is expected to affect the Company’s allowance for loan losses as a result of: (1) encompassing expected losses, not simply those deemed to be already incurred, (2) extending the loss estimate period over the entire life of the loan, and (3) reclassification of the credit loss component of the purchased credit-impaired ("PCI") loan portfolio out of loan carrying value and into the allowance for loan losses. All loans carried at amortized cost, including PCI loans and loans modified in a troubled debt restructuring ("TDR") will be measured under the CECL approach. Existing specialized measurement guidance for PCI loans, which the ASU refers to as purchased credit-deteriorated ("PCD"), and TDRs will be eliminated, although certain separate disclosure guidance will be retained. Measurement of credit impairment of available-for-sale debt securities will generally remain unchanged under the new rules, but any such impairment will be recorded through an allowance, rather than a direct write-down of the security.
The ASU is effective beginning January 1, 2020, with early adoption permitted no sooner than January 1, 2019. Management is not considering early adoption at this time. On the date of adoption, the allowance for loan losses will be adjusted to the CECL estimate for loans held at that date with an offsetting adjustment to retained earnings. Additionally, the carrying value of PCD loans will be increased through an offsetting addition to the allowance for loan losses for the CECL estimate on those loans. The CECL allowance will be re-evaluated in subsequent periods and adjusted through provision expense as needed. The Company is actively engaged in cross-functional implementation efforts and planning for loss modeling requirements consistent with lifetime expected loss estimates. The Company has also been involved in efforts to identify and resolve various implementation issues specific to the application of the standard to credit card receivables. Adoption of the standard has the potential to materially impact stockholders' equity and regulatory capital as well as the Company's financial condition and results of operations. The extent of the impact upon adoption will likely depend on the characteristics of the Company's loan portfolio and economic conditions at that date, as well as forecasted conditions thereafter.
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). The guidance will require lessees to capitalize most leases on their balance sheet whereas under current GAAP only capital leases are recognized on the lessee’s balance sheet. Leases which today are identified as capital leases will generally be identified as financing leases under the new guidance but otherwise their accounting treatment will remain relatively unchanged. Leases identified today as operating leases will generally remain in that category under the new standard, but both a right-of-use asset and a liability for remaining lease payments will now be required to be recognized on the balance sheet for this type of lease. The manner in which expenses associated with all leases are reported on the income statement will remain mostly unchanged. Lessor accounting also remains substantially unchanged by the new standard. The new guidance will become effective for the Company on January 1, 2019, and management does not expect it to have a material impact on the condensed consolidated financial statements.

7

Table of Contents

2.
Investments
The Company’s investment securities consist of the following (dollars in millions):
 
June 30,
2018
 
December 31,
2017
U.S. Treasury securities(1)
$
674

 
$
672

States and political subdivisions of states

 
1

Residential mortgage-backed securities - Agency(2)
848

 
895

Total investment securities
$
1,522

 
$
1,568

 
 
 
 
(1)
Includes $32 million and $48 million of U.S. Treasury securities pledged as swap collateral as of June 30, 2018 and December 31, 2017, respectively.
(2)
Consists of residential mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae.
The amortized cost, gross unrealized gains and losses, and fair value of available-for-sale and held-to-maturity investment securities are as follows (dollars in millions):
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
At June 30, 2018
 
 
 
 
 
 
 
Available-for-Sale Investment Securities(1)
 
 
 
 
 
 
 
U.S. Treasury securities
$
675

 
$

 
$
(1
)
 
$
674

Residential mortgage-backed securities - Agency
639

 

 
(17
)
 
622

Total available-for-sale investment securities
$
1,314

 
$

 
$
(18
)
 
$
1,296

Held-to-Maturity Investment Securities(2)
 
 
 
 
 
 
 
Residential mortgage-backed securities - Agency(3)
$
226

 
$

 
$
(4
)
 
$
222

Total held-to-maturity investment securities
$
226

 
$

 
$
(4
)
 
$
222

 
 
 
 
 
 
 
 
At December 31, 2017
 
 
 
 
 
 
 
Available-for-Sale Investment Securities(1)
 
 
 
 
 
 
 
U.S. Treasury securities
$
675

 
$

 
$
(3
)
 
$
672

Residential mortgage-backed securities - Agency
728

 
1

 
(6
)
 
723

Total available-for-sale investment securities
$
1,403

 
$
1

 
$
(9
)
 
$
1,395

Held-to-Maturity Investment Securities(2)
 
 
 
 
 
 
 
States and political subdivisions of states
$
1

 
$

 
$

 
$
1

Residential mortgage-backed securities - Agency(3) 
172

 
1

 
(1
)
 
172

Total held-to-maturity investment securities
$
173

 
$
1

 
$
(1
)
 
$
173

 
 
 
 
 
 
 
 
(1)
Available-for-sale investment securities are reported at fair value.
(2)
Held-to-maturity investment securities are reported at amortized cost.
(3)
Amounts represent residential mortgage-backed securities that were classified as held-to-maturity as they were entered into as a part of the Company's community reinvestment initiatives.

8

Table of Contents

The following table provides information about investment securities with aggregate gross unrealized losses and the length of time that individual investment securities have been in a continuous unrealized loss position (dollars in millions):
 
Number of Securities in a Loss Position
 
Less than 12 months
 
More than 12 months
 
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
At June 30, 2018
 
 
 
 
 
 
 
 
 
Available-for-Sale Investment Securities
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
1

 
$

 
$

 
$
674

 
$
(1
)
Residential mortgage-backed securities - Agency
31

 
$
509

 
$
(12
)
 
$
113

 
$
(5
)
Held-to-Maturity Investment Securities
 
 
 
 
 
 
 
 
 
Residential mortgage-backed securities - Agency
85

 
$
126

 
$
(2
)
 
$
52

 
$
(2
)
 
 
 
 
 
 
 
 
 
 
At December 31, 2017
 
 
 
 
 
 
 
 
 
Available-for-Sale Investment Securities
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
1

 
$

 
$

 
$
672

 
$
(3
)
Residential mortgage-backed securities - Agency
27

 
$
457

 
$
(3
)
 
$
132

 
$
(3
)
Held-to-Maturity Investment Securities
 
 
 
 
 
 
 
 
 
Residential mortgage-backed securities - Agency
45

 
$
56

 
$

 
$
38

 
$
(1
)
 
 
 
 
 
 
 
 
 
 
There were no losses related to other-than-temporary impairments and no proceeds from sales or recognized gains and losses on available-for-sale securities during the three and six months ended June 30, 2018 and 2017. See Note 7: Accumulated Other Comprehensive Income for unrealized gains and losses on available-for-sale securities during the three and six months ended June 30, 2018 and 2017.
Maturities of available-for-sale debt securities and held-to-maturity debt securities are provided in the following table (dollars in millions):
 
One Year
or
Less
 
After One
Year
Through
Five Years
 
After Five
Years
Through
Ten Years
 
After Ten
Years
 
Total
At June 30, 2018
 
 
 
 
 
 
 
 
 
Available-for-Sale Investment Securities—Amortized Cost
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
675

 
$

 
$

 
$

 
$
675

Residential mortgage-backed securities - Agency(1)

 
90

 
498

 
51

 
639

Total available-for-sale investment securities
$
675

 
$
90

 
$
498

 
$
51

 
$
1,314

Held-to-Maturity Investment Securities—Amortized Cost
 
 
 
 
 
 
 
 
 
Residential mortgage-backed securities - Agency(1)
$

 
$

 
$

 
$
226

 
$
226

Total held-to-maturity investment securities
$

 
$

 
$

 
$
226

 
$
226

Available-for-Sale Investment Securities—Fair Values
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
674

 
$

 
$

 
$

 
$
674

Residential mortgage-backed securities - Agency(1)

 
88

 
484

 
50

 
622

Total available-for-sale investment securities
$
674

 
$
88

 
$
484

 
$
50

 
$
1,296

Held-to-Maturity Investment Securities—Fair Values
 
 
 
 
 
 
 
 
 
Residential mortgage-backed securities - Agency(1)
$

 
$

 
$

 
$
222

 
$
222

Total held-to-maturity investment securities
$

 
$

 
$

 
$
222

 
$
222

 
 
 
 
 
 
 
 
 
 
(1)
Maturities of residential mortgage-backed securities are reflective of the contractual maturities of the investment.

9

Table of Contents

Other Investments
As a part of the Company's community reinvestment initiatives, the Company has made equity investments in certain limited partnerships and limited liability companies that finance the construction and rehabilitation of affordable rental housing, as well as stimulate economic development in low to moderate income communities. These investments are accounted for using the equity method of accounting and are recorded within other assets. The related commitment for future investments is recorded in accrued expenses and other liabilities within the condensed consolidated statements of financial condition. The portion of each investment's operating results allocable to the Company reduces the carrying value of the investments and is recorded in other expense within the condensed consolidated statements of income. The Company further reduces the carrying value of the investments by recognizing any amounts that are in excess of future net tax benefits in other expense. The Company earns a return primarily through the receipt of tax credits allocated to the affordable housing projects and the community revitalization projects. These investments are not consolidated as the Company does not have a controlling financial interest in the entities. As of June 30, 2018 and December 31, 2017, the Company had outstanding investments in these entities of $275 million and $297 million, respectively, and related contingent liabilities of $63 million and $66 million, respectively. Of the above outstanding equity investments, the Company had $271 million and $288 million of investments related to affordable housing projects as of June 30, 2018 and December 31, 2017, respectively, which had $63 million and $66 million related contingent liabilities, respectively.
3.
Loan Receivables
The Company has three loan portfolio segments: credit card loans, other loans and PCI loans.
The Company's classes of receivables within the three portfolio segments are depicted in the following table (dollars in millions):
 
June 30,
2018
 
December 31,
2017
Loan receivables
 
 
 
Credit card loans(1)
$
67,812

 
$
67,291

Other loans
 
 
 
Personal loans
7,304

 
7,374

Private student loans
7,260

 
7,076

Other
571

 
423

Total other loans
15,135

 
14,873

PCI loans(2)
1,842

 
2,084

Total loan receivables
84,789

 
84,248

Allowance for loan losses
(2,828
)
 
(2,621
)
Net loan receivables
$
81,961

 
$
81,627

 
 
 
 
(1)
Amounts include carrying values of $21.1 billion and $21.2 billion in underlying investors’ interest in trust debt at June 30, 2018 and December 31, 2017, respectively, and $8.4 billion and $9.9 billion in seller's interest at June 30, 2018 and December 31, 2017, respectively. See Note 4: Credit Card and Student Loan Securitization Activities for additional information.
(2)
Amounts include carrying values of $669 million and $762 million in loans pledged as collateral against the notes issued from the Student Loan Corporation ("SLC") securitization trusts at June 30, 2018 and December 31, 2017, respectively. See Note 4: Credit Card and Student Loan Securitization Activities for additional information.

10

Table of Contents

Credit Quality Indicators
The Company regularly reviews its collection experience (including delinquencies and net charge-offs) in determining its allowance for loan losses.
Information related to the delinquent and non-accruing loans in the Company’s loan portfolio is shown below by each class of loan receivables except for PCI student loans, which is shown under the heading “— Purchased Credit-Impaired Loans” (dollars in millions):
  
30-89 Days
Delinquent
 
90 or
More Days
Delinquent
 
Total Past
Due
 
90 or
More Days
Delinquent
and
Accruing
 
Total
Non-accruing(1)
At June 30, 2018
 
 
 
 
 
 
 
 
 
Credit card loans(2)
$
723

 
$
743

 
$
1,466

 
$
681

 
$
204

Other loans
 
 
 
 


 
 
 
 
Personal loans(3)
74

 
30

 
104

 
29

 
11

Private student loans (excluding PCI)(4)
106

 
46

 
152

 
45

 
10

Other
1

 
2

 
3

 

 
19

Total other loans (excluding PCI)
181

 
78

 
259

 
74

 
40

Total loan receivables (excluding PCI)
$
904

 
$
821

 
$
1,725

 
$
755

 
$
244

 
 
 
 
 
 
 
 
 
 
At December 31, 2017
 
 
 
 
 
 
 
 
 
Credit card loans(2)
$
781

 
$
751

 
$
1,532

 
$
693

 
$
203

Other loans
 
 
 
 


 
 
 
 
Personal loans(3)
73

 
30

 
103

 
28

 
10

Private student loans (excluding PCI)(4)
134

 
33

 
167

 
33

 
2

Other
3

 
1

 
4

 

 
18

Total other loans (excluding PCI)
210

 
64

 
274

 
61

 
30

Total loan receivables (excluding PCI)
$
991

 
$
815

 
$
1,806

 
$
754

 
$
233

 
 
 
 
 
 
 
 
 
 
 
(1)
The Company estimates that the gross interest income that would have been recorded in accordance with the original terms of non-accruing credit card loans was $10 million and $9 million for the three months ended June 30, 2018 and 2017, respectively, and $19 million and $17 million for the six months ended June 30, 2018 and 2017, respectively. The Company does not separately track the amount of gross interest income that would have been recorded in accordance with the original terms of loans. This amount was estimated based on customers' current balances and most recent interest rates.
(2)
Credit card loans that are 90 or more days delinquent and accruing interest include $85 million and $72 million of loans accounted for as TDRs at June 30, 2018 and December 31, 2017, respectively.
(3)
Personal loans that are 90 or more days delinquent and accruing interest include $5 million of loans accounted for as TDRs at June 30, 2018 and December 31, 2017.
(4)
Private student loans that are 90 or more days delinquent and accruing interest include $7 million and $5 million of loans accounted for as TDRs at June 30, 2018 and December 31, 2017, respectively.


11

Table of Contents

Information related to the net charge-offs in the Company's loan portfolio is shown below by each class of loan receivables except for PCI student loans, which is shown under the heading "— Purchased Credit-Impaired Loans" (dollars in millions):
 
For the Three Months Ended June 30,
 
2018
 
2017
  
Net
Charge-offs
 
Net 
Charge-off
Rate
(1)
 
Net
Charge-offs
 
Net 
Charge-off
Rate
(1)
Credit card loans
$
555

 
3.34
%
 
$
445

 
2.94
%
Other loans
 
 
 
 
 
 
 
Personal loans
72

 
3.97
%
 
54

 
3.18
%
Private student loans (excluding PCI)
21

 
1.16
%
 
20

 
1.15
%
Other
1

 
0.34
%
 
1

 
0.30
%
Total other loans
94

 
2.48
%
 
75

 
2.14
%
Net charge-offs (excluding PCI)
$
649

 
3.18
%
 
$
520

 
2.79
%
Net charge-offs (including PCI)
$
649

 
3.11
%
 
$
520

 
2.71
%
 
 
 
 
 
 
 
For the Six Months Ended June 30,
 
2018
 
2017
  
Net
Charge-off
Dollars
 
Net 
Charge-off
Rate
(1)
 
Net
Charge-off
Dollars
 
Net 
Charge-off
Rate
(1)
Credit card loans
$
1,095

 
3.33
%
 
$
867

 
2.89
%
Other loans
 
 
 
 
 
 
 
Personal loans
145

 
4.00
%
 
105

 
3.17
%
Private student loans (excluding PCI)
43

 
1.17
%
 
34

 
0.99
%
Other
1

 
0.23
%
 
3

 
1.79
%
Total other loans
189

 
2.50
%
 
142

 
2.08
%
Net charge-offs (excluding PCI)
$
1,284

 
3.18
%
 
$
1,009

 
2.74
%
Net charge-offs (including PCI)
$
1,284

 
3.10
%
 
$
1,009

 
2.65
%
 
 
 
 
 
 
 
 
(1)
Net charge-off rate represents net charge-off dollars (annualized) divided by average loans for the reporting period.
As part of credit risk management activities, on an ongoing basis, the Company reviews information related to the performance of a customer’s account with the Company as well as information from credit bureaus, such as FICO or other credit scores, relating to the customer’s broader credit performance. FICO scores are generally obtained at origination of the account and are refreshed monthly or quarterly thereafter to assist in predicting customer behavior. Historically, the Company has noted that a significant portion of delinquent accounts have FICO scores below 660.
The following table provides the most recent FICO scores available for the Company’s customers as a percentage of each class of loan receivables:
 
Credit Risk Profile
by FICO Score
 
660 and 
Above
 
Less than 660
or No Score
At June 30, 2018
 
 
 
Credit card loans
82
%
 
18
%
Personal loans
95
%
 
5
%
Private student loans (excluding PCI)(1)
94
%
 
6
%
 
 
 
 
At December 31, 2017
 
 
 
Credit card loans
82
%
 
18
%
Personal loans
95
%
 
5
%
Private student loans (excluding PCI)(1)
95
%
 
5
%
 
 
 
 
(1)
PCI loans are discussed under the heading "— Purchased Credit-Impaired Loans."

12

Table of Contents

For private student loans, additional credit risk management activities include monitoring the amount of loans in forbearance. Forbearance allows borrowers experiencing temporary financial difficulties and willing to make payments, the ability to temporarily suspend payments. Eligible borrowers have a lifetime cap on forbearance of 12 months. At June 30, 2018 and December 31, 2017, there were $40 million and $29 million, respectively, of private student loans, including PCI, in forbearance, representing 0.7% and 0.5%, respectively, of total student loans in repayment and forbearance.
Allowance for Loan Losses
The following tables provide changes in the Company’s allowance for loan losses (dollars in millions): 
 
For the Three Months Ended June 30, 2018
 
Credit Card
 
Personal Loans
 
Student Loans(1)
 
Other
 
Total
Balance at beginning of period
$
2,252

 
$
301

 
$
170

 
$
13

 
$
2,736

Additions
 
 
 
 
 
 
 
 
 
Provision for loan losses
637

 
84

 
22

 
(1
)
 
742

Deductions
 
 
 
 
 
 
 
 
 
Charge-offs
(684
)
 
(80
)
 
(24
)
 
(1
)
 
(789
)
Recoveries
129

 
8

 
3

 

 
140

Net charge-offs
(555
)
 
(72
)
 
(21
)
 
(1
)
 
(649
)
Other(2)

 

 
(1
)
 

 
(1
)
Balance at end of period
$
2,334

 
$
313

 
$
170

 
$
11

 
$
2,828

 
 
 
 
 
 
 
 
 
 
 
For the Three Months Ended June 30, 2017
 
Credit Card
 
Personal Loans
 
Student Loans(1)
 
Other
 
Total
Balance at beginning of period
$
1,892

 
$
207

 
$
156

 
$
9

 
$
2,264

Additions
 
 
 
 
 
 
 
 
 
Provision for loan losses
533

 
82

 
23

 
2

 
640

Deductions
 
 
 
 
 
 
 
 
 
Charge-offs
(561
)
 
(61
)
 
(22
)
 
(1
)
 
(645
)
Recoveries
116

 
7

 
2

 

 
125

Net charge-offs
(445
)
 
(54
)
 
(20
)
 
(1
)
 
(520
)
Balance at end of period
$
1,980

 
$
235

 
$
159

 
$
10

 
$
2,384

 
 
 
 
 
 
 
 
 
 
(1) Includes both PCI and non-PCI private student loans.
(2) Net change in reserves on PCI pools having no remaining non-accretable difference.

13

Table of Contents

The following tables provide changes in the Company’s allowance for loan losses (dollars in millions): 
 
For the Six Months Ended June 30, 2018
 
Credit Card
 
Personal Loans
 
Student Loans(1)
 
Other
 
Total
Balance at beginning of period
$
2,147

 
$
301

 
$
162

 
$
11

 
$
2,621

Additions
 
 
 
 
 
 
 
 
 
Provision for loan losses
1,282

 
157

 
53

 
1

 
1,493

Deductions
 
 
 
 
 
 
 
 
 
Charge-offs
(1,347
)
 
(161
)
 
(49
)
 
(1
)
 
(1,558
)
Recoveries
252

 
16

 
6

 

 
274

Net charge-offs
(1,095
)
 
(145
)
 
(43
)
 
(1
)
 
(1,284
)
Other(2)

 

 
(2
)
 

 
(2
)
Balance at end of period
$
2,334

 
$
313

 
$
170

 
$
11

 
$
2,828

 
 
 
 
 
 
 
 
 
 
 
For the Six Months Ended June 30, 2017
 
Credit Card
 
Personal Loans
 
Student Loans(1)
 
Other
 
Total
Balance at beginning of period
$
1,790

 
$
200

 
$
158

 
$
19

 
$
2,167

Additions
 
 
 
 
 
 
 
 
 
Provision for loan losses
1,057

 
140

 
35

 
(6
)
 
1,226

Deductions
 
 
 
 
 
 
 
 
 
Charge-offs
(1,096
)
 
(118
)
 
(39
)
 
(3
)
 
(1,256
)
Recoveries
229

 
13

 
5

 

 
247

Net charge-offs
(867
)
 
(105
)
 
(34
)
 
(3
)
 
(1,009
)
Balance at end of period
$
1,980

 
$
235

 
$
159

 
$
10

 
$
2,384

 
 
 
 
 
 
 
 
 
 
(1)
Includes both PCI and non-PCI private student loans.
(2)
Net change in reserves on PCI pools having no remaining non-accretable difference.
Net charge-offs of principal are recorded against the allowance for loan losses, as shown in the preceding table. Information regarding net charge-offs of interest and fee revenues on credit card and other loans is as follows (dollars in millions): 
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
Interest and fees accrued subsequently charged off, net of recoveries (recorded as a reduction of interest income)
$
110

 
$
87

 
$
219

 
$
171

Fees accrued subsequently charged off, net of recoveries (recorded as a reduction to other income)
$
28

 
$
23

 
$
55

 
$
45

 
 
 
 
 
 
 
 

14

Table of Contents

The following tables provide additional detail of the Company’s allowance for loan losses and recorded investment in its loan portfolio by impairment methodology (dollars in millions):
 
Credit Card
 
Personal
Loans
 
Student
Loans(1)
 
Other
Loans
 
Total
At June 30, 2018
 
 
 
 
 
 
 
 
 
Allowance for loans evaluated for impairment as
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment in accordance with ASC 450-20
$
2,074

 
$
276

 
$
121

 
$
4

 
$
2,475

Evaluated for impairment in accordance with
ASC 310-10-35(2)(3)
260

 
37

 
22

 
7

 
326

Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30

 

 
27

 

 
27

Total allowance for loan losses
$
2,334

 
$
313

 
$
170

 
$
11

 
$
2,828

Recorded investment in loans evaluated for impairment as
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment in accordance with ASC 450-20
$
66,114

 
$
7,174

 
$
7,099

 
$
516

 
$
80,903

Evaluated for impairment in accordance with
ASC 310-10-35(2)(3)
1,698

 
130

 
161

 
55

 
2,044

Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30

 

 
1,842

 

 
1,842

Total recorded investment
$
67,812

 
$
7,304

 
$
9,102

 
$
571

 
$
84,789

 
 
 
 
 
 
 
 
 
 
At December 31, 2017
 
 
 
 
 
 
 
 
 
Allowance for loans evaluated for impairment as
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment in accordance with ASC 450-20
$
1,921

 
$
269

 
$
112

 
$
4

 
$
2,306

Evaluated for impairment in accordance with
ASC 310-10-35(2)(3)
226

 
32

 
21

 
7

 
286

Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30

 

 
29

 

 
29

Total allowance for loan losses
$
2,147

 
$
301

 
$
162

 
$
11

 
$
2,621

Recorded investment in loans evaluated for impairment as
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment in accordance with ASC 450-20
$
65,975

 
$
7,263

 
$
6,939

 
$
370

 
$
80,547

Evaluated for impairment in accordance with
ASC 310-10-35(2)(3)
1,316

 
111

 
137

 
53

 
1,617

Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30

 

 
2,084

 

 
2,084

Total recorded investment
$
67,291

 
$
7,374

 
$
9,160

 
$
423

 
$
84,248

 
 
 
 
 
 
 
 
 
 
(1)
Includes both PCI and non-PCI private student loans.
(2)
Loan receivables evaluated for impairment in accordance with ASC 310-10-35 include credit card loans, personal loans and student loans collectively evaluated for impairment in accordance with ASC Subtopic 310-40, Receivables, which consists of modified loans accounted for as TDRs. Other loans are individually evaluated for impairment and generally do not represent TDRs.
(3)
The unpaid principal balance of credit card loans was $1.5 billion and $1.1 billion at June 30, 2018 and December 31, 2017, respectively. The unpaid principal balance of personal loans was $130 million and $109 million at June 30, 2018 and December 31, 2017, respectively. The unpaid principal balance of student loans was $161 million and $135 million at June 30, 2018 and December 31, 2017, respectively. All loans accounted for as TDRs have a related allowance for loan losses.
Troubled Debt Restructurings
The Company has internal loan modification programs that provide relief to credit card, personal loan and student loan borrowers who may be experiencing financial hardship. The Company continually evaluates new programs to determine which of them meet the definition of a TDR. The internal loan modification programs include both temporary and permanent programs, which vary by product. External loan modification programs are also available for credit card and personal loans. Temporary and permanent modifications on credit card and personal loans, as well as temporary modifications on student loans and certain grants of student loan forbearance, result in the loans being considered individually impaired. In addition, loans that defaulted or graduated from modification programs or forbearance are considered to be individually impaired.
For credit card customers, the Company offers temporary hardship programs consisting of an interest rate reduction and in some cases a reduced minimum payment, both lasting for a period no longer than 12 months. The permanent workout program involves changing the structure of the loan to a fixed payment loan with a maturity no longer than 60 months and

15

Table of Contents

reducing the interest rate on the loan. The permanent modification program does not normally provide for the forgiveness of unpaid principal, but may allow for the reversal of certain unpaid interest or fee assessments. The Company also makes permanent loan modifications for customers who request financial assistance through external sources, such as a consumer credit counseling agency program. These loans typically receive a reduced interest rate but continue to be subject to the original minimum payment terms and do not normally include waiver of unpaid principal, interest or fees. Modified credit card loans that are deemed to meet the definition of TDRs includes loans in both temporary and permanent programs.
For personal loan customers, in certain situations the Company offers various payment programs, including temporary and permanent programs. The temporary programs normally consist of a reduction of the minimum payment for a period of no longer than 12 months with the option of a final balloon payment required at the end of the loan term or an extension of the maturity date with the total term not exceeding nine years. Further, in certain circumstances the interest rate on the loan is reduced. The permanent program involves changing the terms of the loan in order to pay off the outstanding balance over a longer term and also in certain circumstances reducing the interest rate on the loan. Similar to the temporary programs, the total term may not exceed nine years. The Company also allows permanent loan modifications for customers who request financial assistance through external sources, similar to the credit card customers discussed above. Payments are modified based on the new terms agreed upon with the credit counseling agency. Personal loans included in temporary and permanent programs are accounted for as TDRs.
To assist student loan borrowers who are experiencing temporary financial difficulties but are willing to resume making payments, the Company may offer hardship forbearance or programs that include payment deferral, temporary payment reduction, temporary interest rate reduction or extended terms. A modified loan typically meets the definition of a TDR based on the cumulative length of the concession period and an evaluation of the credit quality of the borrower, based on FICO scores.
The Company monitors borrower performance after using payment programs or forbearance and the Company believes the programs help to prevent defaults and are useful in assisting customers experiencing financial difficulties. The Company plans to continue to use payment programs and forbearance and, as a result, expects to have additional loans classified as TDRs in the future.

16

Table of Contents

Additional information about modified loans classified as TDRs is shown below (dollars in millions):
 
Average recorded investment in loans
 
Interest income recognized during period loans were impaired(1)
 
Gross interest income that would have been recorded with original terms(2)
For the Three Months Ended June 30, 2018
 
 
 
 
 
Credit card loans(3)
$
1,604

 
$
41

 
$
32

Personal loans
$
125

 
$
3

 
$
2

Private student loans
$
153

 
$
3

 
$

 
 
 
 
 
 
For the Three Months Ended June 30, 2017
 
 
 
 
 
Credit card loans(3)
$
1,137

 
$
25

 
$
22

Personal loans
$
90

 
$
3

 
$
1

Private student loans
$
107

 
$
1

 
$

 
 
 
 
 
 
For the Six Months Ended June 30, 2018
 
 
 
 
 
Credit card loans(3)
$
1,507

 
$
75

 
$
58

Personal loans
$
120

 
$
6

 
$
3

Private student loans
$
147

 
$
6

 
$

 
 
 
 
 
 
For the Six Months Ended June 30, 2017
 
 
 
 
 
Credit card loans(3)
$
1,122

 
$
50

 
$
42

Personal loans
$
87

 
$
5

 
$
2

Private student loans
$
101

 
$
3

 
$

 
 
 
 
 
 
(1)
The Company does not separately track interest income on loans in modification programs. Amounts shown are estimated by applying an average interest rate to the average loans in the various modification programs.
(2)
The Company does not separately track the amount of additional gross interest income that would have been recorded if the loans in modification programs had not been restructured and interest had instead been recorded in accordance with the original terms. Amounts shown are estimated by applying the difference between the average interest rate earned on non-impaired loans and the average interest rate earned on loans in the modification programs to the average loans in the modification programs.
(3)
Includes credit card loans that were modified in TDRs, but are no longer enrolled in a TDR program due to noncompliance with the terms of the modification or due to successful completion of a program after which charging privileges may be reinstated based on customer-level evaluation. The average balance of credit card loans that were no longer enrolled in a TDR program was $397 million and $324 million, respectively, for the three months ended June 30, 2018 and 2017, and $391 million and $317 million, respectively, for the six months ended June 30, 2018 and 2017.


17

Table of Contents

In order to evaluate the primary financial effects that resulted from credit card loans entering into a loan modification program during the three and six months ended June 30, 2018 and 2017, the Company quantified the amount by which interest and fees were reduced during the periods. During the three months ended June 30, 2018 and 2017, the Company forgave approximately $11 million and $10 million, respectively, of interest and fees as a result of accounts entering into a credit card loan modification program. During the six months ended June 30, 2018 and 2017, the Company forgave approximately $23 million and $21 million, respectively, of interest and fees as a result of accounts entering into a credit card loan modification program.
The following table provides information on loans that entered a loan modification program during the period (dollars in millions):
 
For the Three Months Ended June 30,
 
2018
 
2017
 
Number of Accounts
 
Balances
 
Number of Accounts
 
Balances
Accounts that entered a loan modification program during the period
 
 
 
 
 
 
 
Credit card loans
56,003

 
$
363

 
26,078

 
$
157

Personal loans
1,836

 
$
23

 
1,430

 
$
18

Private student loans
1,046

 
$
21

 
1,003

 
$
18

 
 
 
 
 
 
 
 
 
For the Six Months Ended June 30,
 
2018
 
2017
 
Number of Accounts
 
Balances
 
Number of Accounts
 
Balances
Accounts that entered a loan modification program during the period
 
 
 
 
 
 
 
Credit card loans
116,058

 
$
743

 
56,971

 
$
338

Personal loans
3,964

 
$
52

 
2,993

 
$
36

Private student loans
1,952

 
$
37

 
2,020

 
$
35

 
 
 
 
 
 
 
 

18

Table of Contents

The following table presents the carrying value of loans that experienced a payment default during the period that had been modified in a TDR during the 15 months preceding the end of each period (dollars in millions):
 
For the Three Months Ended June 30,
 
2018
 
2017
 
Number of Accounts
 
Aggregated Outstanding Balances Upon Default
 
Number of Accounts
 
Aggregated Outstanding Balances Upon Default
TDRs that subsequently defaulted
 
 
 
 
 
 
 
Credit card loans(1)(2)
8,970

 
$
49

 
8,049

 
$
43

Personal loans(2)
637

 
$
8

 
341

 
$
4

Private student loans(3)
204

 
$
3

 
184

 
$
3

 
 
 
 
 
 
 
 
 
For the Six Months Ended June 30,
 
2018
 
2017
 
Number of Accounts
 
Aggregated Outstanding Balances Upon Default
 
Number of Accounts
 
Aggregated Outstanding Balances Upon Default
TDRs that subsequently defaulted
 
 
 
 
 
 
 
Credit card loans(1)(2)
17,784

 
$
96

 
16,215

 
$
87

Personal loans(2)
1,212

 
$
16

 
648

 
$
8

Private student loans(3)
475

 
$
8

 
369

 
$
6

 
 
 
 
 
 
 
 
(1)
Terms revert back to the pre-modification terms for customers who default from a temporary program and charging privileges remain revoked in most cases.
(2)
For credit card loans and personal loans, a customer defaults from a modification program after two consecutive missed payments. The outstanding balance upon default is generally the loan balance at the end of the month prior to default.
(3)
For student loans, defaults have been defined as loans that are 60 or more days delinquent. The outstanding balance upon default is generally the loan balance at the end of the month prior to default.
Of the account balances that defaulted as shown above for the three months ended June 30, 2018 and 2017, approximately 34% and 39%, respectively, of the total balances were charged off at the end of the month in which they defaulted. Of the account balances that defaulted as shown above for the six months ended June 30, 2018 and 2017, approximately 36% and 39%, respectively, of the total balances were charged off at the end of the month in which they defaulted. For accounts that have defaulted from a loan modification program and have not been subsequently charged off, the balances are included in the allowance for loan loss analysis discussed above under "— Allowance for Loan Losses."
Purchased Credit-Impaired Loans
Purchased loans with evidence of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are considered impaired at acquisition and are reported as PCI loans. The private student loans acquired in the SLC transaction, as well as the additional acquired private student loan portfolio comprise the Company’s only PCI loans at June 30, 2018 and December 31, 2017. Total PCI student loans had an outstanding balance of $1.9 billion and $2.2 billion, including accrued interest, and a related carrying amount of $1.8 billion and $2.1 billion as of June 30, 2018 and December 31, 2017, respectively.
The following table provides changes in accretable yield for the acquired loans during each period (dollars in millions):
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
Balance at beginning of period
$
633

 
$
755

 
$
669

 
$
796

Accretion into interest income
(36
)
 
(40
)
 
(72
)
 
(81
)
Other changes in expected cash flows
11

 
10

 
11

 
10

Balance at end of period
$
608

 
$
725

 
$
608

 
$
725

 
 
 
 
 
 
 
 
Periodically, the Company updates the estimate of cash flows expected to be collected based on management's latest expectations of future net credit losses, borrower prepayments and certain other assumptions that affect cash flows. No

19

Table of Contents

provision expense was recorded during the three and six months ended June 30, 2018 and 2017. The allowance for PCI loan losses at June 30, 2018 and December 31, 2017 was $27 million and $29 million, respectively. For the three and six months ended June 30, 2018 and 2017, the increase in accretable yield was primarily driven by increases in rates on variable rate loans during the first half of 2018 and 2017. Changes to accretable yield are recognized prospectively as an adjustment to yield over the remaining life of the pools.
At June 30, 2018, the 30 or more days delinquency and 90 or more days delinquency rates on PCI student loans (which include loans not yet in repayment) were 2.61% and 0.64%, respectively. At December 31, 2017, the 30 or more days delinquency and 90 or more days delinquency rates on PCI student loans (which include loans not yet in repayment) were 3.24% and 0.93%, respectively. These rates include private student loans that are greater than 120 days delinquent that are covered by an indemnification agreement or insurance arrangements through which the Company expects to recover a substantial portion of the loan. The net charge-off rate on PCI student loans was 0.31% and 0.64% for the three months ended June 30, 2018 and 2017, respectively, and 0.66% and 0.58% for the six months ended June 30, 2018 and 2017, respectively.
4.
Credit Card and Student Loan Securitization Activities
The Company’s securitizations are accounted for as secured borrowings and the related trusts are treated as consolidated subsidiaries of the Company. For a description of the Company’s principles of consolidation with respect to VIEs, see Note 1: Background and Basis of Presentation of the Company’s annual report on Form 10-K for the year ended December 31, 2017.
Credit Card Securitization Activities
The Company accesses the term asset securitization market through the Discover Card Master Trust I (“DCMT”) and the Discover Card Execution Note Trust (“DCENT”). Credit card loan receivables are transferred into DCMT and beneficial interests in DCMT are transferred into DCENT. DCENT issues debt securities to investors that are reported in long-term borrowings.
The DCENT debt structure consists of four classes of securities (DiscoverSeries Class A, B, C and D notes), with the most senior class generally receiving a triple-A rating. In order to issue senior, higher rated classes of notes, it is necessary to obtain the appropriate amount of credit enhancement, generally through the issuance of junior, lower rated or more highly subordinated classes of notes. The subordinated classes are held by wholly-owned subsidiaries of Discover Bank. The Company is exposed to credit-related risk of loss associated with trust assets as of the balance sheet date through the retention of these subordinated interests. The estimated probable incurred loss is included in the allowance for loan losses estimate.
The Company’s retained interests in the assets of the trusts, consisting of investments in DCENT notes held by subsidiaries of Discover Bank, constitute intercompany positions, which are eliminated in the preparation of the Company’s condensed consolidated statements of financial condition.
Upon transfer of credit card loan receivables to the trust, the receivables and certain cash flows derived from them become restricted for use in meeting obligations to the trusts’ creditors. Further, the transferred credit card loan receivables are owned by the trust and are not available to third-party creditors of the Company. The trusts have ownership of cash balances, the amounts of which are reported in restricted cash. With the exception of the seller’s interest in trust receivables, the Company’s interests in trust assets are generally subordinate to the interests of third-party investors and, as such, may not be realized by the Company if needed to absorb deficiencies in cash flows that are allocated to the investors in the trusts’ debt. Apart from the restricted assets related to securitization activities, the investors and the securitization trusts have no recourse to the Company’s other assets or the Company's general credit for a shortage in cash flows.

20

Table of Contents

The carrying values of these restricted assets, which are presented on the Company’s condensed consolidated statements of financial condition as relating to securitization activities, are shown in the following table (dollars in millions):
 
June 30,
2018
 
December 31,
2017
Restricted cash
$
579

 
$
26

 
 
 
 
Investors’ interests held by third-party investors
15,975

 
16,025

Investors’ interests held by wholly-owned subsidiaries of Discover Bank
5,129

 
5,133

Seller’s interest
8,378

 
9,861

Loan receivables(1)
29,482

 
31,019

Allowance for loan losses allocated to securitized loan receivables(1)
(1,020
)
 
(998
)
Net loan receivables
28,462

 
30,021

Other
6

 
5

Carrying value of assets of consolidated variable interest entities
$
29,047

 
$
30,052

 
 
 
 
(1)
The Company maintains its allowance for loan losses at an amount sufficient to absorb probable losses inherent in all loan receivables, which includes all loan receivables in the trusts. Therefore, credit risk associated with the transferred receivables is fully reflected on the Company’s balance sheet in accordance with GAAP.
The debt securities issued by the consolidated trusts are subject to credit, payment and interest rate risks on the transferred credit card loan receivables. To protect investors in the securities, there are certain features or triggering events that could cause an early amortization of the debt securities, including triggers related to the impact of the performance of the trust receivables on the availability and adequacy of cash flows to meet contractual requirements. As of June 30, 2018, no economic or other early amortization events have occurred.
The Company continues to own and service the accounts that generate the loan receivables held by the trusts. Discover Bank receives servicing fees from the trusts based on a percentage of the monthly investor principal balance outstanding. Although the fee income to Discover Bank offsets the fee expense to the trusts and thus is eliminated in consolidation, failure to service the transferred loan receivables in accordance with contractual requirements could lead to a termination of the servicing rights and the loss of future servicing income, net of related expenses.
Student Loan Securitization Activities
Student loan trust receivables underlying third-party investors’ interests are recorded in PCI loans and the related debt issued by the trusts is reported in long-term borrowings. The assets of the trusts are restricted from being sold or pledged as collateral for other borrowings and the cash flows from these restricted assets may be used only to pay obligations of the trusts. With the exception of the trusts’ restricted assets, the trusts and investors have no recourse to the Company’s other assets or the Company's general credit for a shortage in cash flows.
Currently there are two trusts from which securities were issued to investors. Principal payments on the long-term secured borrowings are made as cash is collected on the underlying loans that are used as collateral on the secured borrowings. The Company does not have access to cash collected by the securitization trusts until cash is released in accordance with the trust indenture agreements. Similar to the credit card securitizations, the Company continues to own and service the accounts that generate the student loan receivables held by the trusts and receives servicing fees from the trusts based on either a percentage of the principal balance outstanding or a flat fee per borrower. Although the servicing fee income offsets the fee expense related to the trusts and thus is eliminated in consolidation, failure to service the transferred loan receivables in accordance with contractual requirements could lead to a termination of the servicing rights and the loss of future servicing income, net of related expenses.
Under terms of all the trust arrangements, the Company has the option, but not the obligation, to provide financial support to the trusts, but has never provided such support. A substantial portion of the credit risk associated with the securitized loans has been transferred to third parties under private credit insurance or indemnification arrangements.

21

Table of Contents

The carrying values of these restricted assets, which are presented on the Company’s condensed consolidated statements of financial condition as relating to securitization activities, are shown in the following table (dollars in millions): 
 
June 30,
2018
 
December 31,
2017
Restricted cash
$
51

 
$
55

Student loan receivables
669

 
762

Carrying value of assets of consolidated variable interest entities
$
720

 
$
817

 
 
 
 
5.
Deposits
The Company offers its deposit products to customers through two channels: (i) through direct marketing, internet origination and affinity relationships (“direct-to-consumer deposits”); and (ii) indirectly through contractual arrangements with securities brokerage firms (“brokered deposits”). Direct-to-consumer deposits include certificates of deposit, money market accounts, online savings and checking accounts and IRA certificates of deposit, while brokered deposits include certificates of deposit and sweep accounts.
The following table provides a summary of interest-bearing deposit accounts (dollars in millions):
 
June 30,
2018
 
December 31,
2017
Certificates of deposit in amounts less than $100,000
$
23,740

 
$
23,768

Certificates of deposit in amounts $100,000 or greater(1)
6,258

 
5,984

Savings deposits, including money market deposit accounts
31,070

 
28,413

Total interest-bearing deposits
$
61,068

 
$
58,165

 
 
 
 
(1)
Includes $1.5 billion and $1.4 billion in certificates of deposit equal to or greater than $250,000, the Federal Deposit Insurance Corporation ("FDIC") insurance limit, as of June 30, 2018 and December 31, 2017, respectively.
The following table summarizes certificates of deposit in amounts of $100,000 or greater by contractual maturity (dollars in millions):
Maturity Period
June 30, 2018
Three months or less
$
880

Over three months through six months
826

Over six months through twelve months
1,932

Over twelve months
2,620

Total
$
6,258

 
 
The following table summarizes certificates of deposit maturing over the remainder of this year, over each of the next four years, and thereafter (dollars in millions):
Year
June 30, 2018
2018
$
6,672

2019
9,097

2020
5,095

2021
3,573

2022
2,298

Thereafter
3,263

Total
$
29,998

 
 

22

Table of Contents

6.
Long-Term Borrowings
Long-term borrowings consist of borrowings having original maturities of one year or more. The following table provides a summary of the Company’s long-term borrowings and weighted-average interest rates on outstanding balances (dollars in millions):
 
June 30, 2018
 
December 31, 2017
 
Maturity
 
Interest
Rate
 
Weighted-Average Interest Rate
 
Outstanding Amount
 
Outstanding Amount
Securitized Debt
 
 
 
 
 
 
 
 
 
Fixed-rate asset-backed securities(1)
2018-2024
 
1.39%-3.03%
 
1.92%
 
$
9,472

 
$
8,888

Floating-rate asset-backed securities(2)(3)
2018-2024
 
2.30%-2.67%
 
2.50%
 
6,362

 
7,038

Total Discover Card Master Trust I and Discover Card Execution Note Trust
 
 
 
 
 
 
15,834

 
15,926

 
 
 
 
 
 
 
 
 
 
Floating-rate asset-backed securities(4)(5)(6)
2031-2036
 
2.65%-5.75%
 
3.97%
 
531

 
610

Total SLC Private Student Loan Trusts
 
 
 
 
 
 
531

 
610

Total long-term borrowings - owed to securitization investors
 
 
 
 
 
 
16,365

 
16,536

 
 
 
 
 
 
 
 
 
 
Discover Financial Services (Parent Company)
 
 
 
 
 
 
 
 
 
Fixed-rate senior notes
2019-2027
 
3.75%-10.25%
 
4.25%
 
2,726

 
2,710

Fixed-rate retail notes
2018-2031
 
2.85%-4.60%
 
3.73%
 
348

 
302

 
 
 
 
 
 
 
 
 
 
Discover Bank
 
 
 
 
 
 
 
 
 
Fixed-rate senior bank notes(1)
2018-2026
 
2.60%-4.25%
 
3.37%
 
6,115

 
6,080

Fixed-rate subordinated bank notes
2019-2020
 
7.00%-8.70%
 
7.49%
 
698

 
698

Total long-term borrowings
 
 
 
 
 
 
$
26,252

 
$
26,326

 
 
 
 
 
 
 
 
 
 
(1)
The Company uses interest rate swaps to hedge portions of these long-term borrowings against changes in fair value attributable to changes in London Interbank Offered Rate ("LIBOR"). Use of these interest rate swaps impacts carrying value of the debt. See Note 14: Derivatives and Hedging Activities.
(2)
Discover Card Execution Note Trust floating-rate asset-backed securities include issuances with the following interest rate terms: 1-month LIBOR + 23 to 60 basis points as of June 30, 2018.
(3)
The Company uses interest rate swaps to manage its exposure to changes in interest rates related to future cash flows resulting from interest payments on a portion of these long-term borrowings. There is no impact on debt carrying value from use of these interest rate swaps. See Note 14: Derivatives and Hedging Activities.
(4)
SLC Private Student Loan Trusts floating-rate asset-backed securities include issuances with the following interest rate terms: 3-month LIBOR + 30 to 45 basis points and Prime rate + 100 basis points as of June 30, 2018.
(5)
Repayment of this debt is dependent upon the timing of principal and interest payments on the underlying student loans. The dates shown represent final maturity dates.
(6)
Includes $216 million of senior notes maturing in 2031 and $315 million of senior and subordinated notes maturing in 2036 as of June 30, 2018.

The following table summarizes long-term borrowings maturing over the remainder of this year, over each of the next four years, and thereafter (dollars in millions):
Year
June 30, 2018
2018
$
2,773

2019
5,993

2020
4,688

2021
1,564

2022
2,784

Thereafter
8,450

Total
$
26,252

 
 
The Company has access to committed borrowing capacity through private securitizations to support the funding of its credit card loan receivables. As of June 30, 2018, the total commitment of secured credit facilities through private providers was $6.0 billion, none of which was drawn as of June 30, 2018. Access to the unused portions of the secured credit facilities is subject to the terms of the agreements with each of the providers, which have various expirations in calendar years 2019

23

Table of Contents

through 2020. Borrowings outstanding under each facility bear interest at a margin above LIBOR or the asset-backed commercial paper costs of each individual conduit provider. The terms of each agreement provide for a commitment fee to be paid on the unused capacity and include various affirmative and negative covenants, including performance metrics and legal requirements similar to those required to issue any term securitization transaction.
7.
Accumulated Other Comprehensive Income
Changes in each component of AOCI were as follows (dollars in millions):
 
Unrealized Loss on Available-for-Sale Investment Securities, Net of Tax
 
Gain (Loss) on Cash Flow Hedges, Net of Tax
 
Loss on Pension Plan, Net of Tax
 
AOCI
For the Three Months Ended June 30, 2018
 
 
 
 
 
 
 
Balance at March 31, 2018
$
(12
)
 
$
29

 
$
(156
)
 
$
(139
)
Cumulative effect of ASU No. 2018-02 adoption(1)
(1
)
 
3

 
(31
)
 
(29
)
Net change
(1
)
 
7

 

 
6

Balance at June 30, 2018
$
(14
)

$
39


$
(187
)

$
(162
)
 
 
 
 
 
 
 
 
For the Three Months Ended June 30, 2017
 
 
 
 
 
 
 
Balance at March 31, 2017
$
(2
)
 
$
(8
)
 
$
(145
)
 
$
(155
)
Net change

 
5

 

 
5

Balance at June 30, 2017
$
(2
)
 
$
(3
)
 
$
(145
)
 
$
(150
)
 
 
 
 
 
 
 
 
For the Six Months Ended June 30, 2018
 
 
 
 
 
 
 
Balance at December 31, 2017
$
(5
)
 
$
10

 
$
(157
)
 
$
(152
)
Cumulative effect of ASU No. 2018-02 adoption(1)
(1
)
 
3

 
(31
)
 
(29
)
Net change
(8
)
 
26

 
1

 
19

Balance at June 30, 2018
$
(14
)
 
$
39

 
$
(187
)
 
$
(162
)
 
 
 
 
 
 
 
 
For the Six Months Ended June 30, 2017
 
 
 
 
 
 
 
Balance at December 31, 2016
$
(3
)
 
$
(13
)
 
$
(145
)
 
$
(161
)
Net change
1

 
10

 

 
11

Balance at June 30, 2017
$
(2
)
 
$
(3
)
 
$
(145
)
 
$
(150
)
 
 
 
 
 
 
 
 
(1)
Represents the adjustment to AOCI as a result of adoption of ASU No. 2018-02 in the second quarter of 2018. See Note 1: Background and Basis of Presentation for additional information.

24

Table of Contents

The following table presents each component of other comprehensive income (loss) ("OCI") before reclassifications and amounts reclassified from AOCI for each component of OCI before- and after-tax (dollars in millions):
 
Before Tax
 
Tax Benefit (Expense)
 
Net of Tax
For the Three Months Ended June 30, 2018
 
 
 
 
 
Available-for-Sale Investment Securities
 
 
 
 
 
Net unrealized holding loss arising during the period
$
(1
)
 
$

 
$
(1
)
Net change
$
(1
)
 
$

 
$
(1
)
Cash Flow Hedges
 
 
 
 
 
Net unrealized gain arising during the period
$
10

 
$
(2
)
 
$
8

Amounts reclassified from AOCI
(1
)
 

 
(1
)
Net change
$
9

 
$
(2
)
 
$
7

 
 
 
 
 
 
For the Three Months Ended June 30, 2017
 
 
 
 
 
Cash Flow Hedges
 
 
 
 
 
Net unrealized gain arising during the period
$
3

 
$
(1
)
 
$
2

Amounts reclassified from AOCI
3

 

 
3

Net change
$
6

 
$
(1
)
 
$
5

 
 
 
 
 
 
For the Six Months Ended June 30, 2018
 
 
 
 
 
Available-for-Sale Investment Securities
 
 
 
 
 
Net unrealized holding loss arising during the period
$
(10
)
 
$
2

 
$
(8
)
Net change
$
(10
)
 
$
2

 
$
(8
)
Cash Flow Hedges
 
 
 
 
 
Net unrealized gain arising during the period
$
34

 
$
(8
)
 
$
26

Net change
$
34

 
$
(8
)
 
$
26

Pension Plan
 
 
 
 
 
Unrealized gain arising during the period
$
1

 
$

 
$
1

Net change
$
1

 
$

 
$
1

 
 
 
 
 
 
For the Six Months Ended June 30, 2017
 
Available-for-Sale Investment Securities
 
 
 
 
 
Net unrealized holding gain arising during the period
$
2

 
$
(1
)
 
$
1

Net change
$
2

 
$
(1
)
 
$
1

Cash Flow Hedges
 
 
 
 
 
Net unrealized gain arising during the period
$
9

 
$
(4
)
 
$
5

Amounts reclassified from AOCI
8

 
(3
)
 
5

Net change
$
17

 
$
(7
)
 
$
10

 
 
 
 
 
 

25

Table of Contents

8.
Income Taxes
The following table presents the calculation of the Company's effective income tax rate (dollars in millions, except effective income tax rate):
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
Income before income tax expense
$
877

 
$
867

 
$
1,733

 
$
1,735

Income tax expense
$
208

 
$
321

 
$
398

 
$
625

Effective income tax rate
23.7
%
 
37.1
%
 
23.0
%
 
36.0
%
 
 
 
 
 
 
 
 
Income tax expense decreased $113 million and $227 million, respectively, for the three and six months ended June 30, 2018, as compared to the same periods in 2017. The effective tax rates decreased 13.4% and 13.0%, respectively, for the three and six months ended June 30, 2018 as compared to the same periods in 2017. The decrease in rates is primarily due to a reduction in the U.S. federal statutory income tax rate from 35% to 21% offset by other effects of TCJA. For the six months ended June 30, 2018, the effective tax rate was also favorably impacted by the resolution of certain tax matters.
The Company is subject to examination by the Internal Revenue Service ("IRS") and tax authorities in various state, local and foreign tax jurisdictions. The Company regularly assesses the likelihood of additional assessments or settlements in each of the taxing jurisdictions resulting from these and subsequent years' examinations. The IRS is currently examining the years 2011-2015. At this time, the potential change in unrecognized tax benefits is not expected to be significant over the next 12 months. The Company believes that its reserves are sufficient to cover any tax, penalties and interest that would result from such examinations.
9.
Earnings Per Share
The following table presents the calculation of basic and diluted earnings per share ("EPS") (in millions, except per share amounts):
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
Numerator
 
 
 
 
 
 
 
Net income
$
669

 
$
546

 
$
1,335

 
$
1,110

Preferred stock dividends

 
(10
)
 
(16
)
 
(19
)
Net income available to common stockholders
669

 
536

 
1,319

 
1,091

Income allocated to participating securities
(6
)
 
(4
)
 
(10
)
 
(8
)
Net income allocated to common stockholders
$
663

 
$
532

 
$
1,309

 
$
1,083

Denominator
 
 
 
 
 
 
 
Weighted-average shares of common stock outstanding
348

 
379

 
351

 
382

Weighted-average shares of common stock outstanding and common stock equivalents
348

 
379

 
351

 
382

 
 
 
 
 
 
 
 
Basic earnings per common share
$
1.91

 
$
1.41

 
$
3.73

 
$
2.83

Diluted earnings per common share
$
1.91

 
$
1.40

 
$
3.72

 
$
2.83

 
 
 
 
 
 
 
 
There were no anti-dilutive securities on the computation of diluted EPS for the three and six months ended June 30, 2018 and 2017.

26

Table of Contents

10.
Capital Adequacy
The Company is subject to the capital adequacy guidelines of the Federal Reserve, and Discover Bank, the Company’s main banking subsidiary, is subject to various regulatory capital requirements as administered by the FDIC. Failure to meet minimum capital requirements can result in the initiation of certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial position and results of the Company and Discover Bank. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and Discover Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items, as calculated under regulatory guidelines. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
In 2013, the Federal Reserve, the Office of the Comptroller of the Currency, and the FDIC issued final capital rules under the Basel Committee’s December 2010 framework (referred to as “Basel III”) establishing a new comprehensive capital framework for U.S. banking organizations. The final capital rules ("Basel III rules") substantially revise Basel I rules regarding the risk-based capital requirements applicable to bank holding companies and depository institutions, including the Company. The Basel III rules, which became effective for the Company on January 1, 2015, are subject to phase-in periods through the end of 2018 (the "transition period"). This timing is based on the Company being classified as a "Standardized Approach" entity.
Among other things, the Basel III rules (i) introduced a new capital measure called Common Equity Tier 1 (“CET1”), (ii) specify that Tier 1 capital consists of CET1 and additional Tier 1 capital instruments meeting specified requirements, (iii) apply most deductions/adjustments to regulatory capital measures to CET1 and not to the other components of capital, thus potentially requiring higher levels of CET1 in order to meet minimum ratios and (iv) expand the scope of the deductions/adjustments from capital as compared to existing regulations.
The Basel III minimum capital ratios are as follows:
8.0% Total capital (i.e., Tier 1 plus Tier 2) to risk-weighted assets;
6.0% Tier 1 capital (i.e., CET1 plus Additional Tier 1) to risk-weighted assets;
4.0% Tier 1 capital to average consolidated assets as reported on consolidated financial statements (known as the “leverage ratio”); and
4.5% CET1 to risk-weighted assets.
As of June 30, 2018, the Company and Discover Bank met all Basel III minimum capital ratio requirements to which they were subject. The Company and Discover Bank also met the requirements to be considered "well-capitalized" under Regulation Y and prompt corrective action regulations, respectively, and there have been no conditions or events that management believes have changed the Company's or Discover Bank's category. To be categorized as “well-capitalized,” the Company and Discover Bank must maintain minimum capital ratios as set forth in the table below.

27

Table of Contents

The following table shows the actual capital amounts and ratios of the Company and Discover Bank and comparisons of each to the regulatory minimum and “well-capitalized” requirements (dollars in millions): 
 
Actual
 
Minimum Capital
Requirements
 
Capital Requirements
To Be Classified as
Well-Capitalized
 
Amount
 
Ratio(1)
 
Amount
 
Ratio
 
Amount(2)
 
Ratio(2)
June 30, 2018
 
 
 
 
 
 
 
 
 
 
 
Total capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
11,872

 
13.6
%
 
$
6,958

 
≥8.0%
 
$
8,698

 
≥10.0%
Discover Bank
$
12,455

 
14.5
%
 
$
6,883

 
≥8.0%
 
$
8,604

 
≥10.0%
Tier 1 capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
10,659

 
12.3
%
 
$
5,219

 
≥6.0%
 
$
5,219

 
≥6.0%
Discover Bank
$
10,718

 
12.5
%
 
$
5,163

 
≥6.0%
 
$
6,883

 
≥8.0%
Tier 1 capital (to average assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
10,659

 
10.5
%
 
$
4,063

 
≥4.0%
 
N/A

 
N/A
Discover Bank
$
10,718

 
10.7
%
 
$
4,022

 
≥4.0%
 
$
5,028

 
≥5.0%
CET1 capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
10,096

 
11.6
%
 
$
3,914

 
≥4.5%
 
N/A

 
N/A
Discover Bank
$
10,718

 
12.5
%
 
$
3,872

 
≥4.5%
 
$
5,593

 
≥6.5%
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Total capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
11,952

 
13.8
%
 
$
6,946

 
≥8.0%
 
$
8,683

 
≥10.0%
Discover Bank
$
12,364

 
14.4
%
 
$
6,872

 
≥8.0%
 
$
8,589

 
≥10.0%
Tier 1 capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
10,677

 
12.3
%
 
$
5,210

 
≥6.0%
 
$
5,210

 
≥6.0%
Discover Bank
$
10,533

 
12.3
%
 
$
5,154

 
≥6.0%
 
$
6,872

 
≥8.0%
Tier 1 capital (to average assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
10,677

 
10.8
%
 
$
3,949

 
≥4.0%
 
N/A

 
N/A
Discover Bank
$
10,533

 
10.8
%
 
$
3,912

 
≥4.0%
 
$
4,890

 
≥5.0%
CET1 capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
10,114

 
11.6
%
 
$
3,907

 
≥4.5%
 
N/A

 
N/A
Discover Bank
$
10,533

 
12.3
%
 
$
3,865

 
≥4.5%
 
$
5,583

 
≥6.5%
 
 
 
 
 
 
 
 
 
 
 
 
(1)
Capital ratios are calculated based on the Basel III Standardized Approach rules, subject to applicable transition provisions.
(2)
The Basel III rules do not establish well-capitalized thresholds for these measures for bank holding companies. Existing well-capitalized thresholds established in the Federal Reserve's Regulation Y have been included where available.
11.
Commitments, Contingencies and Guarantees
In the normal course of business, the Company enters into a number of off-balance sheet commitments, transactions and obligations under guarantee arrangements that expose the Company to varying degrees of risk. The Company's commitments, contingencies and guarantee relationships are described below.

28

Table of Contents

Commitments
Lease Commitments
The Company leases various office space and equipment under capital and non-cancelable operating leases, which expire at various dates through 2029. Future minimum payments on capital leases were not material at June 30, 2018. The following table shows future minimum payments on non-cancelable operating leases with original terms in excess of one year (dollars in millions): 
 
June 30, 2018
2018
$
7

2019
13

2020
11

2021
10

2022
7

Thereafter
41

Total minimum lease payments
$
89

 
 
Unused Credit Arrangements
At June 30, 2018, the Company had unused credit arrangements for loans of approximately $194.3 billion. Such arrangements arise primarily from agreements with customers for unused lines of credit on certain credit cards and certain other loan products, provided there is no violation of conditions in the related agreements. These arrangements, substantially all of which the Company can terminate at any time and which do not necessarily represent future cash requirements, are periodically reviewed based on account usage, customer creditworthiness and loan qualification.
Contingencies
See Note 12: Litigation and Regulatory Matters for a description of potential liability arising from pending litigation or regulatory proceedings involving the Company.
Guarantees
The Company has obligations under certain guarantee arrangements, including contracts, indemnification agreements, and representations and warranties, which contingently require the Company to make payments to the guaranteed party based on changes in an underlying asset, liability or equity security of a guaranteed party, rate or index. Also included as guarantees are contracts that contingently require the Company to make payments to a guaranteed party based on another entity's failure to perform under an agreement. The Company's use of guarantees is disclosed below by type of guarantee.
Securitizations Representations and Warranties
As part of the Company’s financing activities, the Company provides representations and warranties that certain assets pledged as collateral in secured borrowing arrangements conform to specified guidelines. Due diligence is performed by the Company, which is intended to ensure that asset guideline qualifications are met. If the assets pledged as collateral do not meet certain conforming guidelines, the Company may be required to replace, repurchase or sell such assets. In its credit card securitization activities, the Company would replace nonconforming receivables through the allocation of excess seller’s interest or from additional transfers from the unrestricted pool of receivables. If the Company could not add enough receivables to satisfy the requirement, an early amortization (or repayment) of investors’ interests would be triggered. In its student loan securitizations, the Company would generally repurchase the loans from the trust at the outstanding principal amount plus interest.
The maximum potential amount of future payments the Company could be required to make would be equal to the current outstanding balances of third-party investor interests in credit card asset-backed securities, and the principal amount of any student loan secured borrowings, plus any unpaid interest for the corresponding secured borrowings. The Company has recorded substantially all of the maximum potential amount of future payments in long-term borrowings on the Company’s condensed consolidated statements of financial condition. The Company has not recorded any incremental contingent liability associated with its secured borrowing representations and warranties. Management believes that the

29

Table of Contents

probability of having to replace, repurchase or sell assets pledged as collateral under secured borrowing arrangements, including an early amortization event, is low.
Mortgage Loans Representations and Warranties
The Company sold loans it originated to investors on a servicing-released basis and the risk of loss or default by the borrower is generally transferred to the investor. However, the Company was required by these investors to make certain representations and warranties relating to credit information, loan documentation and collateral. These representations and warranties may extend through the contractual life of the mortgage loan, even though the Company closed the mortgage origination business in 2015. Subsequent to the sale, if underwriting deficiencies, borrower fraud or documentation defects are discovered in individual mortgage loans, the Company may be obligated to repurchase the respective mortgage loan or indemnify the investors for any losses from borrower defaults if such deficiency or defect cannot be cured within the specified period following discovery. The Company has established a repurchase reserve based on expected losses. At June 30, 2018, this amount was not material and was included in accrued expenses and other liabilities on the condensed consolidated statements of financial condition.
Counterparty Settlement Guarantees
Diners Club and DFS Services LLC (on behalf of PULSE) have various counterparty exposures, which are listed below.
Merchant Guarantee. Diners Club has entered into contractual relationships with certain international merchants, which generally include travel-related businesses, for the benefit of all Diners Club licensees. The licensees hold the primary liability to settle the transactions of their customers with these merchants. However, Diners Club retains a counterparty exposure if a licensee fails to meet its financial payment obligation to one of these merchants.
ATM Guarantee. PULSE entered into contractual relationships with certain international ATM acquirers in which DFS Services LLC retains counterparty exposure if an issuer fails to fulfill its settlement obligation.
Network Alliance Guarantee. Discover Network, Diners Club and PULSE have entered into contractual relationships with certain international payment networks in which DFS Services LLC retains the counterparty exposure if a network fails to fulfill its settlement obligation.
The maximum potential amount of future payments related to such contingent obligations is dependent upon the transaction volume processed between the time a potential counterparty defaults on its settlement and the time at which the Company disables the settlement of any further transactions for the defaulting party. However, there is no limitation on the maximum amount the Company may be liable to pay. The actual amount of the potential exposure cannot be quantified as the Company cannot determine whether particular counterparties will fail to meet their settlement obligations.
While the Company has some contractual remedies to offset these counterparty settlement exposures (such as letters of credit or pledged deposits), in the event that all licensees and/or issuers were to become unable to settle their transactions, the Company estimates its maximum potential counterparty exposures to these settlement guarantees, based on historical transaction volume, would be $149 million for merchant guarantees as of June 30, 2018. The maximum potential counterparty exposures to these settlement guarantees for ATM guarantees would be immaterial as of June 30, 2018. The maximum potential counterparty exposures for network alliance guarantees would be $31 million as of June 30, 2018.
The Company believes that the estimated amounts of maximum potential future payments are not representative of the Company's actual potential loss exposure given Diners Club's and PULSE's insignificant historical losses from these counterparty exposures. As of June 30, 2018, the Company had not recorded any contingent liability in the consolidated financial statements for these counterparty exposures, and management believes that the probability of any payments under these arrangements is low.
Discover Network Merchant Chargeback Guarantees
The Company operates the Discover Network, issues payment cards and permits third parties to issue payment cards. The Company is contingently liable for certain transactions processed on the Discover Network in the event of a dispute between the payment card customer and a merchant. The contingent liability arises if the disputed transaction involves a merchant or merchant acquirer with whom the Discover Network has a direct relationship. If a dispute is resolved in the

30

Table of Contents

customer’s favor, the Discover Network will credit or refund the disputed amount to the Discover Network card issuer, who in turn credits its customer’s account. The Discover Network will then charge back the disputed amount of the payment card transaction to the merchant or merchant acquirer, where permitted by the applicable agreement, to seek recovery of amounts already paid to the merchant for payment card transactions. If the Discover Network is unable to collect the amount subject to dispute from the merchant or merchant acquirer (e.g., in the event of merchant default or dissolution or after expiration of the time period for chargebacks in the applicable agreement), the Discover Network will bear the loss for the amount credited or refunded to the customer. In most instances, a loss by the Discover Network is unlikely to arise in connection with payments on card transactions because most products or services are delivered when purchased and credits are issued by merchants on returned items in a timely fashion, thus minimizing the likelihood of cardholder disputes with respect to amounts paid by the Discover Network. However, where the product or service is not scheduled to be provided to the customer until a later date following the purchase, the likelihood of a contingent payment obligation by the Discover Network increases. Losses related to merchant chargebacks were not material for the three and six months ended June 30, 2018 and 2017.
The maximum potential amount of obligations of the Discover Network arising as a result of such contingent obligations is estimated to be the portion of the total Discover Network transaction volume processed to date for which timely and valid disputes may be raised under applicable law and relevant issuer and customer agreements. There is no limitation on the maximum amount the Company may be liable to pay to issuers. However, the Company believes that such amount is not representative of the Company’s actual potential loss exposure based on the Company’s historical experience. The actual amount of the potential exposure cannot be quantified as the Company cannot determine whether the current or cumulative transaction volumes may include or result in disputed transactions.
The following table summarizes certain information regarding merchant chargeback guarantees (in millions):
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
Aggregate sales transaction volume(1)
$
39,977

 
$
35,885

 
$
75,994

 
$
68,539

 
 
 
 
 
 
 
 
(1)
Represents period transactions processed on the Discover Network for which a potential liability exists that, in aggregate, can differ from credit card sales volume.
The Company did not record any contingent liability in the condensed consolidated financial statements for merchant chargeback guarantees as of June 30, 2018 or December 31, 2017. The Company mitigates the risk of potential loss exposure by withholding settlement from merchants, obtaining third-party guarantees, or obtaining escrow deposits or letters of credit from certain merchant acquirers or merchants that are considered higher risk due to various factors such as time delays in the delivery of products or services. As of June 30, 2018 and December 31, 2017, the Company had escrow deposits and settlement withholdings of $13 million and $10 million, respectively, which are recorded in interest-bearing deposit accounts and accrued expenses and other liabilities on the Company's condensed consolidated statements of financial condition.
12.
Litigation and Regulatory Matters
In the normal course of business, from time to time, the Company has been named as a defendant in various legal actions, including arbitrations, class actions and other litigation, arising in connection with its activities. Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. The litigation process is not predictable and can lead to unexpected results. The Company contests liability and/or the amount of damages as appropriate in each pending matter.
The Company has historically offered its customers an arbitration clause in its customer agreements. The arbitration clause allows the Company and its customers to quickly and economically resolve disputes. Additionally, the arbitration clause has in some instances limited the costs of, and the Company’s exposure to, litigation. Future legal and regulatory challenges and prohibitions may cause the Company to discontinue its offering and use of such clauses. From time to time, the Company is involved in legal actions challenging its arbitration clause. Bills may be periodically introduced in Congress to directly or indirectly prohibit the use of pre-dispute arbitration clauses. On July 10, 2017, the Bureau of Consumer Financial Protection (the "Bureau") issued a final arbitration rule (the "Arbitration Rule") that would have effectively banned consumer financial companies from including class action waivers in arbitration clauses. On November 1, 2017, a resolution of disapproval of the Arbitration Rule was signed into law and the Arbitration Rule was blocked from taking effect and cannot be reissued in substantially the same form, nor can a new rule that is substantially similar be issued unless specifically authorized by a law enacted after the date of the resolution of disapproval.

31

Table of Contents

The Company is also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental agencies regarding the Company’s business including, among other matters, consumer regulatory, accounting, tax and other operational matters, some of which may result in significant adverse judgments, settlements, fines, penalties, injunctions, decreases in regulatory ratings, customer restitution or other relief, which could materially impact the Company's condensed consolidated financial statements, increase its cost of operations, or limit its ability to execute its business strategies and engage in certain business activities. For example, the Company is currently the subject of an action by the Federal Reserve with respect to anti-money laundering and related compliance programs as referred to below. This agreement followed the consent order that Discover Bank entered into with the FDIC on June 13, 2014 related to Discover Bank's anti-money laundering and related compliance programs. This consent order was terminated in August 2017. In addition, certain subsidiaries of the Company are subject to a consent order with the Bureau regarding certain student loan servicing practices, as described below. Pursuant to powers granted under federal banking laws, regulatory agencies have broad and sweeping discretion, and may assess civil money penalties, require changes to certain business practices or require customer restitution at any time. The existing supervisory action related to anti-money laundering and related laws and regulations will limit for a period of time the Company's ability to enter into certain types of acquisitions and make certain types of investments.
In accordance with applicable accounting guidance, the Company establishes an accrued liability for legal and regulatory matters when those matters present loss contingencies which are both probable and estimable. Litigation and regulatory settlement related expense was not material for the three and six months ended June 30, 2018 and 2017.
There may be an exposure to loss in excess of any amounts accrued. The Company believes the estimate of the aggregate range of reasonably possible losses (meaning those losses the likelihood of which is more than remote but less than likely) in excess of the amounts that the Company has accrued for legal and regulatory proceedings is up to $140 million. This estimated range of reasonably possible losses is based upon currently available information for those proceedings in which the Company is involved, takes into account the Company’s best estimate of such losses for those matters for which an estimate can be made, and does not represent the Company’s maximum potential loss exposure. Various aspects of the legal proceedings underlying the estimated range will change from time to time and actual results may vary significantly from the estimate.
The Company’s estimated range above involves significant judgment, given the varying stages of the proceedings, the existence of numerous yet to be resolved issues, the breadth of the claims (often spanning multiple years and, in some cases, a wide range of business activities), unspecified damages and/or the novelty of the legal issues presented. The outcome of pending matters could be material to the Company’s condensed consolidated financial condition, operating results and cash flows for a particular future period, depending on, among other things, the level of the Company’s income for such period, and could adversely affect the Company’s reputation.
On July 5, 2012, the Antitrust Division of the United States Department of Justice (the “Division”) issued a Civil Investigative Demand ("CID") to the Company seeking information regarding an investigation related to potential violations of Sections 1 and 2 of the Sherman Act, 15 U.S.C. §§1-2, by an unidentified party other than Discover. The CID seeks documents, data and narrative responses to several interrogatories and document requests, related to the debit card market. A CID is a request for information in the course of a civil investigation and does not constitute the commencement of legal proceedings. The Division is permitted by statute to issue a CID to anyone whom it believes may have information relevant to an investigation. The receipt of a CID does not presuppose that there is probable cause to believe that a violation of the antitrust laws has occurred or that a formal complaint ultimately will be filed. The Company is cooperating with the Division in connection with the CID.
On May 26, 2015, the Company entered into a written agreement with the Federal Reserve Bank of Chicago where the Company agreed to enhance the Company’s enterprise-wide anti-money laundering and related compliance programs. The agreement does not include civil money penalties.
On July 22, 2015, the Company announced that its subsidiaries, Discover Bank, SLC and Discover Products Inc. (the “Discover Subsidiaries”), agreed to a consent order with the Bureau resolving the agency’s investigation with respect to certain student loan servicing practices. The Bureau’s investigation into these practices has been previously disclosed by the Company, initially in February 2014. The order required the Discover Subsidiaries to provide redress of approximately $16 million to consumers who may have been affected by the activities described in the order related to certain collection calls, overstatements of minimum payment due amounts in billing statements, and provision of interest paid information to consumers, and provide regulatory disclosures with respect to loans acquired in default. In addition, the Discover Subsidiaries were required to pay a $2.5 million civil money penalty to the Bureau. As required by the consent order, on

32

Table of Contents

October 19, 2015, the Discover Subsidiaries submitted to the Bureau a redress plan and a compliance plan designed to ensure that the Discover Subsidiaries provide redress and otherwise comply with the terms of the order.
On September 4, 2015, the District Attorney of Trinity County, California filed a protection products lawsuit against the Company in California state court (The People of the State of California Ex Rel, Eric L. Heryford, District Attorney, Trinity County v. Discover Financial Services, et al.). The District Attorney subsequently dismissed this lawsuit on February 19, 2016 and filed a new complaint in federal court in the Eastern District of California on March 4, 2016 alleging the same cause of action. An amended complaint was filed on March 25, 2016. The lawsuit asserts various claims under California's Unfair Competition Law with respect to the Company's marketing and administration of various protection products. Plaintiff seeks declaratory relief, statutory civil penalties, and attorneys’ fees. The Company filed a motion to dismiss the first amended complaint on April 26, 2016. The motion was granted on June 26, 2018, but the court has granted the plaintiff until September 24, 2018 to file an amended complaint. The Company is not in a position at this time to assess the likely outcome or its exposure, if any, with respect to this matter, but will seek to vigorously defend against all claims asserted by the plaintiff.
On March 8, 2016, a class action lawsuit was filed against the Company, other credit card networks, other issuing banks, and EMVCo in the U.S. District Court for the Northern District of California (B&R Supermarket, Inc., d/b/a Milam’s Market, et al. v. Visa, Inc. et al.) alleging violations of the Sherman Antitrust Act, California's Cartwright Act, and unjust enrichment. Plaintiffs allege a conspiracy by defendants to shift fraud liability to merchants with the migration to the EMV security standard and chip technology. Plaintiffs assert joint and several liability among the defendants and seek unspecified damages, including treble damages, attorneys' fees, costs and injunctive relief. On July 15, 2016, plaintiffs filed an amended complaint that includes additional named plaintiffs, reasserts the original claims, and includes additional state law causes of action. The defendants filed motions to dismiss on August 5, 2016. On September 30, 2016, the court granted the motions to dismiss for certain issuing banks and EMVCo but denied the motions to dismiss filed by the networks, including the Company. In May 2017, while discovery was proceeding and after class certification was fully briefed but not yet ruled upon, the Court entered an order transferring the entire action to a federal court in New York that is presiding over certain related claims that are pending in the actions consolidated as MDL 1720. In June 2017, the federal court in New York declined to consolidate the B&R case with MDL 1720, but ordered the parties to coordinate discovery across the actions to the extent they involved related issues. On July 6, 2017, the Company requested permission to file a motion to dismiss the claims against it in the federal court in New York. On August 24, 2017, the Court held a status conference at which it set a briefing schedule on Discover’s motion to dismiss. In September 2017, Discover filed its motion to dismiss. On November 29, 2017, the Court heard argument on class certification and took the motion under advisement. On January 23, 2018, the Court heard argument on Discover's motion to dismiss. On March 11, 2018, the Court entered an order denying the plaintiffs' motion of class certification without prejudice to filing a renewed motion with additional detail on the proposed class period and alleged antitrust injuries. Fact discovery closed on June 14, 2018, and plaintiffs filed a renewed motion for class certification on July 16, 2018. Opening expert reports are due on August 31, 2018, and class briefing will be complete by November 2018. The Court has not yet set a hearing date on the class motion, and merits expert discovery will close in 2019. The Company is not in a position at this time to assess the likely outcome or its exposure, if any, with respect to this matter, but will seek to vigorously defend against all claims asserted by the plaintiffs.

33

Table of Contents

13.
Fair Value Measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC Topic 820, Fair Value Measurement, provides a three-level hierarchy for classifying financial instruments, which is based on whether the inputs to the valuation techniques used to measure the fair value of each financial instrument are observable or unobservable. It also requires certain disclosures about those measurements. The three-level valuation hierarchy is as follows:
Level 1: Fair values determined by Level 1 inputs are defined as those that utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access.
Level 2: Fair values determined by Level 2 inputs are those that utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active or inactive markets, quoted prices for the identical assets in an inactive market, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. The Company evaluates factors such as the frequency of transactions, the size of the bid-ask spread and the significance of adjustments made when considering transactions involving similar assets or liabilities to assess the relevance of those observed prices. If relevant and observable prices are available, the fair values of the related assets or liabilities would be classified as Level 2.
Level 3: Fair values determined by Level 3 inputs are those based on unobservable inputs and include situations where there is little, if any, market activity for the asset or liability being valued. In instances in which the inputs used to measure fair value may fall into different levels of the fair value hierarchy, the level in the fair value hierarchy within which the fair value measurement in its entirety is classified is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company may utilize both observable and unobservable inputs in determining the fair values of financial instruments classified within the Level 3 category.
The determination of classification of its financial instruments within the fair value hierarchy is performed at least quarterly by the Company. For transfers in and out of the levels of the fair value hierarchy, the Company discloses the fair value measurement based on the value immediately preceding the transfer.
The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and involves consideration of factors specific to the asset or liability. Furthermore, certain techniques used to measure fair value involve some degree of judgment and, as a result, are not necessarily indicative of the amounts the Company would realize in a current market exchange.

34

Table of Contents

Assets and Liabilities Measured at Fair Value on a Recurring Basis
Assets and liabilities measured at fair value on a recurring basis are as follows (dollars in millions):
 
Quoted Price in Active Markets
for Identical
Assets 
(Level 1)
 
Significant
Other
Observable
Inputs 
(Level 2)
 
Significant
Unobservable
Inputs 
(Level 3)
 
Total
Balance at June 30, 2018
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Fair value - OCI
 
 
 
 
 
 
 
U.S. Treasury securities
$
674

 
$

 
$

 
$
674

Residential mortgage-backed securities - Agency

 
622

 

 
622

Available-for-sale investment securities
$
674

 
$
622

 
$

 
$
1,296

 
 
 
 
 
 
 
 
Derivative financial instruments - cash flow hedges(1)
$

 
$
11

 
$

 
$
11

 
 
 
 
 
 
 
 
Fair value - Net income
 
 
 
 
 
 
 
Derivative financial instruments - fair value hedges(1)
$

 
$

 
$

 
$

 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
Fair value - OCI
 
 
 
 
 
 
 
Derivative financial instruments - cash flow hedges(1)
$

 
$

 
$

 
$

 
 
 
 
 
 
 
 
Balance at December 31, 2017
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Fair value - OCI
 
 
 
 
 
 
 
U.S. Treasury securities
$
672

 
$

 
$

 
$
672

Residential mortgage-backed securities - Agency

 
723

 

 
723

Available-for-sale investment securities
$
672

 
$
723

 
$

 
$
1,395

 
 
 
 
 
 
 
 
Derivative financial instruments - cash flow hedges(1)
$

 
$
2

 
$

 
$
2

 
 
 
 
 
 
 
 
Fair value - Net income
 
 
 
 
 
 
 
Derivative financial instruments - fair value hedges(1)
$

 
$
4

 
$

 
$
4

 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
Fair value - OCI
 
 
 
 
 
 
 
Derivative financial instruments - cash flow hedges(1)
$

 
$
3

 
$

 
$
3

 
 
 
 
 
 
 
 
(1)
Derivative instrument carrying values in an asset or liability position are presented as part of other assets or accrued expenses and other liabilities, respectively, in the Company's condensed consolidated statements of financial condition.
Fair value hedge derivative financial instruments in a liability position were immaterial at June 30, 2018 and December 31, 2017. There were no transfers between Levels 1 and 2 within the fair value hierarchy for the three or six months ended June 30, 2018 and 2017.
Available-for-Sale Investment Securities
Investment securities classified as available-for-sale consist of U.S. Treasury securities and residential mortgage-backed securities. The fair value estimates of investment securities classified as Level 1, consisting of U.S. Treasury securities, are determined based on quoted market prices for the same securities. The Company classifies residential mortgage-backed securities as Level 2, the fair value estimates of which are based on the best information available. This data may consist of observed market prices, broker quotes or discounted cash flow models that incorporate assumptions such

35

Table of Contents

as benchmark yields, issuer spreads, prepayment speeds, credit ratings and losses, the priority of which may vary based on availability of information.
The Company validates the fair value estimates provided by the pricing services primarily by comparison to valuations obtained through other pricing sources. The Company evaluates pricing variances amongst different pricing sources to ensure that the valuations utilized are reasonable. The Company also corroborates the reasonableness of the fair value estimates with analysis of trends of significant inputs, such as market interest rate curves. The Company further performs due diligence in understanding the procedures and techniques performed by the pricing services to derive fair value estimates.
At June 30, 2018, amounts reported in residential mortgage-backed securities reflect government-rated obligations issued by Fannie Mae, Freddie Mac and Ginnie Mae with a par value of $626 million, a weighted-average coupon of 2.81% and a weighted-average remaining maturity of three years.
Derivative Financial Instruments
The Company's derivative financial instruments consist of interest rate swaps and foreign exchange forward contracts. These instruments are classified as Level 2 as their fair values are estimated using proprietary pricing models, containing certain assumptions based on readily observable market-based inputs, including interest rate curves, option volatility and foreign currency forward and spot rates. In determining fair values, the pricing models use widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity and the observable market-based inputs. The fair values of the interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts). The variable cash payments are based on an expectation of future interest rates derived from the observable market interest rate curves. The Company considers collateral and master netting agreements that mitigate credit exposure to counterparties in determining the counterparty credit risk valuation adjustment. The fair values of the currency instruments are valued comparing the contracted forward exchange rate pertaining to the specific contract maturities to the current market exchange rate.
The Company validates the fair value estimates of interest rate swaps primarily through comparison to the fair value estimates computed by the counterparties to each of the derivative transactions. The Company evaluates pricing variances amongst different pricing sources to ensure that the valuations utilized are reasonable. The Company also corroborates the reasonableness of the fair value estimates with analysis of trends of significant inputs, such as market interest rate curves. The Company performs due diligence in understanding the impact to any changes to the valuation techniques performed by proprietary pricing models prior to implementation, working closely with the third-party valuation service, and reviews the control objectives of the service at least annually. The Company corroborates the fair value of foreign exchange forward contracts through independent calculation of the fair value estimates.
Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis
The Company also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets include those associated with acquired businesses, including goodwill and other intangible assets. For these assets, measurement at fair value in periods subsequent to the initial recognition of the assets is applicable if one or more of the assets is determined to be impaired. During the three and six months ended June 30, 2018 and 2017, the Company had no material impairments related to these assets.

36

Table of Contents

Financial Instruments Measured at Other Than Fair Value
In accordance with ASU No. 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, the Company uses the exit price notion when measuring the fair value of financial instruments. See Note 1: Background and Basis of Presentation for additional information.
The following tables disclose the estimated fair value of the Company's financial assets and financial liabilities that are not required to be carried at fair value (dollars in millions):
 
Quoted Prices in Active Markets
for Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs (Level 2)
 
Significant
Unobservable
Inputs (Level 3)
 
Total
 
Carrying
Value
Balance at June 30, 2018
 
 
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
 
 
Amortized cost
 
 
 
 
 
 
 
 
 
States and political subdivisions of states
$

 
$

 
$

 
$

 
$

Residential mortgage-backed securities - Agency

 
222

 

 
222

 
226

Held-to-maturity investment securities
$

 
$
222

 
$

 
$
222

 
$
226

 
 
 
 
 
 
 
 
 
 
Net loan receivables
$

 
$

 
$
85,487

 
$
85,487

 
$
81,961

 
 
 
 
 
 
 
 
 
 
Carrying value approximates fair value(1)
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
15,289

 
$

 
$

 
$
15,289

 
$
15,289

Restricted cash
$
630

 
$

 
$

 
$
630

 
$
630

Accrued interest receivables(2)
$

 
$
845

 
$

 
$
845

 
$
845

 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
Amortized cost
 
 
 
 
 
 
 
 
 
Time deposits(3)
$

 
$
29,810

 
$

 
$
29,810

 
$
29,998

 
 
 
 
 
 
 
 
 
 
Long-term borrowings - owed to securitization investors
$

 
$
15,839

 
$
555

 
$
16,394

 
$
16,365

Other long-term borrowings

 
10,025

 

 
10,025

 
9,887

Long-term borrowings
$

 
$
25,864

 
$
555

 
$
26,419

 
$
26,252

 
 
 
 
 
 
 
 
 
 
Carrying value approximates fair value(1)
 
 
 
 
 
 
 
 
 
Accrued interest payables(2)
$

 
$
239

 
$

 
$
239

 
$
239

 
 
 
 
 
 
 
 
 
 
(1) The carrying values of these assets and liabilities approximate fair value due to the nature of their liquidity (i.e., due or payable in less than one year).
(2) Accrued interest receivable and payable carrying values are presented as part of other assets or accrued expenses and other liabilities, respectively, in the Company's
         condensed consolidated statements of financial condition.
(3) Excludes deposits without contractually defined maturities for all periods presented.
 
 
 
 
 
 
 
 
 
 

37

Table of Contents

The following tables disclose the estimated fair value of the Company's financial assets and financial liabilities that are not required to be carried at fair value (dollars in millions):
 
Quoted Prices in Active Markets
for Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs (Level 2)
 
Significant
Unobservable
Inputs (Level 3)
 
Total
 
Carrying
Value
Balance at December 31, 2017
 
 
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
 
 
Amortized cost
 
 
 
 
 
 
 
 
 
States and political subdivisions of states
$

 
$
1

 
$

 
$
1

 
$
1

Residential mortgage-backed securities - Agency

 
172

 

 
172

 
172

Held-to-maturity investment securities
$

 
$
173

 
$

 
$
173

 
$
173

 
 
 
 
 
 
 
 
 
 
Net loan receivables
$

 
$

 
$
85,108

 
$
85,108

 
$
81,627

 
 
 
 
 
 
 
 
 
 
Carrying value approximates fair value(1)
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
13,306

 
$

 
$

 
$
13,306

 
$
13,306

Restricted cash
$
81

 
$

 
$

 
$
81

 
$
81

Accrued interest receivables(2)
$

 
$
818

 
$

 
$
818

 
$
818

 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
Amortized cost
 
 
 
 
 
 
 
 
 
Time deposits(3)
$

 
$
29,848

 
$

 
$
29,848

 
$
29,752

 
 
 
 
 
 
 
 
 
 
Long-term borrowings - owed to securitization investors
$

 
$
15,851

 
$
640

 
$
16,491

 
$
16,536

Other long-term borrowings

 
10,293

 

 
10,293

 
9,790

Long-term borrowings
$

 
$
26,144

 
$
640

 
$
26,784

 
$
26,326

 
 
 
 
 
 
 
 
 
 
Carrying value approximates fair value(1)
 
 
 
 
 
 
 
 
 
Accrued interest payables(2)
$

 
$
214

 
$

 
$
214

 
$
214

 
 
 
 
 
 
 
 
 
 
(1)
The carrying values of these assets and liabilities approximate fair value due to the nature of their liquidity (i.e., due or payable in less than one year).
(2)
Accrued interest receivable and payable carrying values are presented as part of other assets or accrued expenses and other liabilities, respectively, in the Company's condensed consolidated statements of financial condition.
(3)
Excludes deposits without contractually defined maturities for all periods presented.
14.
Derivatives and Hedging Activities
The Company uses derivatives to manage its exposure to various financial risks. The Company does not enter into derivatives for trading or speculative purposes. Certain derivatives used to manage the Company’s exposure to foreign currency are not designated as hedges and do not qualify for hedge accounting.
Derivatives may give rise to counterparty credit risk, which generally is addressed through collateral arrangements as described under the sub-heading "— Collateral Requirements and Credit-Risk Related Contingency Features." The Company enters into derivative transactions with established dealers that meet minimum credit criteria established by the Company. All counterparties must be pre-approved prior to engaging in any transaction with the Company. Counterparties are monitored on a regular basis by the Company to ensure compliance with the Company’s risk policies and limits. In determining the counterparty credit risk valuation adjustment for the fair values of derivatives, the Company considers collateral and legally enforceable master netting agreements that mitigate credit exposure to related counterparties.
All derivatives are recorded in other assets at their gross positive fair values and in accrued expenses and other liabilities at their gross negative fair values. See Note 13: Fair Value Measurements for a description of the valuation methodologies of derivatives. Cash collateral posted and held balances are recorded in other assets and deposits, respectively, in the condensed consolidated statements of financial condition. Collateral amounts recorded in the condensed consolidated statements of financial condition are based on the net collateral posted or held position for each applicable legal entity's

38

Table of Contents

master netting arrangement with each counterparty. Certain cash collateral amounts associated with derivative positions that are cleared through an exchange are legally characterized as settlement of the derivative positions. Such collateral amounts are reflected as offsets to the associated derivatives balances recorded in other assets or in accrued expenses and other liabilities, instead of as collateral in other assets or deposits.
Derivatives Designated as Hedges
Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows arising from changes in interest rates, or other types of forecasted transactions, are considered cash flow hedges. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges.
Cash Flow Hedges
The Company uses interest rate swaps to manage its exposure to changes in interest rates related to future cash flows resulting from interest payments on credit card securitized debt and deposits. The Company's outstanding cash flow hedges are for an initial maximum period of seven years for securitized debt and deposits. The derivatives are designated as hedges of the risk of changes in cash flows on the Company's LIBOR or Federal Funds rate-based interest payments, and qualify for hedge accounting in accordance with ASC Topic 815, Derivatives and Hedging (“ASC 815”).
The change in the fair value of derivatives designated as cash flow hedges is recorded in OCI and is subsequently reclassified into earnings in the period that the hedged forecasted cash flows affect earnings. Amounts reported in AOCI related to derivatives at June 30, 2018 will be reclassified to interest expense as interest payments are accrued on certain of the Company's floating-rate securitized debt and deposits. During the next 12 months, the Company estimates it will reclassify $10 million of pretax benefit to interest expense related to its derivatives designated as cash flow hedges.
Fair Value Hedges
The Company is exposed to changes in fair value of certain of its fixed-rate debt obligations due to changes in interest rates. The Company uses interest rate swaps to manage its exposure to changes in fair value of certain fixed-rate long-term borrowings, including securitized debt and bank or other senior notes, and deposits attributable to changes in LIBOR, a benchmark interest rate as defined by ASC 815. These interest rate swaps qualify as fair value hedges in accordance with ASC 815. Changes in both (i) the fair values of the derivatives and (ii) the hedged long-term borrowings and deposits relating to the risk being hedged are recorded in interest expense. The changes generally provide substantial offset to one another, with any difference in interest expense.
Derivatives Not Designated as Hedges
Foreign Exchange Forward Contracts
The Company has foreign exchange forward contracts that are economic hedges and are not designated as accounting hedges. The Company enters into foreign exchange forward contracts to manage foreign currency risk. Changes in the fair value of these contracts are recorded in other income.
Derivatives Cleared Through an Exchange
The legal characterization of cash variation margin payments on derivatives cleared through an exchange are legally considered settlement payments and are accounted for with corresponding derivative positions as one unit of account and not separately as collateral. With settlement payments on derivative positions cleared through this exchange reflected as offsets to the associated derivative asset and liability balances, the fair values of derivative instruments and collateral balances shown are generally reduced.


39

Table of Contents

Derivatives Activity
The following table summarizes the fair value (including accrued interest) and outstanding notional amounts of derivative instruments and related collateral balances (dollars in millions):
 
June 30, 2018
 
December 31, 2017
 
Notional
Amount
 
Number of Outstanding Derivative Contracts
 
Derivative Assets
 
Derivative Liabilities
 
Notional
Amount
 
Derivative Assets
 
Derivative Liabilities
Derivatives designated as hedges
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps—cash flow hedge
$
3,000

 
6

 
$
11

 
$

 
$
3,800

 
$
2

 
$
3

Interest rate swaps—fair value hedge
$
7,230

 
9

 

 

 
$
7,333

 
4

 

Derivatives not designated as hedges
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange forward contracts(1)
$
32

 
7

 

 

 
$
23

 

 

Total gross derivative assets/liabilities(2)
 
 
 
 
11

 

 
 
 
6

 
3

Less: Collateral held/posted(3)
 
 
 
 
(11
)
 

 
 
 
(1
)
 
(3
)
Total net derivative assets/liabilities
 
 
 
 
$

 
$

 
 
 
$
5

 
$

 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
The foreign exchange forward contracts have notional amounts of EUR 8 million, GBP 11 million, SGD 1 million and INR 464 million as of June 30, 2018 and notional amounts of EUR 7 million, GBP 5 million, SGD 1 million and INR 464 million as of December 31, 2017.
(2)
In addition to the derivatives disclosed in the table, the Company enters into forward contracts to purchase when-issued mortgage-backed securities as part of its community reinvestment initiatives. At June 30, 2018, the Company had one outstanding contract with a notional amount of $20 million and immaterial fair value. At December 31, 2017, the Company had one outstanding contract with a notional amount of $54 million and immaterial fair value.
(3)
Collateral amounts, which consist of both cash and investment securities, are limited to the related derivative asset/liability balance and do not include excess collateral received/pledged.

The following amounts were recorded on the statements of financial condition related to cumulative basis adjustment for fair value hedges (dollars in millions):
 
June 30, 2018
 
Carrying Amount of Hedged Assets/Liabilities
 
Cumulative Amount of Fair Value Hedging Adjustment Increasing (Decreasing) the Carrying Amount of Hedged Assets/Liabilities
Long-term borrowings
$
7,018

 
$
(168
)
 
 
 
 





40

Table of Contents

The following table summarizes the impact of the derivative instruments on income and indicates where within the condensed consolidated financial statements such impact is reported (dollars in millions):
 
Location and Amount of (Loss) Gain Recognized in Income
 
Interest (Expense)
 
 
 
Deposits
 
Long-Term Borrowings
 
Other Income
For the Three Months Ended June 30, 2018
 
 
 
 
 
Total amounts of income and expense line items presented in the statements of income in which the effects of fair value or cash flow hedges are recorded
$
(287
)
 
$
(220
)
 
$
24

 
 
 
 
 
 
The effects of cash flow and fair value hedging:
 
 
 
 
 
Gain on cash flow hedging relationship
 
 
 
 
 
Amounts reclassified from OCI into earnings
$

 
$
1

 
$

 
 
 
 
 
 
Gain (loss) on fair value hedging relationship
 
 
 
 
 
Gain on hedged items
$

 
$
11

 
$

Gain (loss) on interest rate swaps

 
(22
)
 

Total gain (loss) on fair value hedges
$

 
$
(11
)
 
$

 
 
 
 
 
 
The effects of derivatives not designated in hedging relationships:
 
 
 
 
 
Gain on derivatives not designated as hedges
$

 
$

 
$
2

 
 
 
 
 
 
For the Three Months Ended June 30, 2017
 
 
 
 
 
Total amounts of income and expense line items presented in the statements of income in which the effects of fair value or cash flow hedges are recorded
$
(199
)
 
$
(201
)
 
$
22

 
 
 
 
 
 
The effects of cash flow and fair value hedging:
 
 
 
 
 
(Loss) gain on cash flow hedging relationship
 
 
 
 
 
Amounts reclassified from OCI into earnings
$
(2
)
 
$
(1
)
 
$

 
 
 
 
 
 
Gain (loss) on fair value hedging relationship
 
 
 
 
 
Gain (loss) on hedged items
$

 
$
(12
)
 
$

Gain on interest rate swaps

 
15

 

Total gain on fair value hedges
$

 
$
3

 
$

 
 
 
 
 
 
The effects of derivatives not designated in hedging relationships:
 
 
 
 
 
Gain (loss) on derivatives not designated as hedges
$

 
$

 
$
(1
)
 
 
 
 
 
 
 
 
 
 
 
 

41

Table of Contents

The following table summarizes the impact of the derivative instruments on income and indicates where within the condensed consolidated financial statements such impact is reported (dollars in millions):
 
Location and Amount of (Loss) Gain Recognized in Income
 
Interest (Expense)
 
 
 
Deposits
 
Long-Term Borrowings
 
Other Income
For the Six Months Ended June 30, 2018
 
 
 
 
 
Total amounts of income and expense line items presented in the statements of income in which the effects of fair value or cash flow hedges are recorded
$
(549
)
 
$
(427
)
 
$
53

 
 
 
 
 
 
The effects of cash flow and fair value hedging:
 
 
 
 
 
(Loss) gain on cash flow hedging relationship
 
 
 
 
 
Amounts reclassified from OCI into earnings
$
(1
)
 
$
1

 
$

 
 
 
 
 
 
Gain (loss) on fair value hedging relationship
 
 
 
 
 
Gain on hedged items
$

 
$
59

 
$

Gain (loss) on interest rate swaps

 
(74
)
 

Total gain (loss) on fair value hedges
$

 
$
(15
)
 
$

 
 
 
 
 
 
The effects of derivatives not designated in hedging relationships:
 
 
 
 
 
Gain on derivatives not designated as hedges
$

 
$

 
$
1

 
 
 
 
 
 
For the Six Months Ended June 30, 2017
 
 
 
 
 
Total amounts of income and expense line items presented in the statements of income in which the effects of fair value or cash flow hedges are recorded
$
(390
)
 
$
(396
)
 
$
50

 
 
 
 
 
 
The effects of cash flow and fair value hedging:
 
 
 
 
 
(Loss) gain on cash flow hedging relationship
 
 
 
 
 
Amounts reclassified from OCI into earnings
$
(4
)
 
$
(4
)
 
$

 
 
 
 
 
 
Gain (loss) on fair value hedging relationship
 
 
 
 
 
Gain on hedged items
$
1

 
$
3

 
$

(Loss) gain on interest rate swaps
(1
)
 
6

 

Total gain on fair value hedges
$

 
$
9

 
$

 
 
 
 
 
 
The effects of derivatives not designated in hedging relationships:
 
 
 
 
 
Gain (loss) on derivatives not designated as hedges
$

 
$

 
$
(1
)
 
 
 
 
 
 

For the impact of the derivative instruments on OCI, see Note 7: Accumulated Other Comprehensive Income.
Collateral Requirements and Credit-Risk Related Contingency Features
The Company has master netting arrangements and minimum collateral posting thresholds with its counterparties for its fair value and cash flow hedge interest rate swaps and foreign exchange forward contracts. The Company has not sought a legal opinion in relation to the enforceability of its master netting arrangements and, as such, does not report any of these positions on a net basis. Collateral is required by either the Company or its subsidiaries or the counterparty depending on the net fair value position of these derivatives held with that counterparty. The Company may also be required to post collateral with a counterparty for its fair value and cash flow hedge interest rate swaps depending on the credit rating it or Discover Bank receives from specified major credit rating agencies. Collateral receivable or payable amounts are generally not offset against the fair value of these derivatives, but are recorded separately in other assets or deposits. However, certain cash collateral amounts related to positions cleared through an exchange are reflected as offsets to the associated derivatives balances recorded in other assets and accrued expenses and other liabilities.

42

Table of Contents

At June 30, 2018, Discover Bank’s credit rating met specified thresholds set by its counterparties. However, if its credit rating is reduced below investment grade, Discover Bank would be required to post additional collateral. The amount of additional collateral as of June 30, 2018 would have been $20 million. DFS (Parent Company) had no outstanding derivatives as of June 30, 2018, and therefore, no collateral was required.
The Company also has agreements with certain of its derivative counterparties that contain a provision where if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then the Company could also be declared in default on its derivative obligations.
15.
Segment Disclosures
The Company’s business activities are managed in two segments: Direct Banking and Payment Services.
Direct Banking: The Direct Banking segment includes Discover-branded credit cards issued to individuals on the Discover Network and other consumer products and services, including private student loans, personal loans, home equity loans, and other consumer lending and deposit products. The majority of Direct Banking revenues relate to interest income earned on the segment's loan products. Additionally, the Company’s credit card products generate substantially all revenues related to discount and interchange, protection products and loan fee income.
Payment Services: The Payment Services segment includes PULSE, an automated teller machine, debit and electronic funds transfer network; Diners Club, a global payments network; and the Company’s Network Partners business, which provides payment transaction processing and settlement services on the Discover Network. The majority of Payment Services revenues relate to transaction processing revenue from PULSE and royalty and licensee revenue from Diners Club.
The business segment reporting provided to and used by the Company’s chief operating decision maker is prepared using the following principles and allocation conventions:
The Company aggregates operating segments when determining reportable segments.
Corporate overhead is not allocated between segments; all corporate overhead is included in the Direct Banking segment.
Through its operation of the Discover Network, the Direct Banking segment incurs fixed marketing, servicing and infrastructure costs that are not specifically allocated among the segments, with the exception of an allocation of direct and incremental costs driven by the Company's Payment Services segment.
The assets of the Company are not allocated among the operating segments in the information reviewed by the Company’s chief operating decision maker.
The revenues of each segment are derived from external sources. The segments do not earn revenue from intercompany sources.
Income taxes are not specifically allocated between the operating segments in the information reviewed by the Company’s chief operating decision maker.

43

Table of Contents

The following table presents segment data (dollars in millions):
 
Direct
Banking
 
Payment
Services
 
Total
For the Three Months Ended June 30, 2018
 
 
 
 
 
Interest income
 
 
 
 
 
Credit card loans
$
2,139

 
$

 
$
2,139

Private student loans
150

 

 
150

PCI student loans
35

 

 
35

Personal loans
229

 

 
229

Other
83

 

 
83

Total interest income
2,636

 

 
2,636

Interest expense
507

 

 
507

Net interest income
2,129

 

 
2,129

Provision for loan losses
742

 

 
742

Other income
398

 
76

 
474

Other expense
948

 
36

 
984

Income before income tax expense
$
837

 
$
40

 
$
877

 
 
 
 
 
 
For the Three Months Ended June 30, 2017
 
 
 
 
 
Interest income
 
 
 
 
 
Credit card loans
$
1,916

 
$

 
$
1,916

Private student loans
127

 

 
127

PCI student loans
41

 

 
41

Personal loans
207

 

 
207

Other
47

 

 
47

Total interest income
2,338

 

 
2,338

Interest expense
400

 

 
400

Net interest income
1,938

 

 
1,938

Provision for loan losses
639

 
1

 
640

Other income
408

 
73

 
481

Other expense
876

 
36

 
912

Income before income tax expense
$
831

 
$
36

 
$
867

 
 
 
 
 
 
 
 
 
 
 
 

44

Table of Contents

The following table presents segment data (dollars in millions):
 
Direct
Banking
 
Payment
Services
 
Total
For the Six Months Ended June 30, 2018
 
 
 
 
 
Interest income
 
 
 
 
 
Credit card loans
$
4,229

 
$

 
$
4,229

Private student loans
297

 

 
297

PCI student loans
72

 

 
72

Personal loans
455

 

 
455

Other
152

 

 
152

Total interest income
5,205

 

 
5,205

Interest expense
976

 

 
976

Net interest income
4,229

 

 
4,229

Provision for loan losses
1,493

 

 
1,493

Other income
792

 
157

 
949

Other expense
1,880

 
72

 
1,952

Income before income tax expense
$
1,648

 
$
85

 
$
1,733

 
 
 
 
 
 
For the Six Months Ended June 30, 2017
 
 
 
 
 
Interest income
 
 
 
 
 
Credit card loans
$
3,792

 
$

 
$
3,792

Private student loans
251

 

 
251

PCI student loans
82

 

 
82

Personal loans
405

 

 
405

Other
86

 

 
86

Total interest income
4,616

 

 
4,616

Interest expense
786

 

 
786

Net interest income
3,830

 

 
3,830

Provision for loan losses
1,233

 
(7
)
 
1,226

Other income
783

 
145

 
928

Other expense
1,725

 
72

 
1,797

Income before income tax expense
$
1,655

 
$
80

 
$
1,735

 
 
 
 
 
 

45

Table of Contents

16.
Revenue from Contracts with Customers
FASB ASC Topic 606, Revenue from Contracts with Customers, generally applies to the sales of any good or service for which no other specific accounting guidance is provided. ASC 606 defines a principles-based model under which revenue from a contract is allocated to the distinct performance obligations within the contract and recognized in income as each performance obligation is satisfied. The Company’s revenue that is subject to this model includes discount and interchange, protection products fees, transaction processing revenue, and amounts classified as other income.
The following table presents revenue from contracts with customers disaggregated by business segment and reconciles revenue from contracts with customers to total other income (dollars in millions):
 
Direct Banking
 
Payment Services
 
Total
For the Three Months Ended June 30, 2018
 
 
 
 
 
Other income subject to ASC 606
 
 
 
 
 
Discount and interchange revenue, net(1)
$
250

 
$
13

 
$
263

Protection products
50

 

 
50

Transaction processing revenue

 
42

 
42

Other income
3

 
21

 
24

Total other income subject to ASC 606(2)
303

 
76

 
379

Other income not subject to ASC 606
 
 
 
 
 
Loan fee income
95

 

 
95

Total other income not subject to ASC 606
95

 

 
95

Total other income by operating segment
$
398

 
$
76

 
$
474

 
 
 
 
 
 
For the Three Months Ended June 30, 2017
 
 
 
 
 
Other income subject to ASC 606
 
 
 
 
 
Discount and interchange revenue, net(1)
$
268

 
$
10

 
$
278

Protection products
56

 

 
56

Transaction processing revenue

 
42

 
42

Other income
1

 
21

 
22

Total other income subject to ASC 606(2)
325

 
73

 
398

Other income not subject to ASC 606
 
 
 
 

Loan fee income
83

 

 
83

Total other income not subject to ASC 606
83

 

 
83

Total other income by operating segment
$
408

 
$
73

 
$
481

 
 
 
 
 
 
 
 
 
 
 
 

46

Table of Contents

The following table presents revenue from contracts with customers disaggregated by business segment and reconciles revenue from contracts with customers to total other income (dollars in millions):
 
Direct Banking
 
Payment Services
 
Total
For the Six Months Ended June 30, 2018
 
 
 
 
 
Other income subject to ASC 606
 
 
 
 
 
Discount and interchange revenue, net(1)
$
492

 
$
25

 
$
517

Protection products
103

 

 
103

Transaction processing revenue

 
85

 
85

Other income
6

 
47

 
53

Total other income subject to ASC 606(2)
601

 
157

 
758

Other income not subject to ASC 606
 
 
 
 
 
Loan fee income
191

 

 
191

Total other income not subject to ASC 606
191

 

 
191

Total other income by operating segment
$
792

 
$
157

 
$
949

 
 
 
 
 
 
For the Six Months Ended June 30, 2017
 
 
 
 
 
Other income subject to ASC 606
 
 
 
 

Discount and interchange revenue, net(1)
$
491

 
$
20

 
$
511

Protection products
114

 

 
114

Transaction processing revenue

 
81

 
81

Other income
6

 
44

 
50

Total other income subject to ASC 606(2)
611

 
145

 
756

Other income not subject to ASC 606
 
 
 
 

Loan fee income
172

 

 
172

Total other income not subject to ASC 606
172

 

 
172

Total other income by operating segment
$
783

 
$
145

 
$
928

 
 
 
 
 
 
(1)
Net of rewards, including Cashback Bonus rewards, of $461 million and $388 million for the three months ended June 30, 2018 and 2017, respectively, and $853 million and $751 million for the six months ended June 30, 2018 and 2017, respectively.
(2)
Excludes $1 million of deposit product fees that are reported within net interest income for the three and six months ended June 30, 2018 and for the six months ended June 30, 2017. Deposit product fees were immaterial for the three months ended June 30, 2017.
Discount and Interchange Revenue
The Company earns discount revenue from fees charged to merchants with whom it has entered into card acceptance agreements for processing credit card purchase transactions. The Company earns acquirer interchange revenue primarily from merchant acquirers on all Discover Network card transactions and certain Diners Club transactions made by credit card customers at merchants with whom merchant acquirers have entered into card acceptance agreements for processing credit card purchase transactions. These card acceptance arrangements generally renew automatically and do not have fixed durations. Under these agreements, the Company stands ready to process payment transactions as and when each is presented to it. The Company earns discount, interchange and similar fees only if and when transactions are processed. Contractually defined per-transaction fee amounts typically apply to each type of transaction processed and are recognized as revenue at the time each transaction is captured for settlement. These fees are typically collected by the Company as part of the process of settling transactions daily with merchants and acquirers and are fully earned at the time settlement is made.

The Company pays issuer interchange to card-issuing entities that have entered into contractual arrangements to issue cards on the Discover Network and on certain transactions on the Diners Club network. This cost is contractually established and is based on the card-issuing organization’s transaction volume. The Company classifies this cost as a reduction of discount and interchange revenue. Costs of cardholder reward arrangements, including the Cashback Bonus reward program, are classified as reductions of discount and interchange revenue pursuant to guidance under ASC 606 governing consideration payable to a customer. For both issuer interchange and cardholder rewards, the Company accrues the cost at the time each underlying card transaction is captured for settlement.

47

Table of Contents

Protection Products
The Company earns revenue related to fees received for marketing ancillary products and services, including payment protection and identity theft protection services, to its credit card customers. A portion of this revenue comprises amounts earned for arranging for the delivery of products offered by third-party service providers. The amount of revenue recorded is generally based on either a percentage of a customer’s outstanding balance or a flat fee, in either case assessed monthly, and is recognized as earned. These contracts are month-to-month arrangements that are cancellable at any time. The Company recognizes each monthly fee in the period to which the service or coverage relates.
Transaction Processing Revenue
Transaction processing revenue represents switch fees charged to financial institutions and merchants under network participation agreements for processing ATM, debit and POS transactions over the PULSE network, as well as various participation and membership fees. Network participation agreements generally renew automatically and do not have fixed durations, although the Company does enter into fixed-term pricing or incentive arrangements with certain network participants. The impact of such incentives is not material to the Company’s consolidated statements of income. Similar to discount and interchange fees, switch fees are contractually defined per-transaction fee amounts and are assessed and recognized as revenue at the time each transaction is captured for settlement. These fees are typically collected by the Company as part of the process of settling transactions daily with network participants. Membership and other participation fees are recognized over the periods to which each fee relates.
Other Income
Other income includes sales-based royalty revenues earned by Diners Club, merchant fees, certain payments from merchants related to reward programs, revenues from network partners and other miscellaneous revenue items. Sales-based royalty revenues are recognized as the related sales are reported by Diners franchisees. All remaining items of other income are recognized as the related performance obligations are satisfied.
Future Revenue Associated with Customer Contracts
For contracts under which the Company processes payment card transactions, the Company has the right to assess fees for services performed and to collect those fees through the settlement process. The Company generates essentially all of its discount and interchange revenue and transaction processing revenue, as well as some revenue reported as other income, through such contracts. There is no specified quantity of service promised in these contracts as the number of payment transactions is dependent upon cardholder behavior, which is outside the control of the Company and its network customers (i.e., merchants, acquirers, issuers, and other network participants). As noted above, these contracts are typically without fixed durations and renew automatically. For these reasons, the Company does not make or disclose an estimate of revenue associated with performance obligations attributable to the remaining terms of these contracts. Future revenue associated with the Company’s sales-based royalty revenues earned from Diners Club licensees is similarly variable and open-ended, and therefore the Company does not make or disclose an estimate of royalties associated with performance obligations attributable to the remaining terms of the licensing and royalty arrangements. Because of the nature of the services and the manner of collection associated with the majority of the Company's revenue from contracts with customers, material receivables or deferred revenues are not generated.
17.
Subsequent Events
The Company has evaluated events and transactions that have occurred subsequent to June 30, 2018 and determined that there were no subsequent events that would require recognition or disclosure in the condensed consolidated financial statements.

48

Table of Contents

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this quarterly report. This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements, which speak to our expected business and financial performance, among other matters, contain words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “aim,” “will,” “may,” “should,” “could,” “would,” “likely,” and similar expressions. Such statements are based upon the current beliefs and expectations of our management and are subject to significant risks and uncertainties. Actual results may differ materially from those set forth in the forward-looking statements. These forward-looking statements speak only as of the date of this quarterly report, and there is no undertaking to update or revise them as more information becomes available.
The following factors, among others, could cause actual results to differ materially from those set forth in the forward-looking statements: changes in economic variables, such as the availability of consumer credit, the housing market, energy costs, the number and size of personal bankruptcy filings, the rate of unemployment, the levels of consumer confidence and consumer debt and investor sentiment; the impact of current, pending and future legislation, regulation, supervisory guidance and regulatory and legal actions, including, but not limited to, those related to financial regulatory reform, consumer financial services practices, anti-corruption and funding, capital and liquidity; the actions and initiatives of current and potential competitors; our ability to manage our expenses; our ability to successfully achieve card acceptance across our networks and maintain relationships with network participants; our ability to sustain and grow our private student loan, personal loan and home equity loan products; difficulty obtaining regulatory approval for, financing, transitioning, integrating or managing the expenses of acquisitions of or investments in new businesses, products or technologies; our ability to manage our credit risk, market risk, liquidity risk, operational risk, legal and compliance risk and strategic risk; the availability and cost of funding and capital; access to deposit, securitization, equity, debt and credit markets; the impact of rating agency actions; the level and volatility of equity prices, commodity prices and interest rates, currency values, investments, other market fluctuations and other market indices; losses in our investment portfolio; limits on our ability to pay dividends and repurchase our common stock; limits on our ability to receive payments from our subsidiaries; fraudulent activities or material security breaches of key systems; our ability to remain organizationally effective; our ability to increase or sustain Discover card usage or attract new customers; our ability to maintain relationships with merchants; the effect of political, economic and market conditions, geopolitical events and unforeseen or catastrophic events; our ability to introduce new products and services; our ability to manage our relationships with third-party vendors; our ability to maintain current technology and integrate new and acquired systems; our ability to collect amounts for disputed transactions from merchants and merchant acquirers; our ability to attract and retain employees; our ability to protect our reputation and our intellectual property; and new lawsuits, investigations or similar matters or unanticipated developments related to current matters. We routinely evaluate and may pursue acquisitions of or investments in businesses, products, technologies, loan portfolios or deposits, which may involve payment in cash or our debt or equity securities.
Additional factors that could cause our results to differ materially from those described below can be found in this section in this quarterly report and in “Risk Factors,” “Business — Competition,” “Business — Supervision and Regulation” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K for the year ended December 31, 2017, which is filed with the SEC and available at the SEC’s internet site (http://www.sec.gov).
Introduction and Overview
Discover Financial Services ("DFS") is a direct banking and payment services company. We provide direct banking products and services and payment services through our subsidiaries. We offer our customers credit card loans, private student loans, personal loans, home equity loans and deposit products. We also operate the Discover Network, the PULSE network (“PULSE”) and Diners Club International (“Diners Club”). The Discover Network processes transactions for Discover-branded credit and debit cards and provides payment transaction processing and settlement services. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE network with access to ATMs domestically and internationally, as well as point-of-sale terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network of licensees, which are generally financial institutions, that issue Diners Club branded charge cards and/or provide card acceptance services.
Our primary revenues consist of interest income earned on loan receivables and fees earned from customers, financial institutions, merchants and issuers. The primary expenses required to operate our business include funding costs (interest expense), loan loss provisions, customer rewards and expenses incurred to grow, manage and service our loan receivables and

49

Table of Contents

networks. Our business activities are funded primarily through consumer deposits, securitization of loan receivables and the issuance of unsecured debt.
Quarter Highlights
Net income for the three months ended June 30, 2018 was $669 million compared to $546 million for the same period in 2017.
Total loans grew $6.8 billion, or 9%, from June 30, 2017 to $84.8 billion.
Credit card loans grew $6.0 billion, or 10%, to $67.8 billion, and Discover card sales volume increased 9% from June 30, 2017.
Total net charge-off rate increased 40 basis points from the prior year to 3.11%. Net charge-off rate excluding PCI loans increased 39 basis points from the prior year to 3.18% and the credit card delinquency rate for loans over 30 days past due increased 16 basis points from the prior year to 2.16%.
Direct-to-consumer deposits grew $4.6 billion, or 12%, from the prior year to $42.3 billion.
Payment Services transaction dollar volume for the segment was $57.3 billion, up 14% from the prior year.
We received a non-objection to our 2018 Comprehensive Capital Analysis and Review ("CCAR") submission from the Federal Reserve.
Outlook
We continue to focus on deploying capital through disciplined and profitable organic loan growth and by executing against our 2018 capital plan, which includes our share repurchase program and recently increased quarterly common stock dividend. Our marketing strategy remains focused on expanding wallet share with existing customers and adding new accounts. We expect the reduction in income tax expense resulting from the Tax Cuts and Job Act ("TCJA") to continue to benefit us and allow for continued investments in business growth, technology, analytical capabilities, our employees and our community.

The total net charge-off rate is expected to increase in comparison to the prior year and we expect to add to the loan loss reserve to provide for the seasoning of recent loan growth and supply-driven credit normalization. We expect net interest margin to increase slightly due to the impact of prime rate increases on our asset sensitive balance sheet and an expected shift in portfolio mix, which may be partially offset by higher deposit rates.

In our payments segment, we will continue to pursue new ways to drive volume growth in 2018. We continue to leverage our network to support our card-issuing business and we expect the payments industry to remain competitive.
Regulatory Environment and Developments
Following the financial crisis of 2007-2008, regulators proposed and implemented new regulations and supervisory guidance, including under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), and increased their examination and enforcement activities. In February 2017, an executive order was signed identifying principles by which the current administration would regulate the U.S financial system, including making regulation appropriately tailored and efficient. The executive order also directed the Treasury Secretary to identify laws, regulations, guidance and other government policies, among other things, that are inconsistent with those principles. Since June 2017, the Treasury Department has issued multiple reports that have recommended significant changes to many of the rules and regulations implemented in response to the financial crisis of 2007-2008.
Since 2016, Congress has addressed regulation of the financial services sector in several other ways. For example, it exercised its authority under the Congressional Review Act to reject recently promulgated regulations, including a regulation adopted by the Bureau of Consumer Financial Protection (the "Bureau") that limited pre-dispute arbitration agreements.
On May 24, 2018, the President signed into law a package of legislative reforms titled the “Economic Growth, Regulatory Relief, and Consumer Protection Act”, which are intended to promote economic growth, provide tailored regulatory relief for smaller and less complex financial institutions, and enhance consumer protections. Among other provisions, the new law raises the asset threshold for designating a bank holding company as “systemically important” from $50 billion to $250 billion. The new law became effective immediately for bank holding companies with assets less than

50

Table of Contents

$100 billion and will become effective 18 months from its enactment for banks with assets of $100 billion or more. Upon effectiveness of the new law, bank holding companies with assets less than $250 billion will no longer automatically be subject to regulatory requirements that establish enhanced prudential standards pursuant to the Dodd-Frank Act. This change could impact a number of regulations currently applicable to Discover, including requirements to conduct company-run stress tests, submit holding company resolution plans, and implement heightened liquidity risk management requirements. The extent of relief afforded to Discover under the legislation will depend on how it is implemented by the regulatory agencies. For bank holding companies with assets of $100 billion or more, the Federal Reserve will be required to conduct supervisory stress tests to assess capital adequacy on a “periodic” basis and the Federal Reserve will have authority to selectively apply “enhanced prudential standards” by rule or order to such firms if deemed necessary to prevent or mitigate systemic risks or promote safety and soundness after consideration of the companies’ activities, size, and risk profile. It is anticipated that the Federal Reserve and other federal banking regulators will issue further guidance in the coming months to clarify their approaches to implementing the Act’s requirements. Another provision of the law authorizes the Social Security Administration to share information with financial institutions to help detect the unauthorized use of Social Security numbers to open fraudulent accounts. The timing and impact of any information sharing program is unknown.
While advancing regulatory relief initiatives, policymakers at the federal and state levels are increasingly focused on measures to enhance data security and data breach incident response capabilities as a result of growing cybersecurity threats and the number of incidents involving unauthorized access to consumer information, including the September 2017 disclosure of a large data breach at a national credit reporting agency. Regulations at various levels of government have been proposed to address security breach notification and data security standards and several states have recently issued regulations for certain firms operating within their jurisdiction. On June 28, 2018, the Governor of California signed the California Consumer Privacy Act (“CCPA”) into law. The CCPA provides California residents with a broad set of additional privacy rights and remedies modeled in part on the European Union's General Data Protection Regulation. While the CCPA goes into effect on January 1, 2020, it may be amended before then. While it is too early to know their full impact, these developments could ultimately result in the imposition of requirements on Discover and other card issuers or networks that could increase costs or adversely affect the competitiveness of our credit card or debit card products.
The impact of the evolving regulatory environment on our business and operations depends upon a number of factors, including supervisory priorities and actions, our actions, actions of our competitors and other marketplace participants, and the behavior of consumers. For more information on how the regulatory environment, enforcement actions, findings and ratings could also have an impact on our strategies, the value of our assets, or otherwise adversely affect our business see “Risk Factors Economic and Regulatory Environment” of our annual report on Form 10-K for the year ended December 31, 2017. For more information on recent matters affecting us, see Note 12: Litigation and Regulatory Matters to our condensed consolidated financial statements.
Consumer Financial Services
The Bureau regulates consumer financial products and services, as well as certain financial services providers, including Discover. The Bureau has rulemaking and interpretive authority under the Dodd-Frank Act and other federal consumer financial services laws, as well as broad supervisory, examination and enforcement authority over designated financial services providers, including Discover. The Bureau’s regulatory authority includes the exercise of rulemaking, supervision and enforcement powers with respect to “unfair, deceptive or abusive acts or practices” and consumer access to fair, transparent and competitive financial products and services. Historically, the Bureau's policy priorities focused on several financial products of the type we offer (e.g. credit cards and student loans).
The Bureau's interim director recently issued a 5-year strategic plan to ensure that all consumers have access to markets for consumer financial products and services, that laws are implemented and enforced consistently to make markets for consumer financial products and services fair, transparent and competitive, and that the agency fosters efficient and effective processes and the security of resources and information. In furtherance of each of these areas, the Bureau has issued formal requests for information on various topics. It is unclear when a new director will be confirmed and whether this director will continue the interim director's priorities or goals. Notwithstanding any changes in the Bureau's leadership, the Bureau is required by statute to undertake certain actions. For example, pursuant to the Credit Card Accountability Responsibility and Disclosure Act of 2009, the Bureau recently completed its bi-annual review of the consumer credit card market. The review may result in additional guidance for credit card issuers, regulatory changes or legislative recommendations to Congress.
There continues to be legislative and regulatory focus on the private student loan market, including by some state legislatures and state attorneys general. Recent areas of regulatory focus have included servicing, payments and collection

51

Table of Contents

practices, which has resulted in an increase in supervisory examinations of Discover related to private student loans. Legislative focus on student loans has resulted in the enactment of student loan servicing laws in several states, and consideration of new licensing, servicing, reporting and regulatory oversight requirements for student loan servicers. Such legislation, regulation or guidance may increase the complexity and expense of servicing student loans and impact the entire student loan market, which could cause us to change our private student loan products or servicing practices in ways that we may not currently anticipate.
Payment Networks
The Dodd-Frank Act contains several provisions impacting the debit card market, including network participation requirements and interchange fee limitations. The changing debit card environment, including competitor actions related to merchant and acquirer pricing and transaction routing strategies, has adversely affected, and is expected to continue to adversely affect, our PULSE network's business practices, network transaction volume, revenue and prospects for future growth. We continue to closely monitor competitor pricing and technology development strategies in order to assess their impact on our business and on competition in the marketplace. The U.S. Department of Justice is examining some of these competitor pricing strategies. In addition, PULSE filed a lawsuit against Visa in late 2014 with respect to these competitive concerns, which may impact expenses for the payment services segment. In addition, the Dodd-Frank Act's network participation requirements impact PULSE's ability to enter into exclusivity arrangements, which affects PULSE's current business practices and may materially adversely affect its network transaction volume and revenue.
There are initiatives in Europe that may have an impact on our business, including revisions to the Payment Services Directive ("PSD2") and the new General Data Protection Regulation ("GDPR"). Each European Union member state was required to transpose the PSD2 into its national law by January 13, 2018. Among other terms, the PSD2 includes provisions that will regulate surcharging and network access requirements, which may result in differential surcharging of Diners Club cards and may impact Diners Club licensing arrangements in Europe and may impact our Diners Club business. The GDPR came into force on May 25, 2018. The GDPR includes, among other things, a requirement for prompt notice of data breaches and requires companies processing personal data of individuals residing in the EU, regardless of the location of the company, to comply with EU privacy and data protection rules. We have a program in place to comply with the GDPR's requirements.
Banking
Capital
Discover Financial Services and Discover Bank are subject to regulatory capital requirements that became effective January 1, 2015 under final rules issued by the Federal Reserve and the Federal Deposit Insurance Corporation ("FDIC") to implement the provisions under the Basel Committee’s December 2010 framework (referred to as “Basel III”). The final capital rules ("Basel III rules") require minimum risk-based capital and leverage ratios and define what constitutes capital for purposes of calculating those ratios. In addition, the Basel III rules establish a capital conservation buffer ("CCB") above the regulatory minimum capital requirements, which must consist entirely of Common Equity Tier 1 ("CET1") capital and result in higher required minimum ratios by at least 2.5%. The new CCB requirement became effective January 2016; however, the buffer threshold amounts are subject to a gradual phase-in period. In 2017, the highest CCB threshold was 1.25%, which has risen to 1.875% for the 2018 calendar year. The full 2.5% buffer requirement will not be fully phased-in until January 2019. A banking organization is subject to limitations on paying dividends, engaging in share repurchases and paying discretionary bonuses if its capital level falls below any of the minimum capital requirements, taking into account the applicable CCB thresholds. Based on our current capital composition and levels and business plans, we are and expect to continue to be in compliance with the requirements for the foreseeable future. For additional information, see "— Liquidity and Capital Resources — Capital."
Federal banking regulators jointly issued a proposed rule in September 2017 that would simplify the treatment of certain assets and deductions for institutions that are not subject to the advanced approaches capital rule. Among other things, the proposed rule would increase or adjust the deduction thresholds for certain mortgage servicing assets, deferred tax assets, investments in the capital of unconsolidated financial institutions, and minority interests. As proposed, the new rules would apply to Discover Financial Services and its subsidiary banks. While the banking agencies consider comments on the proposed rule, the agencies adopted a rule in November 2017, that provides interim relief to non-advanced approaches banking organizations, such as Discover, by extending the regulatory capital transition periods effective in 2017 for certain items, including regulatory capital deductions, risk weights, and certain minority interest limitations.
In December 2017, the Basel Committee adopted various standards meant to finalize remaining elements of the Basel III reforms first introduced in 2010. Among the new standards are revisions to the standardized approach for credit risk,

52

Table of Contents

which establishes standardized risk weightings used to measure credit risk for purposes of calculating regulatory capital requirements. The new revisions include a provision that would, for the first time, require banking organizations to include a percentage of “unconditionally cancellable commitments” in risk-weighted asset calculations. If this change were to be adopted in the United States by the domestic federal banking agencies and made applicable to all "Standardized Approach" banking organizations such as Discover, it could require credit card issuers to substantially increase the amount of capital they hold against unused credit card lines. The federal banking agencies have publicly indicated support for the new Basel standards but stated that the standards were “designed for internationally active banks” and that any changes to the regulatory capital rules in the United States “will be made through the standard notice-and-comment rulemaking process.”
On April 10, 2018, the Federal Reserve issued a notice of proposed rulemaking that would significantly revise the regulatory capital and stress testing frameworks for mid-sized bank holding companies such as Discover Financial Services. The proposal is intended to make regulatory capital requirements more forward-looking, risk-sensitive, and firm-specific by linking them to the annual CCAR stress testing and capital plan review process. The timing and substance of any final rulemaking is uncertain at this time, however the notice indicates the Federal Reserve intends to adopt a final rule that would be effective on December 31, 2018.
On April 17, 2018, federal banking agencies issued a joint proposal that would, among other things, give bank holding companies and banks, including Discover and its bank subsidiaries, the option to phase in the regulatory capital impacts of implementing the current expected credit loss ("CECL") approach over a three-year transition period. Recognition would be on a straight-line basis (i.e., 25% in year one, 50% in year two, 75% in year three and 100% thereafter). The timing and substance of any final rulemaking is uncertain at this time. For more information on CECL and how it may affect Discover, see Note 1: Background and Basis of Presentation to our condensed consolidated financial statements.
Liquidity
We are subject to the U.S. liquidity coverage ratio rule issued by federal banking regulators. This quantitative requirement is designed to promote the short-term resilience of the liquidity risk profile of large and internationally active banking organizations in the United States. The rule requires covered banks to maintain an amount of high-quality liquid assets sufficient to cover projected net cash outflows during a prospective 30-day calendar period under an acute, hypothetical liquidity stress scenario. Given our current asset size, we are subject to a modified liquidity coverage ratio requirement, which requires a lower level of high-quality liquid assets to meet the minimum ratio requirement due to adjustments to the net cash outflow amount. As of June 30, 2018, our liquidity coverage ratio was in excess of the applicable regulatory requirement. Pursuant to the final rule issued by the Federal Reserve, we will be required to publish quarterly public disclosures regarding our liquidity risk profile and components of our liquidity coverage ratio beginning the fourth quarter of 2018.
Funding
On April 3, 2018, the Federal Reserve Bank of New York began publication of three new reference rates based on overnight repurchase agreement transactions secured by Treasury securities. These new reference rates may be used in future transactions as a replacement for London Interbank Offered Rate ("LIBOR"), which will no longer be maintained after 2021, in certain contracts.
Segments
We manage our business activities in two segments, Direct Banking and Payment Services, based on the products and services provided. For a detailed description of the operations of each segment, as well as the allocation conventions used in our business segment reporting, see Note 15: Segment Disclosures to our condensed consolidated financial statements.

53

Table of Contents

The following table presents segment data (dollars in millions):
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
  
2018
 
2017
 
2018
 
2017
Direct Banking
 
 
 
 
 
 
 
Interest income
 
 
 
 
 
 
 
Credit card
$
2,139

 
$
1,916

 
$
4,229

 
$
3,792

Private student loans
150

 
127

 
297

 
251

PCI student loans
35

 
41

 
72

 
82

Personal loans
229

 
207

 
455

 
405

Other
83

 
47

 
152

 
86

Total interest income
2,636

 
2,338

 
5,205

 
4,616

Interest expense
507

 
400

 
976

 
786

Net interest income
2,129

 
1,938

 
4,229

 
3,830

Provision for loan losses
742

 
639

 
1,493

 
1,233

Other income
398

 
408

 
792

 
783

Other expense
948

 
876

 
1,880

 
1,725

Income before income tax expense
837

 
831

 
1,648

 
1,655

Payment Services
 
 
 
 
 
 
 
Provision for loan losses

 
1

 

 
(7
)
Other income
76

 
73

 
157

 
145

Other expense
36

 
36

 
72

 
72

Income before income tax expense
40

 
36

 
85

 
80

Total income before income tax expense
$
877

 
$
867

 
$
1,733

 
$
1,735

 
 
 
 
 
 
 
 
The following table presents information on transaction volume (in millions):
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
Network Transaction Volume
 
 
 
 
 
 
 
PULSE Network
$
44,308

 
$
38,848

 
$
87,466

 
$
74,914

Network Partners
4,602

 
3,461

 
9,155

 
7,122

Diners Club(1)
8,417

 
7,800

 
16,807

 
15,182

Total Payment Services
57,327

 
50,109

 
113,428

 
97,218

Discover Network—Proprietary(2)
36,339

 
33,342

 
68,721

 
63,201

Total Volume
$
93,666

 
$
83,451

 
$
182,149

 
$
160,419

Transactions Processed on Networks
 
 
 
 
 
 
 
Discover Network
614

 
551

 
1,164

 
1,054

PULSE Network
1,055

 
961

 
2,044

 
1,831

Total
1,669

 
1,512

 
3,208

 
2,885

Credit Card Volume
 
 
 
 
 
 
 
Discover Card Volume(3)
$
38,430

 
$
35,297

 
$
72,757

 
$
67,703

Discover Card Sales Volume(4)
$
35,077

 
$
32,172

 
$
65,927

 
$
61,306

 
 
 


 
 
 
 
(1)
Diners Club volume is derived from data provided by licensees for Diners Club branded cards issued outside North America and is subject to subsequent revision or amendment.
(2)
Represents gross proprietary sales volume on the Discover Network.
(3)
Represents Discover card activity related to net sales, balance transfers, cash advances and other activity.
(4)
Represents Discover card activity related to net sales.

54

Table of Contents

Direct Banking
Our Direct Banking segment reported pretax income of $837 million and $1.6 billion for the three and six months ended June 30, 2018 as compared to pretax income of $831 million and $1.7 billion for the three and six months ended June 30, 2017.
Net interest margin increased for the three and six months ended June 30, 2018 as compared to the same periods in 2017 primarily driven by higher yields on credit card loans, partially offset by higher funding costs, both of which were the result of higher market rates. Interest income increased during the three and six months ended June 30, 2018 as compared to the same periods in 2017 due to loan growth and yield expansion resulting from prime rate increases. Interest expense increased during the three and six months ended June 30, 2018 as compared to the same periods in 2017 primarily due to higher market rates and a larger funding base.
For the three and six months ended June 30, 2018, the provision for loan losses increased as compared to the same periods in 2017 primarily due to higher levels of net charge-offs. For a detailed discussion on provision for loan losses, see "— Loan Quality — Provision and Allowance for Loan Losses."
Total other income decreased in the three months ended June 30, 2018 and increased in the six months ended June 30, 2018, respectively, as compared to the same periods in 2017. During the three and six months ended June 30, 2018, the change was primarily due to higher discount and interchange revenue driven by higher sales volume, which was more than offset by higher promotional rewards in the second quarter of 2018. In addition, the increase in loan fee income was driven primarily by an increase in late fees.
Total other expense increased in the three and six months ended June 30, 2018 as compared to the same periods in 2017. The increase was primarily driven by higher employee compensation and benefits, and marketing and business development. The increase in employee compensation and benefits was due to additional headcount for business growth and technological capabilities, as well as higher average salaries. The increase in marketing and business development was driven primarily by higher brand advertising and acquisition costs targeting loan and deposit growth.
Discover card sales volume was $35.1 billion and $65.9 billion for the three and six months ended June 30, 2018, respectively, which was an increase of 9.0% and 7.5%, respectively, as compared to the same periods in 2017. This volume growth was primarily driven by an increase in active cardmembers.
Payment Services
Our Payment Services segment reported pretax income of $40 million and $85 million for the three and six months ended June 30, 2018, respectively, as compared to pretax income of $36 million and $80 million for the same periods in 2017. The increase was primarily due to higher other income driven by higher volume.
Downturns in the global economy or negative impacts in foreign currency may adversely affect our financial condition or results of operations in our Payment Services segment. We continue to work with our Diners Club licensees with regard to their ability to maintain financing sufficient to support business operations. We may continue to provide additional support in the future, including loans, facilitating transfer of ownership, or acquiring assets or licensees, which may cause us to incur losses. The licensees that we currently consider to be of concern accounted for approximately 4% of Diners Club revenues during the three and six months ended June 30, 2018.
Critical Accounting Estimates
In preparing our condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States ("GAAP"), management must make judgments and use estimates and assumptions about the effects of matters that are uncertain. For estimates that involve a high degree of judgment and subjectivity, it is possible that different estimates could reasonably be derived for the same period. For estimates that are particularly sensitive to changes in economic or market conditions, significant changes to the estimated amount from period to period are also possible. Management believes the current assumptions and other considerations used to estimate amounts reflected in our condensed consolidated financial statements are appropriate. However, if actual experience differs from the assumptions and other considerations used in estimating amounts in our condensed consolidated financial statements, the resulting changes could have a material effect on our consolidated results of operations and, in certain cases, could have a material effect on our consolidated financial condition. Management has identified the estimates related to our allowance for loan losses, the evaluation of goodwill and other non-amortizable intangible assets for potential impairment and the accrual of income taxes

55

Table of Contents

as critical accounting estimates. These critical accounting estimates are discussed in greater detail in our annual report on Form 10-K for the year ended December 31, 2017. That discussion can be found within “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Estimates.” There have not been any material changes in the methods used to formulate these critical accounting estimates from those discussed in our annual report on Form 10-K for the year ended December 31, 2017.
Earnings Summary
The following table outlines changes in our condensed consolidated statements of income (dollars in millions):
 
For the Three Months Ended June 30,
 
2018 vs. 2017
Increase (Decrease)
 
For the Six Months Ended June 30,
 
2018 vs. 2017
Increase (Decrease)
 
2018
 
2017
 
$
 
%
 
2018
 
2017
 
$
 
%
Interest income
$
2,636

 
$
2,338

 
$
298

 
13
 %
 
$
5,205

 
$
4,616

 
$
589

 
13
 %
Interest expense
507

 
400

 
107

 
27
 %
 
976

 
786

 
190

 
24
 %
Net interest income
2,129

 
1,938

 
191

 
10
 %
 
4,229

 
3,830

 
399

 
10
 %
Provision for loan losses
742

 
640

 
102

 
16
 %
 
1,493

 
1,226

 
267

 
22
 %
Net interest income after provision for loan losses
1,387

 
1,298

 
89

 
7
 %
 
2,736

 
2,604

 
132

 
5
 %
Other income
474

 
481

 
(7
)
 
(1
)%
 
949

 
928

 
21

 
2
 %
Other expense
984

 
912

 
72

 
8
 %
 
1,952

 
1,797

 
155

 
9
 %
Income before income tax expense
877

 
867

 
10

 
1
 %
 
1,733

 
1,735

 
(2
)
 
 %
Income tax expense
208

 
321

 
(113
)
 
(35
)%
 
398

 
625

 
(227
)
 
(36
)%
Net income
$
669

 
$
546

 
$
123

 
23
 %
 
$
1,335

 
$
1,110

 
$
225

 
20
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

56

Table of Contents

Net Interest Income
The table that follows this section has been provided to supplement the discussion below and provide further analysis of net interest income and net interest margin. Net interest income represents the difference between interest income earned on our interest-earning assets and the interest expense incurred to finance those assets. We analyze net interest income in total by calculating net interest margin (net interest income as a percentage of average total loan receivables) and net yield on interest-earning assets (net interest income as a percentage of average total interest-earning assets). We also separately consider the impact of the level of loan receivables and the related interest yield and the impact of the cost of funds related to each of our funding sources, along with the income generated by our liquidity portfolio, on net interest income.
Our interest-earning assets consist of: (i) cash and cash equivalents primarily related to amounts on deposit with the Federal Reserve Bank of Philadelphia, (ii) restricted cash, (iii) other short-term investments, (iv) investment securities and (v) loan receivables. Our interest-bearing liabilities consist primarily of deposits, both direct-to-consumer and brokered, and long-term borrowings, including amounts owed to securitization investors. Net interest income is influenced by the following:
The level and composition of loan receivables, including the proportion of credit card loans to other loans, as well as the proportion of loan receivables bearing interest at promotional rates as compared to standard rates;
The credit performance of our loans, particularly with regard to charge-offs of finance charges, which reduce interest income;
The terms of long-term borrowings and certificates of deposit upon initial offering, including maturity and interest rate;
The level and composition of other interest-earning assets, including our liquidity portfolio and interest-bearing liabilities;
Changes in the interest rate environment, including the levels of interest rates and the relationships among interest rate indices, such as the prime rate, the Federal Funds rate, interest rate on excess reserves and LIBOR;
The effectiveness of interest rate swaps in our interest rate risk management program; and
The difference between the carrying amount and future cash flows expected to be collected on PCI loans.
Net interest margin increased for the three and six months ended June 30, 2018 as compared to the same periods in 2017 primarily driven by higher yields on credit card loans, partially offset by higher funding costs, both of which were the result of higher market rates. Interest income increased during the three and six months ended June 30, 2018 as compared to the same periods in 2017 due to loan growth and yield expansion resulting from prime rate increases. Interest expense increased during the three and six months ended June 30, 2018 as compared to the same periods in 2017 primarily due to higher market rates and a larger funding base.

57

Table of Contents

Average Balance Sheet Analysis
(dollars in millions)
 
For the Three Months Ended June 30,
 
2018
 
2017
 
Average Balance
 
Rate
 
Interest
 
Average Balance
 
Rate
 
Interest
Assets
 
 
 
 
 
 
 
 
 
 
 
Interest-earning assets
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
14,870

 
1.82
%
 
$
68

 
$
12,921

 
1.05
%
 
$
35

Restricted cash
466

 
1.85
%
 
2

 
559

 
0.89
%
 
1

Investment securities
1,525

 
1.67
%
 
6

 
1,695

 
1.58
%
 
7

Loan receivables(1)
 
 
 
 
 
 
 
 
 
 
 
Credit card(2)
66,594

 
12.88
%
 
2,139

 
60,700

 
12.66
%
 
1,916

Personal loans
7,304

 
12.55
%
 
228

 
6,820

 
12.22
%
 
208

Private student loans
7,321

 
8.21
%
 
150

 
6,634

 
7.71
%
 
127

PCI student loans
1,898

 
7.45
%
 
35

 
2,386

 
6.72
%
 
40

Other
531

 
6.02
%
 
8

 
314

 
5.59
%
 
4

Total loan receivables
83,648

 
12.28
%
 
2,560

 
76,854

 
11.98
%
 
2,295

Total interest-earning assets
100,509

 
10.52
%
 
2,636

 
92,029

 
10.19
%
 
2,338

Allowance for loan losses
(2,731
)
 
 
 
 
 
(2,262
)
 
 
 
 
Other assets
4,170

 
 
 
 
 
4,147

 
 
 
 
Total assets
$
101,948

 
 
 
 
 
$
93,914

 
 
 
 
Liabilities and Stockholders’ Equity
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing liabilities
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing deposits
 
 
 
 
 
 
 
 
 
 
 
Time deposits(3)
$
29,829

 
2.14
%
 
159

 
$
26,054

 
1.90
%
 
123

Money market deposits(4)
6,938

 
1.73
%
 
30

 
6,808

 
1.25
%
 
21

Other interest-bearing savings deposits
23,858

 
1.65
%
 
98

 
19,694

 
1.11
%
 
55

Total interest-bearing deposits(5)
60,625

 
1.90
%
 
287

 
52,556

 
1.52
%
 
199

Borrowings
 
 
 
 
 
 
 
 
 
 
 
Short-term borrowings
1

 
1.89
%
 

 
2

 
1.06
%
 

Securitized borrowings(3)(4)
16,121

 
2.67
%
 
108

 
16,141

 
2.31
%
 
93

Other long-term borrowings(3)
9,866

 
4.57
%
 
112

 
9,979

 
4.36
%
 
108

Total borrowings
25,988

 
3.39
%
 
220

 
26,122

 
3.09
%
 
201

Total interest-bearing liabilities
86,613

 
2.35
%
 
507

 
78,678

 
2.04
%
 
400

Other liabilities and stockholders’ equity
15,335

 
 
 
 
 
15,236

 
 
 
 
Total liabilities and stockholders’ equity
$
101,948

 
 
 
 
 
$
93,914

 
 
 
 
Net interest income
 
 
 
 
$
2,129

 
 
 
 
 
$
1,938

Net interest margin(6)
 
 
10.21
%
 
 
 
 
 
10.11
%
 
 
Net yield on interest-earning assets(7)
 
 
8.50
%
 
 
 
 
 
8.44
%
 
 
Interest rate spread(8)
 
 
8.17
%
 
 
 
 
 
8.15
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

58

Table of Contents

Average Balance Sheet Analysis
(dollars in millions)
 
For the Six Months Ended June 30,
 
2018
 
2017
 
Average
Balance
 
Rate
 
Interest
 
Average
Balance
 
Rate
 
Interest
Assets
 
 
 
 
 
 
 
 
 
 
 
Interest-earning assets
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
14,193

 
1.70
%
 
$
120

 
$
13,304

 
0.92
%
 
$
61

Restricted cash
643

 
1.61
%
 
5

 
689

 
0.78
%
 
3

Investment securities
1,537

 
1.71
%
 
13

 
1,713

 
1.60
%
 
14

Loan receivables(1)
 
 
 
 
 
 
 
 
 
 
 
Credit card(2)
66,290

 
12.87
%
 
4,229

 
60,413

 
12.66
%
 
3,792

Personal loans
7,345

 
12.49
%
 
455

 
6,702

 
12.20
%
 
405

Private student loans
7,367

 
8.12
%
 
296

 
6,656

 
7.62
%
 
251

PCI student loans
1,958

 
7.41
%
 
72

 
2,452

 
6.69
%
 
81

Other
492

 
6.00
%
 
15

 
298

 
5.50
%
 
9

Total loan receivables
83,452

 
12.24
%
 
5,067

 
76,521

 
11.96
%
 
4,538

Total interest-earning assets
99,825

 
10.52
%
 
5,205

 
92,227

 
10.09
%
 
4,616

Allowance for loan losses
(2,674
)
 
 
 
 
 
(2,214
)
 
 
 
 
Other assets
4,196

 
 
 
 
 
4,157

 
 
 
 
Total assets
$
101,347

 
 
 
 
 
$
94,170

 
 
 
 
Liabilities and Stockholders’ Equity
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing liabilities
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing deposits
 
 
 
 
 
 
 
 
 
 
 
Time deposits(3)
$
30,023

 
2.09
%
 
311

 
$
26,335

 
1.88
%
 
245

Money market deposits(4)
6,856

 
1.66
%
 
56

 
6,859

 
1.20
%
 
41

Other interest-bearing savings deposits
23,168

 
1.59
%
 
182

 
19,363

 
1.09
%
 
104

Total interest-bearing deposits(5)
60,047

 
1.85
%
 
549

 
52,557

 
1.50
%
 
390

Borrowings
 
 
 
 
 
 
 
 
 
 
 
Short-term borrowings
1

 
1.82
%
 

 
2

 
0.89
%
 

Securitized borrowings(3)(4)
16,150

 
2.55
%
 
204

 
16,548

 
2.24
%
 
184

Other long-term borrowings(3)
9,906

 
4.53
%
 
223

 
9,791

 
4.37
%
 
212

Total borrowings
26,057

 
3.30
%
 
427

 
26,341

 
3.03
%
 
396

Total interest-bearing liabilities
86,104

 
2.29
%
 
976

 
78,898

 
2.01
%
 
786

Other liabilities and stockholders’ equity
15,243

 
 
 
 
 
15,272

 
 
 
 
Total liabilities and stockholders’ equity
$
101,347

 
 
 
 
 
$
94,170

 
 
 
 
Net interest income
 
 
 
 
$
4,229

 
 
 
 
 
$
3,830

Net interest margin(6)
 
 
10.22
%
 
 
 
 
 
10.09
%
 
 
Net yield on interest-bearing assets(7)
 
 
8.54
%
 
 
 
 
 
8.37
%
 
 
Interest rate spread(8)
 
 
8.23
%
 
 
 
 
 
8.08
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
Average balances of loan receivables include non-accruing loans, which are included in the yield calculations. If the non-accruing loan balances were excluded, there would not be a material impact on the amounts reported above.
(2)
Interest income on credit card loans includes $60 million and $54 million of amortization of balance transfer fees for the three months ended June 30, 2018 and 2017, respectively, and $119 million and $106 million for the six months ended June 30, 2018 and 2017, respectively.
(3)
Includes the impact of interest rate swap agreements used to change a portion of fixed-rate funding to floating-rate funding.
(4)
Includes the impact of interest rate swap agreements used to change a portion of floating-rate funding to fixed-rate funding.
(5)
Includes the impact of FDIC insurance premiums and Large Institution Surcharge.
(6)
Net interest margin represents net interest income as a percentage of average total loan receivables.
(7)
Net yield on interest-earning assets represents net interest income as a percentage of average total interest-earning assets.
(8)
Interest rate spread represents the difference between the rate on total interest-earning assets and the rate on total interest-bearing liabilities.

59

Table of Contents

Loan Quality
Loan receivables consist of the following (dollars in millions): 
 
June 30,
2018
 
December 31, 2017
Loan receivables
 
 
 
Credit card loans
$
67,812

 
$
67,291

Other loans
 
 
 
Personal loans
7,304

 
7,374

Private student loans
7,260

 
7,076

Other
571

 
423

Total other loans
15,135

 
14,873

PCI loans(1)
1,842

 
2,084

Total loan receivables
84,789

 
84,248

Allowance for loan losses
(2,828
)
 
(2,621
)
Net loan receivables
$
81,961

 
$
81,627

 
 
 
 
(1)
Represents PCI private student loans. See Note 3: Loan Receivables to our condensed consolidated financial statements for more information regarding PCI loans.
Provision and Allowance for Loan Losses
Provision for loan losses is the expense related to maintaining the allowance for loan losses at an appropriate level to absorb the estimated probable losses in the loan portfolio at each period end date. While establishing the estimate for probable losses requires significant management judgment, the factors that influence the provision for loan losses include:
The impact of general economic conditions on the consumer, including national and regional conditions, unemployment levels, bankruptcy trends and interest rate movements;
Changes in consumer spending, payment and credit utilization behaviors;
Changes in our loan portfolio, including the overall mix of accounts, products and loan balances within the portfolio and maturation of the loan portfolio;
The level and direction of historical and anticipated loan delinquencies and charge-offs;
The credit quality of the loan portfolio, which reflects, among other factors, our credit granting practices and effectiveness of collection efforts; and
Regulatory changes or new regulatory guidance.
In determining the allowance for loan losses, we estimate probable losses separately for segments of the loan portfolio that have similar risk characteristics. We use a migration analysis to estimate the likelihood that a loan will progress through the various stages of delinquency. We use other analyses to estimate losses incurred from non-delinquent accounts, which adds to the identification of loss emergence. We use these analyses together as a basis for determining our allowance for loan losses.
The provision for loan losses is the amount of expense realized after considering the level of net charge-offs in the period and the required amount of allowance for loan losses at the balance sheet date. For the three and six months ended June 30, 2018, the provision for loan losses increased by $102 million and $267 million, or 16% and 22%, respectively, as compared to the same periods in 2017 primarily due to higher levels of net charge-offs.
The allowance for loan losses was $2.8 billion at June 30, 2018, which reflects a $207 million reserve build over the amount of the allowance for loan losses at December 31, 2017. The reserve build, which related primarily to credit card loans, was due to seasoning of continued loan growth and supply driven credit normalization.

60

Table of Contents

The following tables provide changes in our allowance for loan losses (dollars in millions):
 
For the Three Months Ended June 30, 2018
 
Credit Card
 
Personal Loans
 
Student Loans(1)
 
Other
 
Total
Balance at beginning of period
$
2,252

 
$
301

 
$
170

 
$
13

 
$
2,736

Additions
 
 
 
 
 
 
 
 
 
Provision for loan losses
637

 
84

 
22

 
(1
)
 
742

Deductions
 
 
 
 
 
 
 
 
 
Charge-offs
(684
)
 
(80
)
 
(24
)
 
(1
)
 
(789
)
Recoveries
129

 
8

 
3

 

 
140

Net charge-offs
(555
)
 
(72
)
 
(21
)
 
(1
)
 
(649
)
Other(2)

 

 
(1
)
 

 
(1
)
Balance at end of period
$
2,334

 
$
313

 
$
170

 
$
11

 
$
2,828

 


 
 
 
 
 
 
 


 
For the Three Months Ended June 30, 2017
 
Credit Card
 
Personal Loans
 
Student Loans(1)
 
Other
 
Total
Balance at beginning of period
$
1,892

 
$
207

 
$
156

 
$
9

 
$
2,264

Additions
 
 
 
 
 
 
 
 
 
Provision for loan losses
533

 
82

 
23

 
2

 
640

Deductions
 
 
 
 
 
 
 
 
 
Charge-offs
(561
)
 
(61
)
 
(22
)
 
(1
)
 
(645
)
Recoveries
116

 
7

 
2

 

 
125

Net charge-offs
(445
)
 
(54
)
 
(20
)
 
(1
)
 
(520
)
Balance at end of period
$
1,980

 
$
235

 
$
159

 
$
10

 
$
2,384

 
 
 
 
 
 
 
 
 
 
 
For the Six Months Ended June 30, 2018
 
Credit Card
 
Personal Loans
 
Student Loans(1)
 
Other
 
Total
Balance at beginning of period
$
2,147

 
$
301

 
$
162

 
$
11

 
$
2,621

Additions
 
 
 
 
 
 
 
 
 
Provision for loan losses
1,282

 
157

 
53

 
1

 
1,493

Deductions
 
 
 
 
 
 
 
 
 
Charge-offs
(1,347
)
 
(161
)
 
(49
)
 
(1
)
 
(1,558
)
Recoveries
252

 
16

 
6

 

 
274

Net charge-offs
(1,095
)
 
(145
)
 
(43
)
 
(1
)
 
(1,284
)
Other(2)

 

 
(2
)
 

 
(2
)
Balance at end of period
$
2,334

 
$
313

 
$
170

 
$
11

 
$
2,828




 


 


 


 


 
For the Six Months Ended June 30, 2017
 
Credit Card
 
Personal Loans
 
Student Loans(1)
 
Other
 
Total
Balance at beginning of period
$
1,790

 
$
200

 
$
158

 
$
19

 
$
2,167

Additions
 
 
 
 
 
 
 
 
 
Provision for loan losses
1,057

 
140

 
35

 
(6
)
 
1,226

Deductions
 
 
 
 
 
 
 
 
 
Charge-offs
(1,096
)
 
(118
)
 
(39
)
 
(3
)
 
(1,256
)
Recoveries
229

 
13

 
5

 

 
247

Net charge-offs
(867
)
 
(105
)
 
(34
)
 
(3
)
 
(1,009
)
Balance at end of period
$
1,980

 
$
235

 
$
159

 
$
10

 
$
2,384

 
 
 
 
 
 
 
 
 
 
(1)
Includes both PCI and non-PCI private student loans.
(2)
Net change in reserves on PCI pools having no remaining non-accretable difference.

61

Table of Contents

Net Charge-offs
Our net charge-offs include the principal amount of losses charged off less principal recoveries and exclude charged-off and recovered interest and fees and fraud losses. Charged-off and recovered interest and fees are recorded in interest income and loan fee income, respectively, which is effectively a reclassification of the provision for loan losses, while fraud losses are recorded in other expense. Credit card loan receivables are charged off at the end of the month during which an account becomes 180 days contractually past due. Personal loans and private student loans, which are closed-end consumer loan receivables, are generally charged off at the end of the month during which an account becomes 120 days contractually past due. Generally, customer bankruptcies and probate accounts are charged off at the end of the month 60 days following the receipt of notification of the bankruptcy or death but not later than the 180-day or 120-day contractual time frame.
The following table presents amounts and rates of net charge-offs of key loan products (dollars in millions):
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
$
 
%
 
$
 
%
 
$
 
%
 
$
 
%
Credit card loans
$
555

 
3.34
%
 
$
445

 
2.94
%
 
$
1,095

 
3.33
%
 
$
867

 
2.89
%
Personal loans
$
72

 
3.97
%
 
$
54

 
3.18
%
 
$
145

 
4.00
%
 
$
105

 
3.17
%
Private student loans (excluding PCI(1))
$
21

 
1.16
%
 
$
20

 
1.15
%
 
$
43

 
1.17
%
 
$
34

 
0.99
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
Charge-offs for PCI loans did not result in a charge to earnings during any of the periods presented and are therefore excluded from the calculation. See Note 3: Loan Receivables to our condensed consolidated financial statements for more information regarding the accounting for charge-offs on PCI loans.
The net charge-off rates on our credit card and personal loans increased 40 and 79 basis points, respectively, for the three months ended June 30, 2018 and 44 and 83 basis points, respectively, for the six months ended June 30, 2018 when compared to the same periods in 2017. The increase for credit card and personal loans was driven by seasoning of continued loan growth and supply driven credit normalization. The net charge-off rate on our private student loans remained relatively flat for the three months ended June 30, 2018 and increased 18 basis points for the six months ended June 30, 2018 when compared to the same periods in 2017. The increase for the six months ended June 30, 2018 was driven by seasoning of continued loan growth and supply driven credit normalization.

62

Table of Contents

Delinquencies
Delinquencies are an indicator of credit quality at a point in time. A loan balance is considered delinquent when contractual payments on the loan become 30 days past due.
The following table presents the amounts and delinquency rates of key loan products that are 30 and 90 days or more delinquent, loan receivables that are not accruing interest, regardless of delinquency and restructured loans (dollars in millions):
 
June 30, 2018
 
December 31, 2017
 
$
 
%
 
$
 
%
Loans 30 or more days delinquent
 
 
 
 
 
 
 
Credit card loans
$
1,466

 
2.16
%
 
$
1,532

 
2.28
%
Personal loans
$
104

 
1.42
%
 
$
103

 
1.40
%
Private student loans (excluding PCI loans(1))
$
152

 
2.10
%
 
$
167

 
2.35
%
 
 
 
 
 
 
 
 
Loans 90 or more days delinquent
 
 
 
 
 
 
 
Credit card loans
$
743

 
1.09
%
 
$
751

 
1.12
%
Personal loans
$
30

 
0.42
%
 
$
30

 
0.41
%
Private student loans (excluding PCI loans(1))
$
46

 
0.64
%
 
$
33

 
0.47
%
 
 
 
 
 
 
 
 
Loans not accruing interest
$
244

 
0.29
%
 
$
233

 
0.28
%
 
 
 
 
 
 
 
 
Restructured loans
 
 
 
 
 
 
 
Credit card loans(2)
$
1,698

 
2.50
%
 
$
1,316

 
1.96
%
Personal loans(3)
$
130

 
1.78
%
 
$
111

 
1.51
%
Private student loans (excluding PCI loans(1))(4)
$
161

 
2.22
%
 
$
137

 
1.94
%
 
 
 
 
 
 
 
 
(1)
Excludes PCI loans, which are accounted for on a pooled basis. Since a pool is accounted for as a single asset with a single composite interest rate and aggregate expectation of cash flows, the past-due status of a pool, or that of the individual loans within a pool, is not meaningful. Because we are recognizing interest income on a pool of loans, it is all considered to be performing.
(2)
Restructured credit card loans include $88 million and $74 million at June 30, 2018 and December 31, 2017, respectively, which are also included in loans 90 or more days delinquent.
(3)
Restructured personal loans include $5 million at June 30, 2018 and December 31, 2017, which are also included in loans 90 or more days delinquent.
(4)
Restructured private student loans include $7 million and $5 million at June 30, 2018 and December 31, 2017, respectively, which are also included in loans 90 or more days delinquent.
The 30-day and 90-day delinquency rates for credit card loans at June 30, 2018 decreased compared to December 31, 2017 primarily due to seasonality. The 30-day and 90-day delinquency rates for personal loans were relatively flat compared to December 31, 2017. The 30-day delinquency rate for private student loans at June 30, 2018 decreased while the 90-day delinquency rate increased compared to December 31, 2017 as a result of seasonality of the portfolio.
The restructured loan balances at June 30, 2018 increased as compared to December 31, 2017 due to seasoning of continued loan growth and greater utilization of programs available.
Modified and Restructured Loans
We have loan modification programs that provide for temporary or permanent hardship relief for our credit card loans to borrowers experiencing financial difficulties. We offer temporary hardship programs consisting of an interest rate reduction and in some cases a reduced minimum payment, both lasting for a period no longer than 12 months. The permanent modification program involves changing the structure of the loan to a fixed payment loan with a maturity no longer than 60 months and reducing the interest rate on the loan. The permanent modification program does not normally provide for the forgiveness of unpaid principal, but may allow for the reversal of certain unpaid interest or fee assessments. We also make permanent loan modifications for customers who request financial assistance through external sources, such as a consumer credit counseling agency program. These loans continue to be subject to the original minimum payment terms and do not normally include waiver of unpaid principal, interest or fees. Modified credit card loans that are deemed to meet the definition of troubled debt restructurings ("TDRs") in both temporary and permanent programs.
For personal loan customers, in certain situations we offer various payment programs, including temporary and permanent programs. The temporary programs normally consist of a reduction of the minimum payment for a period of no

63

Table of Contents

longer than 12 months with the option of a final balloon payment required at the end of the loan term or an extension of the maturity date with the total term not exceeding nine years. Further, in certain circumstances, the interest rate on the loan is reduced. The permanent programs involve changing the terms of the loan in order to pay off the outstanding balance over a longer term and also in certain circumstances reducing the interest rate on the loan. Similar to the temporary programs, the total term may not exceed nine years. We also allow permanent loan modifications for customers who request financial assistance through external sources, similar to our credit card customers discussed above. Payments are modified based on the new terms agreed upon with the credit counseling agency. Personal loans included in temporary and permanent programs are accounted for as TDRs.
At June 30, 2018, there was $5.5 billion of private student loans in repayment, which includes both PCI and non-PCI loans to students who are not in deferment. To assist student loan borrowers who are experiencing temporary financial difficulties but are willing to resume making payments, we may offer hardship forbearance or programs that include payment deferral, temporary payment reduction, temporary interest rate reduction or extended terms. A non-PCI modified loan typically meets the definition of a TDR based on the cumulative length of the concession period and an evaluation of the credit quality of the borrower based on FICO scores.
Borrower performance after using payment programs or forbearance is monitored and we believe the programs help to prevent defaults and are useful in assisting customers experiencing financial difficulties. We plan to continue to use payment programs and forbearance and, as a result, we expect to have additional loans classified as TDRs in the future.
For additional information regarding the accounting treatment for these loans as well as amounts recorded in the financial statements related to these loans, see Note 3: Loan Receivables to our condensed consolidated financial statements.
Other Income
The following table presents the components of other income (dollars in millions):
 
For the Three Months Ended June 30,
 
2018 vs. 2017
(Decrease) Increase
 
For the Six Months Ended June 30,
 
2018 vs. 2017
Increase (Decrease)
 
2018
 
2017
 
$
 
%
 
2018
 
2017
 
$
 
%
Discount and interchange revenue, net(1)
$
263

 
$
278

 
$
(15
)
 
(5
)%
 
$
517

 
$
511

 
$
6

 
1
 %
Protection products revenue
50

 
56

 
(6
)
 
(11
)%
 
103

 
114

 
(11
)
 
(10
)%
Loan fee income
95

 
83

 
12

 
14
 %
 
191

 
172

 
19

 
11
 %
Transaction processing revenue
42

 
42

 

 
 %
 
85

 
81

 
4

 
5
 %
Other income
24

 
22

 
2

 
9
 %
 
53

 
50

 
3

 
6
 %
Total other income
$
474

 
$
481

 
$
(7
)
 
(1
)%
 
$
949

 
$
928

 
$
21

 
2
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
Net of rewards, including Cashback Bonus rewards, of $461 million and $388 million for the three months ended June 30, 2018 and 2017, respectively, and $853 million and $751 million of for the six months ended June 30, 2018 and 2017, respectively.
Total other income decreased in the three months ended June 30, 2018 and increased in the six months ended June 30, 2018, respectively, as compared to the same periods in 2017. During the three and six months ended June 30, 2018, the change was primarily due to higher discount and interchange revenue driven by higher sales volume, which was more than offset by higher promotional rewards in the second quarter of 2018. In addition, the increase in loan fee income was driven primarily by an increase in late fees.

64

Table of Contents

Other Expense
The following table represents the components of other expense (dollars in millions):
 
For the Three Months Ended June 30,
 
2018 vs. 2017
Increase (Decrease)
 
For the Six Months Ended June 30,
 
2018 vs. 2017
Increase
 
2018
 
2017
 
$
 
%
 
2018
 
2017
 
$
 
%
Employee compensation and benefits
$
400

 
$
367

 
$
33

 
9
 %
 
$
805

 
$
730

 
$
75

 
10
%
Marketing and business development
224

 
192

 
32

 
17
 %
 
409

 
360

 
49

 
14
%
Information processing and communications
86

 
77

 
9

 
12
 %
 
168

 
157

 
11

 
7
%
Professional fees
161

 
156

 
5

 
3
 %
 
316

 
303

 
13

 
4
%
Premises and equipment
24

 
23

 
1

 
4
 %
 
50

 
48

 
2

 
4
%
Other expense
89

 
97

 
(8
)
 
(8
)%
 
204

 
199

 
5

 
3
%
Total other expense
$
984

 
$
912

 
$
72

 
8
 %
 
$
1,952

 
$
1,797

 
$
155

 
9
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total other expense increased in the three and six months ended June 30, 2018, respectively, as compared to the same periods in 2017. The increase was primarily driven by higher employee compensation and benefits, and marketing and business development. The increase in employee compensation and benefits was due to additional headcount for business growth and technological capabilities, as well as higher average salaries. The increase in marketing and business development was driven primarily by higher brand advertising and acquisition costs targeting loan and deposit growth.
Income Tax Expense
The following table presents the calculation of the effective income tax rate (dollars in millions, except effective income tax rate):
 
For the Three Months Ended June 30,
 
For the Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
Income before income tax expense
$
877

 
$
867

 
$
1,733

 
$
1,735

Income tax expense
$
208

 
$
321

 
$
398

 
$
625

Effective income tax rate
23.7
%

37.1
%

23.0
%

36.0
%
 
 
 
 
 
 
 
 
Income tax expense decreased $113 million and $227 million, respectively, for the three and six months ended June 30, 2018 as compared to the same periods in 2017. The effective tax rates decreased 13.4% and 13.0%, respectively, for the three and six months ended June 30, 2018 as compared to the same periods in 2017. The decrease in rates is primarily due to a reduction in the U.S. federal statutory income tax rate from 35% to 21% offset by other effects of TCJA. For the six months ended June 30, 2018, the effective tax rate was also favorably impacted by the resolution of certain tax matters.
Liquidity and Capital Resources
Funding and Liquidity
We seek to maintain stable, diversified and cost-effective funding sources and a strong liquidity profile in order to fund our business and repay or refinance our maturing obligations under both normal operating conditions and periods of economic or financial stress. In managing our liquidity risk, we seek to maintain a prudent liability maturity profile and ready access to an ample store of primary and contingent liquidity sources. Our primary funding sources include direct-to-consumer and brokered deposits, public term asset-backed securitizations and other short-term and long-term borrowings. Our primary liquidity sources include a liquidity portfolio comprised of highly liquid, unencumbered assets, including cash and cash equivalents and investment securities, and borrowing capacity through private term asset-backed securitizations. In addition, we have unused borrowing capacity with the Federal Reserve discount window, which provides another source of contingent liquidity.

65

Table of Contents

Funding Sources
Deposits
We offer deposit products to customers through two channels: (i) through direct marketing, internet origination and affinity relationships (“direct-to-consumer deposits”); and (ii) indirectly through contractual arrangements with securities brokerage firms (“brokered deposits”). Direct-to-consumer deposits include certificates of deposit, money market accounts, online savings and checking accounts, and IRA certificates of deposit, while brokered deposits include certificates of deposit and sweep accounts. At June 30, 2018, we had $42.3 billion of direct-to-consumer deposits and $19.4 billion of brokered and other deposits.
Credit Card Securitization Financing
We securitize credit card receivables as a source of funding. We access the asset-backed securitization market using the Discover Card Master Trust I ("DCMT") and the Discover Card Execution Note Trust ("DCENT"), through which we issue DCENT DiscoverSeries notes in both public and private transactions. From time to time, we may add credit card receivables to these trusts to create sufficient funding capacity for future securitizations while managing seller’s interest. We retain significant exposure to the performance of trust assets through holdings of the seller's interest and subordinated security classes of DCENT.
The securitization structures include certain features designed to protect investors. The primary feature relates to the availability and adequacy of cash flows in the securitized pool of receivables to meet contractual requirements, the insufficiency of which triggers early repayment of the securities. We refer to this as "economic early amortization", which is based on excess spread levels. Excess spread is the amount by which income received by a trust during a collection period, including interest collections, fees and interchange, exceeds the fees and expenses of the trust during such collection period, including interest expense, servicing fees and charged-off receivables. In the event of an economic early amortization, which would occur if the excess spread fell below 0% on a three-month rolling average basis, we would be required to repay the affected outstanding securitized borrowings using available collections received by the trust; the period of ultimate repayment would be determined by the amount and timing of collections received. An early amortization event would impair our liquidity, and may require us to utilize our available non-securitization related contingent liquidity or rely on alternative funding sources, which may or may not be available at the time. As of June 30, 2018, the DiscoverSeries three-month rolling average excess spread was 12.61%.
We may elect to add receivables to the restricted pool of receivables, subject to certain requirements. Through our wholly-owned indirect subsidiary, Discover Funding LLC, we are required to maintain a contractual minimum level of receivables in the trust in excess of the face value of outstanding investors’ interests. This excess is referred to as the minimum seller’s interest. The required minimum seller’s interest in the pool of trust receivables, which is included in credit card loan receivables restricted for securitization investors, is set at approximately 7% in excess of the total investors’ interests (which includes interests held by third parties as well as those interests held by us). If the level of receivables in the trust were to fall below the required minimum, we would be required to add receivables from the unrestricted pool of receivables, which would increase the amount of credit card loan receivables restricted for securitization investors. A decline in the amount of the excess seller’s interest could occur if balance repayments and charge-offs exceeded new lending on the securitized accounts or as a result of changes in total outstanding investors’ interests. Seller's interest is impacted by seasonality as higher balance repayments tend to occur in the first calendar year quarter. If we could not add enough receivables to satisfy the minimum seller's interest requirement, an early amortization (or repayment) of investors’ interests would be triggered. No accounts were added to those restricted for securitization investors for the three or six months ended June 30, 2018.
At June 30, 2018, we had $16.0 billion of outstanding public asset-backed securities and $5.1 billion of outstanding subordinated asset-backed securities that had been issued to our wholly-owned subsidiaries.
The following table summarizes expected contractual maturities of the investors’ interests in credit card securitizations, excluding those that have been issued to our wholly-owned subsidiaries (dollars in millions):
At June 30, 2018
Total
 
Less Than
One Year
 
One Year
Through
Three Years
 
Four Years
Through
Five Years
 
After Five
Years
Scheduled maturities of long-term borrowings - owed to credit card securitization investors
$
15,834

 
$
5,316

 
$
5,926

 
$
3,272

 
$
1,320

 
 
 
 
 
 
 
 
 
 

66

Table of Contents

The triple-A rating of DCENT Class A Notes issued to date has been based, in part, on an FDIC rule, which created a safe harbor that provides that the FDIC, as conservator or receiver, will not, using its power to disaffirm or repudiate contracts, seek to reclaim or recover assets transferred in connection with a securitization, or recharacterize them as assets of the insured depository institution, provided such transfer satisfies the conditions for sale accounting treatment under previous GAAP. Although the implementation of the Financial Accounting Standards Board Accounting Standards Codification Topic 860, Transfers and Servicing, no longer qualified certain transfers of assets for sale accounting treatment, the FDIC approved a final rule that preserved the safe-harbor treatment applicable to revolving trusts and master trusts, including DCMT, so long as those trusts would have satisfied the original FDIC safe harbor if evaluated under GAAP pertaining to transfers of financial assets in effect prior to December 1, 2009. Other legislative and regulatory developments may, however, impact our ability and/or desire to issue asset-backed securities in the future.
Other Long-Term Borrowings—Student Loans
At June 30, 2018, we had $533 million of remaining principal balance outstanding on securitized debt assumed as part of our acquisition of The Student Loan Corporation. Principal and interest payments on the underlying student loans will reduce the balance of these secured borrowings over time.
Other Long-Term Borrowings - Corporate and Bank Debt
The following table provides a summary of Discover Financial Services (Parent Company) and Discover Bank outstanding fixed-rate debt (dollars in millions):
At June 30, 2018
Principal Amount Outstanding
Discover Financial Services (Parent Company) fixed-rate senior notes, maturing 2019-2027
$
2,900

Discover Financial Services (Parent Company) fixed-rate retail notes, maturing 2018-2031
$
354

Discover Bank fixed-rate senior bank notes, maturing 2018-2026
$
6,200

Discover Bank fixed-rate subordinated bank notes, maturing 2019-2020
$
700

 
 
Certain Discover Financial Services senior notes require us to offer to repurchase the notes at a price equal to 101% of their aggregate principal amount plus accrued and unpaid interest in the event of a change of control involving us and a corresponding ratings downgrade to below investment grade.
Short-Term Borrowings
As part of our regular funding strategy, we may from time to time borrow short-term funds in the federal funds market or the repurchase (“repo”) market through repurchase agreements. Federal funds are short-term, unsecured loans between banks or other financial entities with a Federal Reserve account. Funds borrowed in the repo market are short-term, collateralized loans, usually secured with highly-rated investment securities such as U.S. Treasury bills or notes, or federal agency mortgage bonds or debentures. At June 30, 2018 and December 31, 2017, there were no outstanding balances in the federal funds market or repurchase agreements.
Additional Funding Sources
Private Asset-Backed Securitizations
We have access to committed borrowing capacity through privately placed asset-backed securitizations. At June 30, 2018, we had total committed capacity of $6.0 billion, none of which was drawn. While we may utilize funding from these private securitizations from time to time for normal business operations, their committed nature also makes them a reliable contingency funding source. Therefore, we reserve some undrawn capacity, informed by our liquidity stress testing results, for potential contingency funding needs. We also seek to ensure the stability and reliability of these securitizations by staggering their maturity dates, renewing them approximately one year prior to their scheduled maturity dates and periodically drawing them for operational testing purposes.
Federal Reserve
Discover Bank has access to the Federal Reserve Bank of Philadelphia’s discount window. As of June 30, 2018, Discover Bank had $30.4 billion of available borrowing capacity through the discount window based on the amount and type

67

Table of Contents

of assets pledged, primarily consumer loans. We have no borrowings outstanding under the discount window and reserve this capacity as a source of contingent liquidity.
Funding Uses
Our primary uses of funds include the extensions of loans and credit, primarily through Discover Bank, the purchase of investment securities for our liquidity portfolio, working capital, and debt and capital service. We assess funding uses and liquidity needs under stressed and normal operating conditions, considering primary uses of funding, such as on-balance sheet loans, and contingent uses of funding, such as the need to post additional collateral for derivatives positions. In order to anticipate funding needs under stress, we conduct liquidity stress testing to assess the impact of idiosyncratic, systemic, and hybrid (idiosyncratic and systemic) scenarios with varying levels of liquidity risk reflecting a range of stress severity.
Credit Ratings
Our borrowing costs and capacity in certain funding markets, including those for securitizations and unsecured senior and subordinated debt, may be affected by the credit ratings of DFS, Discover Bank and the securitization trusts. Downgrades in these credit ratings could result in higher interest expense on our unsecured debt and asset securitizations, as well as higher collateral enhancement requirements for both our public and private asset securitizations. In addition to increased funding costs, deterioration in credit ratings could reduce our borrowing capacity in the unsecured debt and asset securitization capital markets.
We also maintain agreements with certain of our derivative counterparties that contain provisions that require DFS and Discover Bank to maintain an investment grade credit rating from specified major credit rating agencies. At June 30, 2018, Discover Bank's credit rating met specified thresholds set by its counterparties. However, if its credit ratings were reduced below investment grade, Discover Bank would be required to post additional collateral, which, as of June 30, 2018, would have been $20 million. DFS (Parent Company) had no outstanding derivatives as of June 30, 2018, and therefore, no collateral was required.
A credit rating is not a recommendation to buy, sell or hold securities, may be subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating. Our credit ratings are summarized in the following table:
 
Moody’s Investors Service
 
Standard & Poor’s
 
Fitch
Ratings
Discover Financial Services
 
 
 
 
 
Senior unsecured debt
Ba1
 
BBB-
 
BBB+
Outlook for Discover Financial Services senior unsecured debt
Positive
 
Stable
 
Stable
Discover Bank
 
 
 
 
 
Senior unsecured debt
Baa3
 
BBB
 
BBB+
Outlook for Discover Bank senior unsecured debt
Positive
 
Stable
 
Stable
Subordinated debt
Ba1
 
BBB-
 
BBB
Discover Card Execution Note Trust
 
 
 
 
 
Class A(1)
Aaa(sf)
 
AAA(sf)
 
AAA(sf)
 
 
 
 
 
 
(1)
An “sf” in the rating denotes rating agency identification for structured finance product ratings.
Liquidity
We seek to ensure that we have adequate liquidity to sustain business operations, fund asset growth and satisfy debt obligations under stressed and normal operating conditions. In addition to the funding sources discussed in the previous section, we also maintain highly liquid, unencumbered assets in our liquidity portfolio that we expect to be able to convert to cash quickly and with little loss of value using either the repo market or outright sales.
We maintain a liquidity risk and funding management policy, which outlines the overall framework and general principles we follow in managing liquidity risk across our business. The policy is approved by the Board of Directors with implementation responsibilities delegated to the Asset and Liability Management Committee (the “ALCO”). Additionally, we maintain a liquidity management framework document, which outlines the general strategies, objectives and principles we utilize to manage our liquidity position and the various liquidity risks inherent in our business model. We seek to balance the trade-offs between maintaining too much liquidity, which may be costly, with having too little liquidity, which could cause

68

Table of Contents

financial distress. Liquidity risk is centrally managed by the ALCO, which is chaired by our Treasurer and has cross-functional membership. The ALCO monitors the liquidity risk profiles of DFS and Discover Bank and oversees any actions Corporate Treasury may take to ensure that we maintain ready access to our funding sources and sufficient liquidity to meet current and projected needs. In addition, the ALCO and our Board of Directors regularly review our compliance with our liquidity limits at DFS and Discover Bank, which are established in accordance with the liquidity risk appetite set by our Board of Directors.
We employ a variety of metrics to monitor and manage liquidity. We utilize early warning indicators (“EWIs”) to detect the initial phases of liquidity stress events and a reporting and escalation process that is designed to be consistent with regulatory guidance. The EWIs include both idiosyncratic and systemic measures, and are monitored on a daily basis and reported to the ALCO regularly. A warning from one or more of these indicators triggers prompt review and decision-making by our senior management team, and in certain instances may lead to the convening of a senior-level response team and activation of our contingency funding plan.
In addition, we conduct liquidity stress testing regularly and ensure contingency funding is in place to address potential liquidity shortfalls. We evaluate a range of stress scenarios that are designed in accordance with regulatory requirements, including idiosyncratic, systemic and a combination of such events that could impact funding sources and our ability to meet liquidity needs. These scenarios measure the projected liquidity position at DFS and Discover Bank across a range of time horizons by comparing estimated contingency funding needs to available contingent liquidity.
Our primary contingent liquidity sources include our liquidity portfolio and private securitizations with unused borrowing capacity. In addition, we have unused borrowing capacity with the Federal Reserve discount window, which provides an additional source of contingent liquidity. We seek to maintain sufficient liquidity to be able to satisfy all maturing obligations and fund business operations for at least 12 months in a severe stress environment. In such an environment, we may also take actions to curtail the size of our balance sheet, which would reduce the need for funding and liquidity.
At June 30, 2018, our liquidity portfolio is comprised of highly liquid, unencumbered assets, including cash and cash equivalents and investment securities. Cash and cash equivalents were primarily in the form of deposits with the Federal Reserve. Investment securities primarily included debt obligations of the U.S. Treasury and residential mortgage-backed securities issued by U.S. government housing agencies or Government Sponsored Enterprises. These investments are considered highly liquid, and we expect to have the ability to raise cash by selling them, utilizing repurchase agreements or pledging certain of these investments to access secured funding. The size and composition of our liquidity portfolio may fluctuate based upon the size of our balance sheet as well as operational requirements and market conditions.
At June 30, 2018, our liquidity portfolio and undrawn credit facilities were $52.1 billion, which was $3.4 billion higher than the balance at December 31, 2017. During the three and six months ended June 30, 2018, the average balance of our liquidity portfolio was $16.5 billion and $15.8 billion, respectively.
 
June 30,
2018
 
December 31,
2017
 
(dollars in millions)
Liquidity portfolio
 
 
 
Cash and cash equivalents(1)
$
14,439

 
$
12,213

Investment securities(2)
1,264

 
1,347

Total liquidity portfolio
15,703

 
13,560

Private asset-backed securitizations(3)
6,000

 
6,000

Primary liquidity sources
21,703

 
19,560

Federal Reserve discount window(3)
30,422

 
29,153

Total liquidity portfolio and undrawn credit facilities
$
52,125

 
$
48,713

 
 
 
 
(1)
Cash in the process of settlement and restricted cash are excluded from cash and cash equivalents for liquidity purposes.
(2)
Excludes $32 million and $48 million of U.S. Treasury securities that have been pledged as swap collateral in lieu of cash as of June 30, 2018 and December 31, 2017, respectively.
(3)
See "— Additional Funding Sources" for additional information.

69

Table of Contents

Bank Holding Company Liquidity
The primary uses of funds at the unconsolidated DFS level include debt service obligations (interest payments and return of principal) and capital service and management activities, which include dividend payments on capital instruments and the periodic repurchase of shares of our common stock. Our primary sources of funds at the bank holding company level include the proceeds from the issuance of unsecured debt and capital securities, as well as dividends from our subsidiaries, particularly Discover Bank. Under periods of idiosyncratic or systemic stress, the bank holding company could lose or experience impaired access to the capital markets. In addition, our regulators have the discretion to restrict dividend payments from Discover Bank to the bank holding company.
We utilize a measure referred to as Number of Months of Pre-Funding to determine the length of time Discover Financial Services can meet upcoming funding obligations including common and preferred stock dividend payments and debt service obligations using existing cash resources. At June 30, 2018, Discover Financial Services had sufficient cash resources to fund the dividend and debt service payments for more than 18 months.
We structure our debt maturity schedule to minimize the amount of debt maturing within a short period of time. See Note 6: Long-Term Borrowings to our condensed consolidated financial statements for further information regarding our debt. Our ALCO and Board of Directors regularly review our compliance with our liquidity limits as a bank holding company, which are established in accordance with the liquidity risk appetite articulated by our Board.
Capital
Our primary sources of capital are the earnings generated by our businesses and the proceeds from issuances of capital securities. We seek to manage capital to a level and composition sufficient to support the growth and risks of our businesses and to meet regulatory requirements, rating agency targets and debt investor expectations. Within these constraints, we are focused on deploying capital in a manner that provides attractive returns to our stockholders. The level, composition and utilization of capital are influenced by changes in the economic environment, strategic initiatives, and legislative and regulatory developments.
Under regulatory capital requirements adopted by the Federal Reserve and the FDIC, DFS, along with Discover Bank, must maintain minimum levels of capital. Failure to meet minimum capital requirements can result in the initiation of certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could limit our business activities and have a direct material effect on our financial position and results. We must meet specific capital requirements that involve quantitative measures of assets, liabilities and certain off-balance sheet items, as calculated under regulatory guidance and regulations. Current or future legislative or regulatory initiatives may require us to hold more capital in the future.
In 2013, the Federal Reserve, the Office of the Comptroller of the Currency, and the FDIC issued the Basel III rules applicable to DFS and Discover Bank. Under those rules, DFS and Discover Bank are classified as "Standardized Approach" entities, defined as U.S. banking organizations with consolidated total assets over $50 billion but not exceeding $250 billion and consolidated total on-balance sheet foreign exposures less than $10 billion. Additional phase-in requirements related to components of the final capital rules will become effective through 2019. The Basel III rules include new minimum and "well-capitalized" risk-based capital and leverage ratios, effective January 1, 2015, and refine the definition of what constitutes "capital" for purposes of calculating those ratios of which certain requirements are subject to phase-in periods through the end of 2018 (the "transition period"). During the transition period, the effects of the changes to capital (i.e., certain deductions and adjustments) are recognized in 20% increments from 2015 through 2018. For example, one of the deductions from CET1 capital, goodwill and intangibles, was subject to a 40% of total deduction in 2015 that increased to 60% in 2016 and so on, until reaching 100% deduction of total in 2018. For additional information regarding the risk-based capital and leverage ratios, see Note 10: Capital Adequacy to our condensed consolidated financial statements.
The Basel III rules also introduced a CCB on top of the minimum risk-weighted asset ratios. The buffer is designed to absorb losses during periods of economic stress. The calculation of the buffer started to phase in beginning on January 1, 2016 at the rate of 0.625% and increases by 0.625% on each subsequent January 1 until it reaches the maximum 2.5% on January 1, 2019. When the CCB is fully phased-in on January 1, 2019, this will effectively result in minimum ratios of (i) CET1 to risk-weighted assets of at least 7.0%, (ii) Tier 1 capital to risk-weighted assets of at least 8.5% and (iii) Total capital to risk-weighted assets of at least 10.5%. Banking institutions with a capital ratio below the required amount will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.

70

Table of Contents

Another main component of the Basel III rules is a prescribed standardized approach for calculating risk-weighted assets that expands the risk-weight range from 0% to 100% (under Basel I) to 0% to 1,250% (under Basel III). The new range is intended to be more risk-sensitive and the risk weight assigned depends on the nature of the asset in question.
The Basel III rules provide for a number of the deductions from and adjustments to CET1, to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15%.
Basel III also requires disclosures relating to market discipline. This series of disclosures is commonly referred to as “Pillar 3.” The objective is to increase transparency of capital requirements for banking organizations. We are required to make prescribed regulatory disclosures on a quarterly basis regarding our capital structure, capital adequacy, risk exposures and risk-weighted assets. The Pillar 3 disclosures are made publicly available on our website in a report called "Basel III Regulatory Capital Disclosures."
At June 30, 2018, DFS and Discover Bank met the requirements for "well-capitalized" status under Regulation Y and the prompt corrective action rules, respectively, exceeding the regulatory minimums to which they were subject under the applicable rules.
As discussed in Note 10: Capital Adequacy to our condensed consolidated financial statements, we are subject to a CET1 capital ratio requirement under the Basel III rules. At June 30, 2018, there was no difference between our CET1 capital ratio of 11.6% calculated under Basel III transition rules and our CET1 capital ratio calculated under Basel III fully phased-in rules. We disclose tangible common equity, which represents common equity less goodwill and intangibles. Management believes that common stockholders' equity excluding goodwill and intangibles is a more meaningful measure to investors of our true net asset value. As of June 30, 2018, tangible common equity is not formally defined by U.S. GAAP or codified in the federal banking regulations and, as such, is considered to be a non-GAAP financial measure. Other financial services companies may also disclose this metric and definitions may vary, so we advise users of this information to exercise caution in comparing this metric for different companies.
The following table provides a reconciliation of total common stockholders’ equity (a U.S. GAAP financial measure) to tangible common equity (dollars in millions):
 
June 30,
2018
 
December 31,
2017
Total common stockholders’ equity(1)
$
10,326

 
$
10,329

Less: Goodwill
(255
)
 
(255
)
Less: Intangible assets, net
(162
)
 
(163
)
Tangible common equity
$
9,909

 
$
9,911

 
 
 
 
(1)
Total common stockholders’ equity is calculated as total stockholders’ equity less preferred stock.
Additionally, we are required to submit an annual capital plan to the Federal Reserve that includes an assessment of our expected uses and sources of capital over a nine-quarter planning horizon. We submitted our annual capital plan to the Federal Reserve under its CCAR program and received notice in June 2018 that the Federal Reserve does not object to our proposed capital plan, including planned quarterly capital distributions through June 30, 2019. Our ability to make capital distributions, including our ability to pay dividends on or repurchase shares of our common stock, will continue to be subject to the Federal Reserve’s review and non-objection of the actions that we propose each year in our annual capital plan.
In June 2018, the Federal Reserve published the results of its annual supervisory stress tests for bank holding companies with $50 billion or more in total consolidated assets, including DFS. At that same time, we published company-run stress test results for DFS and Discover Bank. DFS is required to publish company-run stress tests results twice each year in accordance with Federal Reserve rules and Discover Bank is required to publish bank-run stress test results under FDIC rules.
We recently declared a quarterly cash dividend on our common stock of $0.40 per share, payable on September 6, 2018 to holders of record on August 23, 2018, which is an increase from $0.35 per share paid in each of the last four quarters. We also recently declared a semi-annual cash dividend on our preferred stock of $2,750 per share, equal to $27.50 per depositary share, payable on October 30, 2018 to holders of record on October 15, 2018, which is consistent with the amount paid in the second quarter of 2018.

71

Table of Contents

On July 19, 2018, our Board of Directors approved a share repurchase program authorizing the repurchase of up to $3.0 billion of our outstanding shares of common stock. The program expires on January 31, 2020 and may be terminated at any time. This program replaced the prior $2.8 billion share repurchase program, which had $671 million of remaining authorization. During the three months ended June 30, 2018, we repurchased approximately 8 million shares, or 2%, of our outstanding common stock for $555 million. We expect to continue to repurchase shares under our program from time to time based on market conditions and other factors, subject to legal and regulatory requirements and restrictions, including non-objection from the Federal Reserve as described above. Share repurchases under the program may be made through a variety of methods, including open market purchases, privately negotiated transactions or other purchases, including block trades, accelerated share repurchase transactions, or any combination of such methods.
The amount and size of any future dividends and share repurchases will depend upon our results of operations, financial condition, capital levels, cash requirements, future prospects and other factors. The declaration and payment of future dividends, as well as the amount thereof, are subject to the discretion of our Board of Directors. Holders of our shares of common stock are subject to the prior dividend rights of holders of our preferred stock or the depositary shares representing such preferred stock outstanding, and if full dividends have not been declared and paid on all outstanding shares of preferred stock in any dividend period, no dividend may be declared or paid or set aside for payment on our common stock. In addition, as noted above, banking laws and regulations and our banking regulators may limit our ability to pay dividends and make share repurchases, including limitations on the extent to which our banking subsidiaries can provide funds to us through dividends, loans or otherwise. Further, current or future regulatory initiatives may require us to hold more capital in the future. There can be no assurance that we will declare and pay any dividends or repurchase any shares of our common stock in the future.
Certain Off-Balance Sheet Arrangements
Guarantees
Guarantees are contracts or indemnification agreements that contingently require us to make payments to a guaranteed party based on changes in an underlying asset, liability, or equity security of a guaranteed party, rate or index. Also included in guarantees are contracts that contingently require the guarantor to make payments to a guaranteed party based on another entity’s failure to perform under an agreement. Our guarantees relate to transactions processed on the Discover Network and certain transactions processed by PULSE and Diners Club. See Note 11: Commitments, Contingencies and Guarantees to our condensed consolidated financial statements for further discussion regarding our guarantees.
Contractual Obligations and Contingent Liabilities and Commitments
In the normal course of business, we enter into various contractual obligations that may require future cash payments. Contractual obligations at June 30, 2018, which include deposits, long-term borrowings, operating and capital lease obligations, interest payments on fixed-rate debt, purchase obligations and other liabilities were $91.6 billion. For a description of our contractual obligations, see our annual report on Form 10-K for the year ended December 31, 2017 under “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Contractual Obligations and Contingent Liabilities and Commitments.”
We extend credit for consumer loans, primarily arising from agreements with customers for unused lines of credit on certain credit cards and certain other loan products, provided there is no violation of conditions established in the related agreement. At June 30, 2018, our unused credit arrangements were approximately $194.3 billion. These arrangements, substantially all of which we can terminate at any time and which do not necessarily represent future cash requirements, are periodically reviewed based on account usage, customer creditworthiness and loan qualification. In addition, in the ordinary course of business, we guarantee payment on behalf of subsidiaries relating to contractual obligations with external parties. The activities of the subsidiaries covered by any such guarantees are included in our condensed consolidated financial statements.
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Market risk refers to the risk that a change in the level of one or more market prices, rates, indices, correlations or other market factors will result in losses for a position or portfolio. We are exposed to market risk primarily from changes in interest rates.

72

Table of Contents

Interest Rate Risk
We borrow money from a variety of depositors and institutions in order to provide loans to our customers, as well as invest in other assets and our business. These loans and other assets earn interest, which we use to pay interest on the money borrowed. Our net interest income and, therefore, earnings, will be reduced if the interest rate earned on assets increases at a slower pace than the interest rate on our borrowings. Changes in interest rates and our competitors' responses to those changes may influence customer payment rates, loan balances or deposit account activity. As a result, we may incur higher funding costs, which has the potential to decrease earnings.
Our interest rate risk management policies are designed to measure and manage the potential volatility of earnings that may arise from changes in interest rates by having a financing portfolio that reflects our mix of variable- and fixed-rate assets. To the extent that the repricing characteristics of the assets and liabilities in a particular portfolio are not sufficiently matched, we may utilize interest rate derivative contracts, such as swap agreements, to achieve our objectives. Interest rate swap agreements effectively convert the underlying asset or liability from fixed- to floating-rate or from floating- to fixed-rate. See Note 14: Derivatives and Hedging Activities to our condensed consolidated financial statements for information on our derivatives activity.
We use an interest rate sensitivity simulation to assess our interest rate risk exposure. For purposes of presenting the possible earnings effect of a hypothetical, adverse change in interest rates over the 12-month period from our reporting date, we assume that all interest rate sensitive assets and liabilities will be impacted by a hypothetical, immediate 100 basis point change in interest rates relative to market consensus expectations as of the beginning of the period. The sensitivity is based upon the hypothetical assumption that all relevant types of interest rates would change instantaneously, simultaneously and to the same degree.
Our interest rate sensitive assets include our variable-rate loan receivables and the assets that make up our liquidity portfolio. We have limitations on our ability to mitigate interest rate risk by adjusting rates on existing balances and competitive actions may limit our ability to increase the rates that we charge to customers for new loans. At June 30, 2018, the majority of our credit card and student loans charge variable rates. Assets with rates that are fixed at period end but which will mature, or otherwise contractually reset to a market-based indexed rate or other fixed rate prior to the end of the 12-month period, are considered to be rate sensitive. The latter category includes certain revolving credit card loans that may be offered at below-market rates for an introductory period, such as balance transfers and special promotional programs, after which the loans will contractually reprice in accordance with our normal market-based pricing structure. For purposes of measuring rate sensitivity for such loans, only the effect of the hypothetical 100 basis point increase in the underlying market-based indexed rate has been considered. For assets that have a fixed interest rate but which contractually will, or are assumed to, reset to a market-based indexed rate or other fixed rate during the next 12 months, earnings sensitivity is measured from the expected repricing date. In addition, for all interest rate sensitive assets, earnings sensitivity is calculated net of expected loan losses, which for purposes of this analysis are assumed to remain unchanged relative to our baseline expectations over the analysis horizon.
Interest rate sensitive liabilities are assumed to be those for which the stated interest rate is not contractually fixed for the next 12-month period. Thus, liabilities that vary with changes in a market-based index, such as the federal funds rate or LIBOR, which will reset before the end of the 12-month period, or liabilities whose rates are fixed at the fiscal period end, but which will mature and are assumed to be replaced with a market-based indexed rate prior to the end of the 12-month period, also are considered to be rate sensitive. For these fixed-rate liabilities, earnings sensitivity is measured from the expected maturity date.
Net interest income sensitivity requires assumptions to be made regarding market conditions, consumer behavior, and the overall growth and composition of the balance sheet. These assumptions are inherently uncertain and, as a result, actual earnings may differ from the simulated earnings presented above. Our actual earnings depend on multiple factors including, but not limited to, the direction and timing of changes in interest rates, the movement of short-term versus long-term rates, balance sheet composition, competitor actions affecting pricing decisions in our loans and deposits, and strategic actions undertaken by management.


73

Table of Contents

The following table shows the impacts to net interest income over the following 12-month period that we estimate would result from an immediate and parallel change in interest rates affecting all interest rate sensitive assets and liabilities (dollars in millions).
 
At June 30, 2018
 
At December 31, 2017
Basis point change
$
 
%
 
$
 
%
+100
$
205

 
2.22
 %
 
$
179

 
2.03
 %
-100
$
(215
)
 
(2.32
)%
 
$
(190
)
 
(2.15
)%
 
 
 
 
 
 
 
 
Item 4.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), which are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
Changes in Internal Control over Financial Reporting
There have been no changes in our internal control over financial reporting (as such term is defined in Exchange Act Rule 13a-15(f) and 15d-15(f)) that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

74

Table of Contents

Part II.
OTHER INFORMATION
Item 1.
Legal Proceedings
For a description of legal proceedings, see Note 12: Litigation and Regulatory Matters to our condensed consolidated financial statements.
Item 1A.
Risk Factors
There have been no material changes to the risk factors disclosed in our annual report on Form 10-K for the year ended December 31, 2017.
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
The following table sets forth information regarding purchases of our common stock related to our share repurchase program and employee transactions that were made by us or on our behalf during the most recent quarter.
Period
Total Number of Shares Purchased
 
Average Price Paid Per Share
 
Total Number of Shares Purchased as Part of Publicly Announced Plan or Program(1)
 
Maximum Dollar Value of Shares that may yet be purchased under the Plans or Programs (1)
April 1 - 30, 2018
 
 
 
 
 
 
 
Repurchase program(1)
2,561,652

 
$
71.74

 
2,561,652

 
$
1,042,595,923

Employee transactions(2)

 
$

 
N/A

 
N/A

May 1 - 31, 2018
 
 
 
 
 
 
 
Repurchase program(1)
2,594,328

 
$
74.28

 
2,594,328

 
$
849,885,846

Employee transactions(2)
3,063

 
$
73.39

 
N/A

 
N/A

June 1 - 30, 2018
 
 
 
 
 
 
 
Repurchase program(1)
2,403,993

 
$
74.26

 
2,403,993

 
$
671,370,188

Employee transactions(2)
414

 
$
76.19

 
N/A

 
N/A

 
 
 
 
 
 
 
 
Total
 
 
 
 
 
 
 
Repurchase program(1)
7,559,973

 
$
73.41

 
7,559,973

 
$
671,370,188

Employee transactions(2)
3,477

 
$
73.73

 
N/A

 
N/A

 
 
 
 
 
 
 
 
(1)
On July 19, 2018, our board of directors approved a share repurchase program authorizing the purchase of up to $3.0 billion of our outstanding shares of common stock. This share repurchase program expires on January 31, 2020 and may be terminated at any time.
(2)
Reflects shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon the delivery of outstanding shares underlying restricted stock units or upon the exercise of stock options.
Item 3.
Defaults Upon Senior Securities
None.
Item 4.
Mine Safety Disclosures
None.
Item 5.
Other Information
None.
Item 6.
Exhibits
See "Exhibit Index" for documents filed herewith and incorporated herein by reference.



75

Table of Contents

Exhibit Index
Exhibit
Number
 
Description
 
 
 
 
Statement regarding computation of ratio of earnings to fixed charges and computation of ratio of earnings to fixed charges and preferred stock dividends.
 
 
 
 
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.
 
 
 
 
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.
 
 
 
 
Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code.
 
 
 
101.INS
 
XBRL Instance Document.
 
 
 
101.SCH
 
XBRL Taxonomy Extension Schema Document.
 
 
 
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document.
 
 
 
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document.
 
 
 
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document.
 
 
 
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document.
 
 
 

76

Table of Contents

Signature
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
Discover Financial Services
(Registrant)
 
 
 
 
 
By:
 
/s/ R. MARK GRAF
 
 
 
R. Mark Graf
Executive Vice President, Chief Financial Officer
Date: August 1, 2018

77