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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
| x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2012
OR
| ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File No. 1-13300
CAPITAL ONE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
| Delaware | 54-1719854 | |
| (State or Other Jurisdiction of Incorporation or Organization) |
(I.R.S. Employer Identification No.) | |
| 1680 Capital One Drive, McLean, Virginia |
22102 | |
| (Address of Principal Executive Offices) | (Zip Code) | |
Registrant’s telephone number, including area code: (703) 720-1000
Securities registered pursuant to section 12(b) of the act:
| Title of Each Class |
Name of Each Exchange on Which Registered | |
| Common Stock (par value $.01 per share) | New York Stock Exchange | |
| Warrants (expiring November 14, 2018) | New York Stock Exchange | |
| Depository Shares, Each Representing a 1/40th Interest in a Share of Fixed Rate Non-Cumulative Perpetual Preferred Stock, Series B | New York Stock Exchange |
Securities Registered Pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d) of the Act. Yes ¨ No x
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 ¨
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 ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
| Large accelerated filer | x | Accelerated filer | ¨ | |||
| Non-accelerated filer | ¨ | Smaller reporting company | ¨ |
Indicate by check mark whether the registrant is a Shell Company (as defined in Rule 12b-2 of the Exchange Act) Yes ¨ No x
The aggregate market value of the voting stock held by non-affiliates of the registrant as of the close of business on June 30, 2012.
Common Stock, $.01 Par Value: $31,515,866,408*
| * | In determining this figure, the registrant assumed that the executive officers of the registrant and the registrant’s directors are affiliates of the registrant. Such assumption shall not be deemed to be conclusive for any other purpose. |
The number of shares outstanding of the registrant’s common stock as of the close of business on January 31, 2013.
Common Stock, $.01 Par Value: 582,248,632 shares
DOCUMENTS INCORPORATED BY REFERENCE
| 1. | Portions of the Proxy Statement for the annual meeting of stockholders to be held on May 2, 2013, are incorporated by reference into Part III. |
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INDEX OF MD&A TABLES AND SUPPLEMENTAL TABLES
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PART I
General
Capital One Financial Corporation, a Delaware Corporation established in 1995 and headquartered in McLean, Virginia, is a diversified financial services holding company with banking and non-banking subsidiaries. Capital One Financial Corporation and its subsidiaries (the “Company”) offer a broad array of financial products and services to consumers, small businesses and commercial clients through branches, the internet and other distribution channels. As of December 31, 2012, our principal subsidiaries included:
| • | Capital One Bank (USA), National Association (“COBNA”), which currently offers credit and debit card products, other lending products and deposit products; and |
| • | Capital One, National Association (“CONA”), which offers a broad spectrum of banking products and financial services to consumers, small businesses and commercial clients. |
The Company and its subsidiaries are hereafter collectively referred to as “we”, “us” or “our.” CONA and COBNA are collectively referred to as the “Banks.” References to “this Report” or our “2012 Form 10-K” are to our Annual Report on Form 10-K for the fiscal year ended December 31, 2012. All references to 2012, 2011, 2010, 2009 and 2008 refer to our fiscal years ended, or the dates, as the context requires, December 31, 2012, December 31, 2011, December 31, 2010, December 31, 2009 and December 31, 2008, respectively.
As one of the nation’s 10 largest banks based on deposits as of December 31, 2012, we service banking customer accounts through the internet and branch locations primarily in New York, New Jersey, Texas, Louisiana, Maryland, Virginia and the District of Columbia. In addition to bank lending, treasury management and depository services, we offer credit and debit card products, auto loans and mortgage banking in markets across the United States. We were the fourth largest issuer of Visa® (“Visa”) and MasterCard® (“MasterCard”) credit cards in the United States based on the outstanding balance of credit card loans as of December 31, 2012.
We also offer products outside of the United States principally through Capital One (Europe) plc (“COEP”), an indirect subsidiary of COBNA organized and located in the United Kingdom (“U.K.”), and through a branch of COBNA in Canada. COEP has authority, among other things, to provide credit card and installment loans. Effective December 1, 2010, as a result of the transition of our U.K. operations to an Authorized Payment Institution, we are no longer authorized to accept deposits in the U.K. Our branch of COBNA in Canada has the authority to provide credit card loans.
We had total loans held for investment of $205.9 billion, deposits of $212.5 billion and stockholders’ equity of $40.5 billion as of December 31, 2012, compared with total loans held for investment of $135.9 billion, deposits of $128.2 billion and stockholders’ equity of $29.7 billion as of December 31, 2011.
Recent Acquisitions
We regularly explore and evaluate opportunities to acquire financial services companies and financial assets, including credit card and other loan portfolios, and enter into strategic partnerships as part of our growth strategy. We also regularly consider the potential disposition of certain of our assets, branches, partnership agreements or lines of businesses. We may issue equity or debt in connection with acquisitions, including public offerings, to fund such acquisitions. Below we provide information on acquisitions completed in 2012 and 2011.
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Acquisitions in 2012
ING Direct
On February 17, 2012, we completed the acquisition (the “ING Direct acquisition”) of substantially all of the ING Direct business in the United States (“ING Direct”) from ING Groep N.V., ING Bank N.V., ING Direct N.V. and ING Direct Bancorp (collectively the “ING Direct Sellers”). The ING Direct acquisition resulted in the addition of loans of $40.4 billion, other assets of $53.9 billion and deposits of $84.4 billion as of the acquisition date.
On October 17, 2012, the Office of the Comptroller of the Currency (“OCC”) approved, subject to several conditions, CONA’s application to merge with ING Bank, fsb with CONA surviving the merger. Capital One effected the merger on November 1, 2012. In addition, the OCC approved CONA’s companion application to reduce capital surplus, which was necessary to manage excess capital levels that would result from the merger. CONA effected the reduction in surplus through a return of capital to Capital One Financial Corporation immediately prior to the merger. The merger and reduction in CONA’s capital surplus had no effect on Capital One’s total capital.
HSBC—U.S. Credit Card Business
On May 1, 2012, pursuant to the agreement with HSBC Finance Corporation, HSBC USA Inc. and HSBC Technology and Services (USA) Inc. (collectively, “HSBC”), we closed the acquisition of substantially all of the assets and assumed liabilities of HSBC’s credit card and private-label credit card business in the United States (other than the HSBC Bank USA, National Association consumer credit card program and certain other retained assets and liabilities) (the “2012 U.S. card acquisition,” which we sometimes refer to as the “HSBC U.S. card acquisition”). The 2012 U.S. card acquisition included (i) the acquisition of HSBC’s U.S. credit card portfolio, (ii) its on-going private label and co-branded partnerships, and (iii) other assets, including infrastructure and capabilities. At closing, we acquired approximately 27 million new active accounts, approximately $27.8 billion in outstanding credit card receivables designated as held for investment and approximately $327 million in other net assets.
Acquisitions in 2011
Hudson’s Bay Company—Credit Card Portfolio
On January 7, 2011, we acquired the existing credit card loan portfolio of Hudson’s Bay Company (“HBC”), one of the largest retailers in Canada, from GE Capital Retail Finance. The acquisition included outstanding credit card loan receivables with a fair value of approximately $1.4 billion and the transfer of approximately 400 employees directly involved in managing HBC’s loan portfolio. The acquisition and partnership with HBC significantly expanded our credit card customer base in Canada, tripling the number of customer accounts, and provided an additional distribution channel.
Kohl’s—Credit Card Portfolio
On April 1, 2011, we acquired the existing private-label credit card loan portfolio of Kohl’s Department Stores (“Kohl’s”) from JPMorgan Chase & Co. pursuant to a partnership agreement we entered into in August 2010 with Kohl’s. The existing portfolio consisted of more than 20 million Kohl’s customer accounts with an outstanding principal and interest balance of approximately $3.7 billion at acquisition. Under the terms of the partnership agreement and in conjunction with the acquisition, we began issuing Kohl’s branded private-label credit cards to new and existing Kohl’s customers on April 1, 2011.
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Additional Information
Our common stock trades on the New York Stock Exchange (“NYSE”) under the symbol “COF” and is included in the S&P 100 Index. As of January 31, 2013, there were 14,059 holders of record of our common stock. Our principal executive office is located at 1680 Capital One Drive, McLean, Virginia 22102 (telephone number (703) 720-1000). We maintain a Web site at www.capitalone.com. Documents available on our Web site include: (i) our Code of Business Conduct and Ethics for the Corporation; (ii) our Corporate Governance Principles; and (iii) charters for the Audit and Risk, Compensation, Finance and Trust Oversight, and Governance and Nominating Committees of the Board of Directors. These documents also are available in print to any shareholder who requests a copy.
In addition, we make available free of charge through our Web site our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports as soon as reasonably practicable after electronically filing or furnishing such material to the U.S. Securities and Exchange Commission (“SEC”).
OPERATIONS AND BUSINESS SEGMENTS
Our consolidated total net revenues are derived primarily from lending to consumer and commercial customers and by deposit-taking activities net of the costs associated with funding our assets, which generate net interest income, and by activities that generate non-interest income, such as fee-based services provided to customers and merchant interchange fees with respect to certain credit card transactions. Our expenses primarily consist of the provision for credit losses, operating expenses (including associate salaries and benefits, occupancy and equipment costs, professional services, infrastructure enhancements and branch operations and expansion costs), marketing expenses and income taxes.
Our principal operations are currently organized for management reporting purposes into three primary business segments, which are defined primarily based on the products and services provided or the type of customer served: Credit Card, Consumer Banking and Commercial Banking. The operations of acquired businesses have been integrated into our existing business segments. The acquired ING Direct business is primarily reflected in our Consumer Banking business, while the business acquired in the 2012 U.S. card acquisition is reflected in our Credit Card business. Certain activities that are not part of a segment, such as management of our corporate investment portfolio and asset/liability management by our centralized Corporate Treasury group, are included in the “Other” category.
| • | Credit Card: Consists of our domestic consumer and small business card lending, national small business lending, national closed end installment lending and the international card lending businesses in Canada and the United Kingdom. |
| • | Consumer Banking: Consists of our branch-based lending and deposit gathering activities for consumers and small businesses, national deposit gathering, national auto lending and consumer home loan lending and servicing activities. |
| • | Commercial Banking: Consists of our lending, deposit gathering and treasury management services to commercial real estate and commercial and industrial customers. Our commercial and industrial customers typically include companies with annual revenues between $10 million to $1.0 billion. |
In the first quarter of 2012, we re-aligned the loan categories reported by our Commercial Banking business and the loan customer and product types included within each category. Prior period amounts have been recast to conform to the current period presentation.
Customer usage and payment patterns, credit quality, levels of marketing expense and operating efficiency all affect our profitability. In our Credit Card business, we experience fluctuations in purchase volumes and the level of outstanding loan receivables due to higher seasonal consumer spending and payment patterns around the
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winter holiday season, summer vacations and back-to-school periods. Although there is some seasonal impact to purchase volumes and credit card loan balances in our Credit Card business, these seasonal trends have not caused significant fluctuations in our results of operations. No individual quarter in 2012, 2011 or 2010 accounted for more than 30% of our total revenues in any of these fiscal years. Delinquency rates in our consumer lending businesses also have historically exhibited seasonal patterns, with delinquency rates generally tending to decrease in the first two quarters of the year as customers use income tax refunds to pay down outstanding loan balances.
For additional information on our business segments, including the financial performance of each business and the realignment of our Commercial Banking business, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”)—Executive Summary and Business Outlook,” “MD&A—Business Segment Financial Performance” and “Note 20—Business Segments” of this Report.
General
Capital One Financial Corporation is a bank holding company (“BHC”) under Section 3 of the Bank Holding Company Act of 1956, as amended (12 U.S.C. § 1842) (the “BHC Act”) and is subject to the requirements of the BHC Act, including its capital adequacy standards and limitations on our nonbanking activities. We are also subject to supervision, examination and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). Permissible activities for a BHC include those activities that are so closely related to banking as to be a proper incident thereto, such as consumer lending and other activities that have been approved by the Federal Reserve by regulation or order. Certain servicing activities are also permissible for a BHC if conducted for or on behalf of the BHC or any of its affiliates. Impermissible activities for BHCs include activities that are related to commerce such as retail sales of nonfinancial products. Under Federal Reserve policy, we are expected to act as a source of financial and managerial strength to any banks that we control, including the Banks, and to commit resources to support them.
On May 27, 2005, we became a “financial holding company” under the Gramm-Leach-Bliley Act amendments to the BHC Act (the “GLBA”). The GLBA removed many of the restrictions on the activities of BHCs that become financial holding companies. A financial holding company, and the nonbank companies under its control, are permitted to engage in activities considered financial in nature (including, for example, insurance underwriting, agency sales and brokerage, securities underwriting and dealing and merchant banking activities), incidental to financial activities or complementary to financial activities if the Federal Reserve determines that they pose no risk to the safety or soundness of depository institutions or the financial system in general.
Our election to become a financial holding company under the GLBA certifies that the depository institutions we control meet certain criteria, including capital, management and Community Reinvestment Act (“CRA”) requirements. Effective July 21, 2011, under amendments to the BHC Act enacted under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), Capital One Financial Corporation also must be “well capitalized” and “well managed.” If we were to fail to continue to meet the criteria for financial holding company status, we could, depending on which requirements we failed to meet, face restrictions on new financial activities or acquisitions or be required to discontinue existing activities that are not generally permissible for bank holding companies.
The Banks are national associations chartered under the laws of the United States, the deposits of which are insured by the Deposit Insurance Fund (the “DIF”) of the Federal Deposit Insurance Corporation (the “FDIC”) up to applicable limits. In addition to regulatory requirements imposed as a result of COBNA’s international operations (discussed below), the Banks are subject to comprehensive regulation and periodic examination by the OCC, the FDIC and, effective July 21, 2011, by the Consumer Financial Protection Bureau (the “CFPB”).
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We are also registered as a financial institution holding company under Virginia law and, as such, we are subject to periodic examination by Virginia’s Bureau of Financial Institutions. We also face regulation in the international jurisdictions in which we conduct business (see below under “Regulation of International Business by Non–U.S. Authorities”).
Regulation of Business Activities
The activities of the Banks as consumer lenders also are subject to regulation under various federal laws, including the Truth-in-Lending Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act (the “FCRA”), the CRA and the Servicemembers Civil Relief Act, as well as under various state laws. Depending on the underlying issue and applicable law, regulators are often authorized to impose penalties for violations of these statutes and, in certain cases, to order banks to compensate injured borrowers. Borrowers may also have a private right of action for certain violations. Federal bankruptcy and state debtor relief and collection laws also affect the ability of a bank to collect outstanding balances owed by borrowers. These laws may affect the ability of banks to collect outstanding balances.
Regulations of Consumer Lending Activities
The Credit CARD Act (amending the Truth-In-Lending Act) enacted in May 2009, and related changes to Regulation Z, impose a number of restrictions on credit card practices impacting rates and fees and update the disclosures required for open-end credit. Overlimit fees may not be imposed without prior consent, and the number of such fees that can be charged for the same violation is constrained. The amount of any penalty fee or charge must be “reasonable and proportional” to the violation. The Credit CARD Act also significantly restricts the ability of a card issuer to increase rates charged on pre-existing card balances. Card issuers are generally prohibited from raising rates on pre-existing balances when generally prevailing interest rates change. Moreover, the circumstances under which a card issuer can raise the interest rate on pre-existing balances of a customer whose risk of default increases are restricted. Payments above the minimum payment must be allocated first to balances with the highest interest rate. The amount of fees charged to credit card accounts with lower credit lines is limited. A consumer’s ability to pay must be taken into account before issuing credit or increasing credit limits.
State Consumer Financial Laws
The Dodd-Frank Act created the CFPB, a new independent supervisory body, that is the primary regulator for federal consumer financial statutes. State attorneys general will be authorized to enforce new regulations issued by the CFPB. State consumer financial laws will continue to be preempted under the National Bank Act under the existing standard set forth in the Supreme Court decision in Barnett Bank of Marion County, N.A. v. Nelson, which preempts any state law that significantly interferes with or impairs banking powers. OCC determinations of such preemption, however, must be on a case-by-case basis, and courts reviewing the OCC’s preemption determinations will now consider the appropriateness of those determinations under a different standard of judicial review. These laws may affect the ability of the Banks to collect outstanding balances.
Mortgage Lending
The Dodd-Frank Act prescribes additional disclosure requirements and substantive limitations on our mortgage lending activities. Most of these provisions require the issuance of regulations by the CFPB or other federal agencies before they become effective. Though we do not expect the resulting regulations to have a material impact on our operations, one new requirement under the Dodd-Frank Act, the requirement for mortgage loan securitizers to retain a portion of the economic risk associated with certain mortgage loans, could impact the type and amount of mortgage loans we offer, depending on the final regulations.
Debit Interchange Fees
The Dodd-Frank Act requires that the amount of any interchange fee received by a debit card issuer with respect to debit card transactions be reasonable and proportional to the cost incurred by the issuer with respect to the
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transaction. In June 2011, the Federal Reserve adopted a final rule and an interim final rule (which largely was adopted in final form in July 2012) implementing the portion of the Dodd-Frank Act that limits interchange fees received by a debit card issuer. The final rules limit interchange fees per debit card transaction to $.21 plus five basis points of the transaction amount and provide for an additional $.01 fraud prevention adjustment to the interchange fee for issuers that meet certain fraud prevention requirements.
Dividends, Stock Repurchases and Transfers of Funds
In November 2011, the Federal Reserve finalized capital planning rules applicable to large bank holding companies like us (commonly referred to as Comprehensive Capital Analysis and Review or CCAR). Under the rules, bank holding companies with consolidated assets of $50 billion or more must submit capital plans to the Federal Reserve on an annual basis and must obtain approval from the Federal Reserve before making most capital distributions. The purpose of the rules is to ensure that large bank holding companies have robust, forward-looking capital planning processes that account for their unique risks and capital needs to continue operations through times of economic and financial stress. As part of its evaluation of a capital plan, the Federal Reserve will consider the comprehensiveness of the plan, the reasonableness of assumptions and analysis and methodologies used to assess capital adequacy and the ability of the bank holding company to maintain capital above each minimum regulatory capital ratio and above a Tier 1 common ratio of 5% on a pro forma basis under expected and stressful conditions throughout a planning horizon of at least nine quarters.
Traditionally, dividends to us from our direct and indirect subsidiaries have represented a major source of funds for us to pay dividends on our stock, make payments on corporate debt securities and meet our other obligations. There are various federal law limitations on the extent to which the Banks can finance or otherwise supply funds to us through dividends and loans. These limitations include minimum regulatory capital requirements, federal banking law requirements concerning the payment of dividends out of net profits or surplus, Sections 23A and 23B of the Federal Reserve Act and Regulation W governing transactions between an insured depository institution and its affiliates, as well as general federal regulatory oversight to prevent unsafe or unsound practices. In general, federal and applicable state banking laws prohibit, without first obtaining regulatory approval, insured depository institutions, such as the Banks, from making dividend distributions if such distributions are not paid out of available earnings or would cause the institution to fail to meet applicable capital adequacy standards.
Capital Adequacy
The Banks are subject to capital adequacy guidelines adopted by federal banking regulators. For a further discussion of the capital adequacy guidelines, see “MD&A—Capital Management” and “Note 13—Regulatory and Capital Adequacy.” The Banks exceeded minimum regulatory requirements under these guidelines as of December 31, 2012.
FDICIA and Prompt Corrective Action
In general, the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) subjects banks to significantly increased regulation and supervision. Among other things, FDICIA requires federal banking agencies to take “prompt corrective action” for banks that do not meet minimum capital requirements. FDICIA establishes five capital ratio levels: well capitalized; adequately capitalized; undercapitalized; significantly undercapitalized; and critically undercapitalized. Under applicable regulations, a bank is considered to be well capitalized if it maintains a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6%, a Tier 1 leverage capital ratio of at least 5% and is not subject to any supervisory agreement, order or directive to meet and maintain a specific capital level for any capital measure. A bank is considered to be adequately capitalized if it maintains a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4%, a Tier 1 leverage capital ratio of at least 4% (3% for certain highly rated institutions), and does not otherwise meet the well capitalized definition. The three undercapitalized categories are based upon the
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amount by which a bank falls below the ratios applicable to adequately capitalized institutions. The capital categories are determined solely for purposes of applying FDICIA’s prompt corrective action provisions, and such capital categories may not constitute an accurate representation of the Banks’ overall financial condition or prospects. As of December 31, 2012, each of the Banks met the requirements for a well-capitalized institution.
As summarized below, the Federal Reserve, OCC and FDIC released a proposed rule in June 2012 that would update the prompt corrective action framework to reflect new, higher regulatory capital minimums. For a further discussion of the Basel III proposed rule, see “Basel III and U.S. Capital Rules Proposals” below.
As an additional means to identify problems in the financial management of depository institutions, FDICIA requires regulators to establish certain non-capital safety and soundness standards. The standards relate generally to operations and management, asset quality, interest rate exposure and executive compensation. The agencies are authorized to take action against institutions that fail to meet such standards.
Enhanced Prudential Standards and Other Requirements under the Dodd-Frank Act
With the enactment of the Dodd-Frank Act, because we are a bank holding company with consolidated assets of $50 billion or greater (a “covered company”), we are subject to certain enhanced prudential standards, including requirements that may be recommended by the Financial Stability Oversight Council (the “Council”) and implemented by the Federal Reserve and other regulators. As a result, we expect to be subject to more stringent standards and requirements than those applicable for smaller institutions, including risk-based capital requirements, leverage limits and liquidity requirements. The Council also may issue recommendations to the Federal Reserve or other primary financial regulatory agency to apply new or heightened standards to risky financial activities or practices. In December 2011, the Federal Reserve released proposed rules beginning to implement the enhanced prudential standards. If finalized as proposed, we will be subject to new requirements regarding liquidity management, risk management, and single-counterparty credit limits. The proposal also implements an early remediation framework, under which a covered company could be subject to enforcement actions, growth limits, prohibitions on capital distributions and other consequences if a triggering event were to occur. The Federal Reserve also indicates in the proposal that it intends to implement the Basel III capital surcharge framework, although the extent to which that would apply to us is unclear. In October 2012, the Federal Reserve released a final rule that implements the requirement in the Dodd-Frank Act that the Federal Reserve conduct annual stress tests on the capacity of our capital to absorb losses as a result of adverse economic conditions. The rule also implements the requirement that we conduct our own semiannual stress tests. The rule also requires us to publish the results of the stress tests on our Web site or other public forum. The OCC finalized a similar stress test rule in October 2012, to implement the requirement that each of the Banks conduct annual stress tests. In addition, in 2011, the Federal Reserve finalized rules requiring us to implement resolution planning for orderly resolution in the event of material financial distress or failure of us. The FDIC has issued similar rules regarding resolution planning applicable to the Banks.
In addition to the provisions described throughout this Supervision and Regulation section, the Dodd-Frank Act imposes new, more stringent standards and requirements with respect to bank and nonbank acquisitions and mergers, affiliate transactions, and proprietary trading (the “Volcker Rule”). In 2012, the Commodity Futures Trading Commission (“CFTC”) and the SEC jointly issued final rules further defining the Dodd-Frank Act’s “swap dealer” definitions. Based on the final rules, no Capital One entity will be required to register with the CFTC or SEC as a swap dealer; however, this may change in the future. If such registration occurs, the registered entity is currently required to comply with additional regulatory requirements relating to its derivatives activities. The Dodd-Frank Act also requires all swap market participants to keep swap transaction data records and report certain information to swap data repositories on a real-time and on-going basis. Further, each swap, group, category, type or class of swap that the CFTC or SEC determines must be cleared will need to be cleared through a derivatives clearinghouse unless the swap is eligible for a clearing exemption and executed on a designated contract market (“DCM”), exchange or swap execution facility (“SEF”) unless no DCM, exchange or SEF has made the swap available for trading. The Dodd-Frank Act also prohibits conflicts of interest relating to
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securitizations and generally requires securitizers to retain a 5% economic interest in the credit risk of assets sold through the issuance of asset-backed securitizations, with an exemption for traditionally underwritten residential mortgage loans that meet the definition of a qualified residential mortgage loan. In addition, the Dodd-Frank Act includes provisions related to corporate governance and executive compensation and new fees and assessments, among others.
The federal agencies have significant discretion in drafting the implementing rules and regulations of the Dodd-Frank Act. These rules may result in modifications to our business models and organizational structure, and may subject us to escalating costs associated with any such changes. However, the full impact of the Dodd-Frank Act will not be known for many months or, in some cases, years. In addition, the Dodd-Frank Act requires various studies and reports to be delivered to Congress, which could result in additional legislative or regulatory action.
Basel II
U.S. Federal banking regulators finalized the “Advanced” version of Basel II in December 2007. These Advanced Approaches rules are mandatory for those institutions with consolidated total assets of $250 billion or more or consolidated total on-balance-sheet foreign exposure of $10 billion or more. We became subject to these rules at the end of 2012 primarily as a result of the ING Direct acquisition.
Prior to full implementation of the Basel II framework, organizations must complete a qualification period of four consecutive quarters, known as the parallel run, during which they must meet the requirements of the rule to the satisfaction of their primary U.S. banking regulator. We currently expect to enter parallel run on January 1, 2015. This will require completing a written implementation plan and building processes and systems to comply with the rules. Compliance with the Basel II rules will require a material investment of resources.
The Collins Amendment within the Dodd-Frank Act and the U.S. banking regulators’ implementing final rules establish a capital floor so that organizations subject to the Basel II Advanced Approaches rules may not hold less capital than would be required using the generally applicable risk-based and leverage capital calculations. Our current analysis suggests that our risk-weighted assets will increase under the Basel II framework, and therefore we would need to hold more regulatory capital in order to maintain a given capital ratio. We will continue to monitor regulators’ implementation of the new rules with respect to the institutions that are subject to them and assess the potential impact to us.
Basel III and U.S. Capital Rules Proposals
In December 2009, the Basel Committee on Banking Supervision (the “Basel Committee”) released proposals for additional capital and liquidity requirements, which have been clarified and amended in recent pronouncements (“Basel III”). In September 2010, the Basel Committee announced a package of reforms that included detailed capital ratios and capital conservation buffers, subject to transition periods through 2018. In December 2010, the Basel Committee published a final framework on capital and liquidity, consistent in large part with the prior proposals. In November 2011, the Basel Committee adopted a framework that would require additional Tier 1 common capital for systemically important institutions. This surcharge would vary based on the firm’s systemic importance as determined using five criteria (size, interconnectedness, lack of substitutability, cross-jurisdictional activity and complexity). As described above, the U.S. federal banking agencies have stated that they intend to implement this surcharge, although the extent to which it would apply to us is unclear.
The Federal Reserve, OCC and FDIC released in June 2012 three proposed rules that would substantially revise the federal banking agencies’ current capital rules, including the current Basel II Advanced Approaches, and implement the Basel III capital framework described above. The first proposal, known as the Basel III proposal, would increase the general risk-based capital ratio minimum requirements, modify the definition of regulatory capital, establish a minimum Tier 1 common ratio requirement, introduce a new capital conservation buffer requirement, and update the prompt corrective action framework to reflect the new regulatory capital minimums.
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For those institutions subject to the Basel II Advanced Approaches framework discussed above, the proposal would also implement a supplementary leverage ratio that incorporates a broader set of exposures in the denominator and would introduce a new countercyclical capital buffer requirement. The second proposal, known as the Standardized Approach proposal, would revise the federal banking agencies’ general approach for calculating risk-weighted assets to reflect a more risk-sensitive risk-weighting approach and remove reliance on external credit ratings, as required by Section 939A of the Dodd-Frank Act. The third proposal would modify the existing Basel II rules for calculating risk-weighted assets by implementing elements of the Basel III framework and removing reliance on external credit ratings. As discussed above, under the Collins Amendment within the Dodd-Frank Act, organizations subject to the Basel II rules must calculate their risk-based capital under both the Standardized Approach and the Advanced Approach and use the lower of each of the relevant capital ratios to determine whether it meets the minimum risk-based capital requirements.
The proposed rules would go into effect according to different start dates and phase-in periods. If finalized as proposed, the rules would increase the minimum capital that we and other institutions would be required to hold.
In December 2010, the Basel Committee also published a liquidity framework, which was subsequently amended in January 2013. The liquidity framework includes two standards for liquidity risk supervision, each subject to observation periods and transitional arrangements. One standard promotes short-term resilience by requiring sufficient high-quality liquid assets to survive a stress scenario lasting for 30 days. This standard, the liquidity coverage ratio (“LCR”), is included in the amended liquidity framework. The other standard promotes longer-term resilience by requiring sufficient stable funding over a one-year period, based on the liquidity characteristics of assets and activities. This standard remains under development by the Basel Committee. We expect that minimum liquidity requirements for us and other institutions will increase as a result of the Basel III liquidity framework, though rules implementing the Basel III liquidity framework have not yet been proposed by the U.S. federal banking agencies.
We will continue to monitor regulators’ implementation of the new capital and liquidity rules and assess the potential impact to us.
Market Risk Capital Rule
A market risk capital rule, which the federal banking regulators amended in August 2012, supplements both the general risk-based capital rules and the Basel II Advanced Approaches rules by requiring institutions subject to the rule to adjust their risk-based capital ratios to reflect the market risk in their trading activities. The rule applies to institutions with aggregate trading assets and liabilities equal to the lesser of (i) 10 percent or more of total assets or (ii) $1 billion or more. We are not yet subject to this rule but may become subject to it in the future.
Deposits and Deposit Insurance
Each of CONA and COBNA, as an insured depository institution, is a member of the DIF maintained by the FDIC. Through the DIF, the FDIC insures the deposits of insured depository institutions up to prescribed limits for each depositor. The DIF was formed on March 31, 2006, upon the merger of the Bank Insurance Fund and the Savings Association Insurance Fund in accordance with the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”). The Reform Act permits the FDIC to set a Designated Reserve Ratio (“DRR”) for the DIF. To maintain the DIF, member institutions may be assessed an insurance premium, and the FDIC may take action to increase insurance premiums if the DRR falls below its required level.
Prior to passage of the Dodd-Frank Act, the FDIC had established a plan to restore the DIF in the face of recent insurance losses and future loss projections, which resulted in several rules that generally increased deposit insurance rates and purported to improve risk differentiation so that riskier institutions bear a greater share of insurance premiums. The Dodd- Frank Act reformed the management of the DIF in several ways: raised the minimum DRR to 1.35% (from the former minimum of 1.15%) and removed the upper limit on the DRR;
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required that the reserve ratio reach 1.35% by September 30, 2020 (rather than 1.15% by the end of 2016); required that in setting assessments, the FDIC must offset the effect of meeting the increased reserve ratio on small insured depository institutions; and eliminated the requirement that the FDIC pay dividends from the DIF when the reserve ratio reaches certain levels. The FDIC has set the DRR at 2% and, in lieu of dividends, has established progressively lower assessment rate schedules as the reserve ratio meets certain trigger levels. The Dodd-Frank Act also required the FDIC to change the deposit insurance assessment base from deposits to average consolidated total assets minus average tangible equity. In February 2011, the FDIC finalized rules to implement this change that significantly modified how deposit insurance assessment rates are calculated for those banks with assets of $10 billion or greater.
Banks may accept brokered deposits as part of their funding. Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), as discussed in “MD&A—Liquidity Risk,” only “well-capitalized” and “adequately-capitalized” institutions may accept brokered deposits. Adequately-capitalized institutions, however, must first obtain a waiver from the FDIC before accepting brokered deposits, and such deposits may not pay rates that significantly exceed the rates paid on deposits of similar maturity from the institution’s normal market area or, for deposits from outside the institution’s normal market area, the national rate on deposits of comparable maturity.
The FDIC is authorized to terminate a bank’s deposit insurance upon a finding by the FDIC that the bank’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the bank’s regulatory agency. The termination of deposit insurance for a bank could have a material adverse effect on its liquidity and its earnings.
Overdraft Protection
The Federal Reserve amended Regulation E in November 2009 to limit the ability to assess overdraft fees for paying ATM and one-time debit card transactions that overdraw a consumer’s account, unless the consumer opts in to such payment of overdrafts. The rule does not apply to overdraft services with respect to checks, ACH transactions, or recurring debit card transactions, or to the payment of overdrafts pursuant to a line of credit or a service that transfers funds from another account. We are required to provide to customers written notice describing our overdraft service, fees imposed and other information, and to provide customers with a reasonable opportunity to opt in to the service. Before we may assess fees for paying discretionary overdrafts, a customer must affirmatively opt in, which could negatively impact our deposit business revenue.
Source of Strength and Liability for Commonly-Controlled Institutions
Under the regulations issued by the Federal Reserve, a bank holding company must serve as a source of financial and managerial strength to its subsidiary banks (the so-called “source of strength doctrine”). The Dodd-Frank Act codified the source of strength doctrine, directing the Federal Reserve to require bank holding companies to serve as a source of financial strength to its subsidiary banks.
Under the “cross-guarantee” provision of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), insured depository institutions such as the Banks may be liable to the FDIC with respect to any loss incurred, or reasonably anticipated to be incurred, by the FDIC in connection with the default of, or FDIC assistance to, any commonly controlled insured depository institution. The Banks are commonly controlled within the meaning of the FIRREA cross-guarantee provision.
FDIC Orderly Liquidation Authority
The Dodd-Frank Act provides the FDIC with liquidation authority that may be used to liquidate non-bank financial companies, including Capital One Financial Corporation and its non-bank subsidiaries, if the Treasury
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Secretary, in consultation with the President and based on the recommendation of the Federal Reserve and another federal agency, determines that doing so is necessary, among other criteria, to mitigate serious adverse effects on U.S. financial stability. Upon such a determination, the FDIC would be appointed receiver and must liquidate the company in a way that mitigates significant risks to financial stability and minimizes moral hazard. The costs of a liquidation of a financial company would be borne by shareholders and unsecured creditors and then, if necessary, by risk-based assessments on large financial companies. The FDIC has issued rules implementing certain provisions of its liquidation authority and may issue additional rules in the future.
FFIEC Account Management Guidance
On January 8, 2003, the Federal Financial Institutions Examination Council (“FFIEC”) released Account Management and Loss Allowance Guidance (the “Guidance”). The Guidance applies to all credit lending of regulated financial institutions and generally requires that banks properly manage several elements of their lending programs, including line assignments, over-limit practices, minimum payment and negative amortization, workout and settlement programs, and the accounting methodology used for various assets and income items related to loans.
We believe that our account management and loss allowance practices are prudent and appropriate and, consistent with the Guidance. We caution, however, the Guidance provides wide discretion to bank regulatory agencies in the application of the Guidance to any particular institution and its account management and loss allowance practices. Accordingly, under the Guidance, bank examiners could require changes in our account management or loss allowance practices in the future, and such changes could have an adverse impact on our financial condition or results of operation.
Fair Credit Reporting
Like other financial institutions, the Banks rely upon consumer reports for prescreen marketing, underwriting new loans and for reviewing and managing risks associated with existing accounts. In addition, the Banks furnish customer account information to the major consumer reporting agencies. The use of consumer reports by the Banks and furnishing of account information to the consumer reporting agencies is regulated under the FCRA on a uniform, nationwide basis. This includes restrictions on the ability of the Banks to share consumer report information with affiliates and to use customer account information shared by affiliates for a marketing purpose. The Fair and Accurate Credit Transactions Act of 2003 (the “FACT Act”), extends the federal preemption of the FCRA permanently, although the law authorizes states to enact laws regulating certain subject matters so long as they are not inconsistent with the conduct required by the FCRA. The FACT Act also added new provisions to the FCRA designed to address the growing crime of identity theft and to improve the accuracy of consumer credit information. Generally, FCRA rulemaking and enforcement authority with respect to the Banks now resides with CFPB. In addition, the FCRA creates a limited private right of action for consumers to seek relief for certain violations of the FCRA.
Investment in the Company and the Banks
Certain acquisitions of our capital stock may be subject to regulatory approval or notice under federal or state law. Investors are responsible for ensuring that they do not, directly or indirectly, acquire shares of our capital stock in excess of the amount that can be acquired without regulatory approval. Each of the Banks is an “insured depository institution” within the meaning of the Change in Bank Control Act.
Consequently, federal law and regulations prohibit any person or company from acquiring control of us without, in most cases, prior written approval of the Federal Reserve or the OCC, as applicable. Control is conclusively presumed if, among other things, a person or company acquires more than 25% of any class of our voting stock. A rebuttable presumption of control arises if a person or company acquires more than 10% of any class of voting stock and is subject to any of a number of specified “control factors” as set forth in the applicable regulations.
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Additionally, COBNA and CONA are “banks” within the meaning of Chapter 13 of Title 6.1 of the Code of Virginia governing the acquisition of interests in Virginia financial institutions (the “Financial Institution Holding Company Act”). The Financial Institution Holding Company Act prohibits any person or entity from acquiring, or making any public offer to acquire, control of a Virginia financial institution or its holding company without making application to, and receiving prior approval from, the Virginia Bureau of Financial Institutions.
USA PATRIOT Act of 2001
The USA PATRIOT Act of 2001 (the “Patriot Act”) contains sweeping anti-money laundering and financial transparency laws as well as enhanced information collection tools and enforcement mechanisms for the U.S. government, including: due diligence requirements for private banking and correspondent accounts; standards for verifying customer identification at account opening; rules to promote cooperation among financial institutions, regulators, and law enforcement in identifying parties that may be involved in terrorism or money laundering; reporting requirements applicable to the receipt of coins and currency of more than $10,000 in nonfinancial trades or businesses; and more broadly applicable suspicious activity reporting requirements.
The Department of Treasury, in consultation with the Federal Reserve and other federal financial institution regulators, has promulgated rules and regulations implementing the Patriot Act that prohibit correspondent accounts for foreign shell banks at U.S. financial institutions; require financial institutions to maintain certain records relating to correspondent accounts for foreign banks; require financial institutions to produce certain records upon request of the appropriate federal banking agency; require due diligence with respect to private banking and correspondent banking accounts; facilitate information sharing between government and financial institutions; require verification of customer identification; and require financial institutions to have an anti-money laundering program in place.
Non-Bank Activities
Our non-bank subsidiaries are subject to supervision and regulation by various other federal and state authorities. Capital One Investment Services LLC, Capital One Southcoast, Inc. and Capital One Sharebuilder, Inc. are registered broker-dealers regulated by the SEC and the Financial Industry Regulatory Authority. Our broker-dealer subsidiaries are subject to, among other things, net capital rules designed to measure the general financial condition and liquidity of a broker-dealer. Under these rules, broker-dealers are required to maintain the minimum net capital deemed necessary to meet their continuing commitments to customers and others, and are required to keep a substantial portion of their assets in relatively liquid form. These rules also limit the ability of broker-dealers to transfer capital to parent companies and other affiliates. Broker-dealers are also subject to other regulations covering their business operations, including sales and trading practices, public offerings, publication of research reports, use and safekeeping of client funds and securities, capital structure, record-keeping and the conduct of directors, officers and employees.
Capital One Asset Management LLC, which provides investment advice to institutions, foundations, endowments and high net worth individuals, is an SEC-registered investment adviser regulated under the Investment Advisers Act of 1940. ShareBuilder Advisors, LLC is also an SEC-registered investment adviser. Capital One Financial Advisors LLC is a state-registered investment adviser.
Finally, our insurance agency subsidiaries are regulated by state insurance regulatory agencies in the states in which we operate. Capital One Agency LLC is a licensed insurance agency that provides both personal and business insurance services to retail and commercial clients and is regulated by the New York State Department of Financial Services in its home state and by the state insurance regulatory agencies in the states in which it operates.
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Regulation of International Business by Non-U.S. Authorities
COBNA is subject to regulation in foreign jurisdictions where it operates, currently in the United Kingdom and Canada.
United Kingdom
In the United Kingdom, COBNA operates through Capital One (Europe) plc (“COEP”), which was established in 2000 and is an authorized payment institution regulated by the Financial Services Authority (the “FSA”) under the Payment Services Regulations 2009. COEP’s indirect parent, Capital One Global Corporation, is wholly-owned by COBNA and is subject to regulation as an “agreement corporation” under the Federal Reserve’s Regulation K.
A coalition government of the Liberal Democrat and Conservative parties was established in the U.K. following the general election held in May 2010. The new coalition government has made significant changes to the framework of financial services regulation. As part of these changes, in April 2013, the Financial Services Authority (the “FSA”) will cease to exist in its current form and will split into a new Prudential Regulatory Authority (the “PRA”) and a new Financial Conduct Authority (the “FCA”). From April 2013, COEP will be regulated by the FCA and not the PRA. The FCA is expected to be a more engaged regulator that will be involved earlier in a product’s lifecycle and will focus more heavily on consumer outcomes. Consultation activity is also expected during 2013 as to whether and how the U.K. consumer credit regime currently regulated by the Office of Fair Trading (the “OFT”) should transfer to the FCA and/or whether the existing underlying legislative framework for consumer credit regulation (under the Consumer Credit Act 1974) should be replaced with a model similar to regulation of other retail financial services (under the Financial Services and Markets Act 2000).
Regulatory focus on Payment Protection Insurance (“PPI”) complaint handling has continued following the introduction of new FSA rules in December 2010 governing the handling of PPI complaints. As anticipated, PPI complaint volumes have increased significantly following the regulatory focus on PPI. COEP has completed root cause analysis of its historic PPI sales and developed a remediation plan. The FSA is monitoring firms’ compliance with the new complaint handling rules.
Cross-border interchange fees continue to be under scrutiny from the European Commission (the “EC”) and the OFT. In May 2012, the EC held that MasterCard’s “interchange” fees were anticompetitive, and its decisions were upheld by the General Court. The General Court held that there was no merchant or consumer benefit that could justify the restriction on competition implied by the fee. MasterCard has appealed this decision, although it is not expected that the appeal will be concluded before 2014. The OFT has indicated its own investigation will remain on hold until after the outcome of MasterCard’s appeal. In August 2012, Visa Europe was warned by the EC that its multilateral interchange fees may also violate the EU’s competition rules. Twelve major U.K. retailer groups have issued proceedings against various MasterCard companies and the MasterCard U.K. Members Forum Limited (“MMF”) for damages arising from their alleged anti-competitive behavior in the setting of U.K. and intra-European Economic Area fallback interchange fees. COEP is a shareholder in MMF. MMF is in liquidation and, as a result, COEP and other member banks are providing the legal fees required to enable MMF to defend the claims. MasterCard has issued an application to stay the proceedings pending the outcome of MasterCard’s appeal of the General Court’s decision. Three further retail groups have commenced proceedings against MasterCard, but not MMF, and further claims from retailers against MasterCard, MMF or credit card issuers may follow.
The EC has also issued a draft regulation which will replace the Data Protection Act 1998. This will be directly effective without the need for additional U.K. legislation. The date on which the regulation will come into force has not yet been confirmed, but it is expected to be in the next two years. There will then be a two-year grace
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period to work towards compliance with the regulation. Key proposed changes that we expect would impact COEP include:
| • | Requirement on companies to notify any breach of the regulation to the Information Commissioner’s Office (“ICO”) and to individuals whose data has been affected or compromised as a result of the breach; |
| • | Increased powers, including the ability to assess fines, given to the ICO; |
| • | Requirement to conduct a Privacy Impact Assessment for all areas of the business including any changes to systems. |
| • | Mandatory appointment of a data protection officer who must act independently and autonomously at all times. |
| • | Widening of the definition of personal data. |
Canada
In Canada, COBNA operates as an authorized foreign bank pursuant to the Bank Act (Canada) (the “Bank Act”) and is permitted to conduct its credit card business in Canada through its Canadian branch, Capital One Bank (Canada Branch) (“Capital One Canada”). The primary regulator of Capital One Canada is the Office of the Superintendent of Financial Institutions Canada (“OSFI”). Other regulators include the Financial Consumer Agency of Canada (“FCAC”), the Office of the Privacy Commissioner of Canada, and the Financial Transactions and Reports Analysis Centre of Canada. Capital One Canada is subject to regulation under various Canadian federal laws, including the Bank Act and its regulations, the Proceeds of Crime (Money Laundering) and Terrorist Financing Act and the Personal Information Protection and Electronic Documents Act.
In 2012, there were two new regulatory developments that affect credit cards issued by federally regulated financial institutions in Canada. These amendments could increase our operational and compliance costs and affect the types and terms of products that we offer in Canada.
In March 2012, Negative Option Billing Regulations were made under the Bank Act. These regulations require federally regulated financial institutions to obtain the express consent of individuals before providing new primary or optional products and services to individuals. Generally, the Negative Option Billing Regulations prescribe the timing, manner and content of disclosure that must be provided to individuals before they can expressly consent to new products or services. These regulations came into force on August 1, 2012.
In September 2012, the Credit Business Practices (Banks, Authorized Foreign Banks, Trust and Loan Companies, Retail Associations, Canadian Insurance Companies and Foreign Insurance Companies) Regulations were amended to require a bank to obtain express consent prior to providing credit card checks to a borrower. If consent is given orally, the bank must provide confirmation of that consent in writing (paper or electronic). The amended regulations also provide that the use of the credit card or the use of the check does not constitute express consent. These amendments will come into force on June 20, 2013.
Each of our business segments operates in a highly competitive environment, and we face competition in all aspects of our business from numerous bank and non-bank providers of financial services.
Our Credit Card business competes with international, national, regional and local issuers of Visa® and MasterCard® credit cards, as well as with American Express®, Discover Card®, private-label card brands, and, to a certain extent, issuers of debit cards. In general, customers are attracted to credit card issuers largely on the basis of price, credit limit and other product features.
Our Consumer Banking and Commercial Banking businesses compete with national and state banks and direct banks for deposits, auto loans, mortgages and trust accounts and with savings and loan associations and credit
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unions for loans and deposits. Our competitors also include automotive finance companies, mortgage banking companies and other financial services providers that provide loans, deposits, and other similar services and products. In addition, we compete against non-depository institutions that are able to offer these products and services. Securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. Combinations of this type could significantly change the competitive environment in which we conduct business. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services. These technological advances may diminish the importance of depository institutions and other financial intermediaries in the transfer of funds between parties. In addition, competition among direct banks is intense because online banking provides customers the ability to rapidly deposit and withdraw funds and open and close accounts in favor of products and services offered by competitors.
Our businesses generally compete on the basis of the quality and range of their products and services, transaction execution, innovation and price. Competition varies based on the types of clients, customers, industries and geographies served. Our ability to compete depends, in part, on our ability to attract and retain our professional and other associates and on our reputation. In the current environment, customers are generally attracted to depository institutions that are perceived as stable, with solid liquidity and funding.
We believe that we are able to compete effectively in our current markets. There can be no assurance, however, that our ability to market products and services successfully or to obtain adequate returns on our products and services will not be impacted by the nature of the competition that now exists or may later develop, or by the broader economic environment. For a discussion of the risks related to our competitive environment, please refer to “Item 1A. Risk Factors.”
A central part of our philosophy is to attract and retain a highly capable staff. We had 39,593 employees, whom we refer to as “associates,” as of December 31, 2012. None of our associates are covered under a collective bargaining agreement, and management considers our associate relations to be satisfactory.
Geographic Diversity
Our consumer loan portfolios, including credit cards, are diversified across the United States with modest concentration in California, Texas, New York, Florida, Louisiana and Illinois. We also have credit card loans in the U.K. and Canada. Our commercial loans are concentrated in New York, Texas, Louisiana and New Jersey. See “MD&A—Credit Risk Profile” and “Note 5—Loans” for additional information.
Technology/Systems
We leverage information technology to achieve our business objectives and to develop and deliver products and services that satisfy our customers’ needs. A key part of our strategic focus is the development of efficient, flexible computer and operational systems to support complex marketing and account management strategies, the servicing of our customers, and the development of new and diversified products. We believe that the continued development and integration of these systems is an important part of our efforts to reduce costs, improve quality and provide faster, more flexible technology services. Consequently, we continuously review capabilities and develop or acquire systems, processes and competencies to meet our unique business requirements.
As part of our continuous efforts to review and improve our technologies, we may either develop such capabilities internally or rely on third party outsourcers who have the ability to deliver technology that is of higher quality, lower cost, or both. Over time, we have increasingly relied on third party outsourcers to help us
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deliver systems and operational infrastructure. These relationships include (but are not limited to): Total System Services Inc. (“TSYS”) for processing services for our North American and United Kingdom portfolios of consumer and small business credit card accounts, Fidelity Information Services (“FIS”) for the Capital One banking systems and IBM Corporation for management of our North American data centers.
To protect our systems and technologies, we employ security, backup and recovery systems and generally require the same of our third-party service providers. In addition, we perform, or cause to be performed, a variety of vulnerability and penetration testing on the platforms, systems and applications used to provide our products and services in an effort to ensure that any attacks on these platforms, systems and applications are unlikely to succeed. Despite these controls, Capital One, along with several other U.S. financial services providers, was targeted recently on several occasions with distributed denial-of-service attacks from sophisticated third parties that succeeded, on a few occasions, in temporarily limiting our ability to service customers through online platforms.
Intellectual Property
As part of our overall and ongoing strategy to protect and enhance our intellectual property, we rely on a variety of protections, including copyrights, trademarks, trade secrets, patents and certain restrictions on disclosure, solicitation, and competition. We also undertake other measures to control access to and distribution of our other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use certain intellectual property or proprietary information without authorization. Our precautions may not prevent misappropriation or infringement of our intellectual property or proprietary information. In addition, our competitors and other third parties also file patent applications for innovations that are used in our industry. The ability of our competitors and other third parties to obtain such patents may adversely affect our ability to compete. Conversely, our ability to obtain such patents may increase our competitive advantage. There can be no assurance that we will be successful in such efforts, or that the ability of our competitors to obtain such patents may not adversely impact our financial results.
From time to time, we have made and will make forward-looking statements, including those that discuss, among other things, strategies, goals, outlook or other non-historical matters; projections, revenues, income, expenses, capital measures, returns, accruals for claims in litigation and for other claims against us; earnings per share or other financial measures for us; future financial and operating results; our plans, objectives, expectations and intentions; the projected impact and benefits of the ING Direct and 2012 U.S. card acquisitions (collectively, the “Transactions”); and the assumptions that underlie these matters.
To the extent that any such information is forward-looking, it is intended to fit within the safe harbor for forward-looking information provided by the Private Securities Litigation Reform Act of 1995. Numerous factors could cause our actual results to differ materially from those described in such forward-looking statements, including, among other things:
| • | general economic and business conditions in the U.S., the U.K., Canada and our local markets, including conditions affecting employment levels, interest rates, consumer income and confidence, spending and savings that may affect consumer bankruptcies, defaults, charge-offs and deposit activity; |
| • | an increase or decrease in credit losses (including increases due to a worsening of general economic conditions in the credit environment); |
| • | financial, legal, regulatory, tax or accounting changes or actions, including the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the regulations promulgated thereunder, regulations governing bank capital and liquidity standards, including Basel-related initiatives and potential changes to financial accounting and reporting standards; |
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| • | the possibility that we may not fully realize the projected cost savings and other projected benefits of the Transactions; |
| • | difficulties and delays in integrating the assets and businesses acquired in the Transactions; |
| • | business disruption following the Transactions; |
| • | diversion of management time on issues related to the Transactions, including integration of the assets and businesses acquired; |
| • | reputational risks and the reaction of customers and counterparties to the Transactions; |
| • | disruptions relating to the Transactions negatively impacting our ability to maintain relationships with customers, employees and suppliers; |
| • | changes in asset quality and credit risk as a result of the Transactions; |
| • | developments, changes or actions relating to any litigation matter involving us; |
| • | the inability to sustain revenue and earnings growth; |
| • | increases or decreases in interest rates; |
| • | our ability to access the capital markets at attractive rates and terms to capitalize and fund our operations and future growth; |
| • | the success of our marketing efforts in attracting and retaining customers; |
| • | increases or decreases in our aggregate loan balances or the number of customers and the growth rate and composition thereof, including increases or decreases resulting from factors such as shifting product mix, amount of actual marketing expenses we incur and attrition of loan balances; |
| • | the level of future repurchase or indemnification requests we may receive, the actual future performance of mortgage loans relating to such requests, the success rates of claimants against us, any developments in litigation and the actual recoveries we may make on any collateral relating to claims against us; |
| • | the amount and rate of deposit growth; |
| • | changes in the reputation of or expectations regarding the financial services industry or us with respect to practices, products or financial condition; |
| • | any significant disruption in our operations or technology platform; |
| • | our ability to maintain a compliance infrastructure suitable for the nature of our business; |
| • | our ability to control costs; |
| • | the amount of, and rate of growth in, our expenses as our business develops or changes or as it expands into new market areas; |
| • | our ability to execute on our strategic and operational plans; |
| • | any significant disruption of, or loss of public confidence in, the United States Mail service affecting our response rates and consumer payments; |
| • | any significant disruption of, or loss of public confidence in, the internet affecting the ability of our customers to access their accounts and conduct banking transactions; |
| • | our ability to recruit and retain experienced personnel to assist in the management and operations of new products and services; |
| • | changes in the labor and employment markets; |
| • | fraud or misconduct by our customers, employees or business partners; |
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| • | competition from providers of products and services that compete with our businesses; and |
| • | other risk factors listed from time to time in reports that we file with the SEC. |
Any forward-looking statements made by us or on our behalf speak only as of the date they are made or as of the date indicated, and we do not undertake any obligation to update forward-looking statements as a result of new information, future events or otherwise. You should carefully consider the factors discussed above in evaluating these forward-looking statements. For additional information on factors that could materially influence forward-looking statements included in this Report, see the risk factors set forth under “Part I—Item 1A. Risk Factors” in this Annual Report on Form 10-K.
Business Risks
This section highlights specific risks that could affect our business. Although we have tried to discuss all material risks of which we are aware at the time this Annual Report on Form 10-K has been filed, other risks may prove to be important in the future, including those that are not currently ascertainable. In addition to the factors discussed elsewhere in this Annual Report, other factors that could cause actual results to differ materially from our forward looking statements include:
The Current Business Environment, Including A Slow or Delayed Economic Recovery, May Adversely Affect Our Industry, Business, Results Of Operations And Capital Levels.
The recent global recession resulted in a general tightening in the credit markets, lower levels of liquidity, reduced asset values (including commercial properties), sharp and prolonged declines in residential home values and sales volumes, reduced business profits, increased rates of business and consumer repayment delinquency, increased rates of business and consumer bankruptcy, and increased and prolonged unemployment, some of which have had a negative impact on our results of operation. Although the overall economic recovery seems to be underway, it has remained modest and fragile. A recovery that is only shallow and very gradual, marked by continued elevated unemployment rates and reduced home prices, or another downturn, may have a material adverse effect on our financial condition and results of operations as customers default on their loans or maintain lower deposit levels or, in the case of credit card accounts, carry lower balances and reduce credit card purchase activity.
In particular, we may face the following risks in connection with these events:
| • | Adverse macroeconomic conditions may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which could have a negative impact on our results of operations. In addition, changes in consumer behavior, including decreased consumer spending and a shift in consumer payment behavior towards avoiding late fees, over-limit fees, finance charges and other fees, could have a negative impact on our results of operations. |
| • | Increases in bankruptcies could cause increases in our charge-off rates, which could have a negative impact on our results of operations. |
| • | Our ability to recover debt that we have previously charged-off may be limited, which could have a negative impact on our results of operations. |
| • | The processes and models we use to estimate inherent losses may no longer be reliable because they rely on complex judgments, including assumptions and forecasts of economic conditions which may no longer be capable of accurate estimation in an unpredictable economic environment, which could have a negative impact on our results of operations. |
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| • | Our ability to assess the creditworthiness of our customers may be impaired if the criteria or models we use to underwrite and manage our customers become less predictive of future losses, which could cause our losses to rise and have a negative impact on our results of operations. |
| • | Significant concern regarding the creditworthiness of some of the governments in Europe and uncertainty stemming from U.S. debt and budget matters have contributed to volatility in the financial markets and led to greater economic uncertainty worldwide. Concerns about sovereign debt in Europe and the U.S. debt could diminish economic recovery and lead to further stress in the financial markets, both globally and in the United States, which could have a negative impact on our financial results. |
| • | Our ability to borrow from other financial institutions or to engage in funding transactions on favorable terms or at all could be adversely affected by disruptions in the capital markets or other events, including actions by rating agencies and deteriorating investor expectations, which could limit our access to funding. The interest rates that we pay on our securities are also influenced by, among other things, applicable credit ratings from recognized rating agencies. A downgrade to any of these credit ratings could affect our ability to access the capital markets, increase our borrowing costs and have a negative impact on our results of operations. Increased charge-offs, rising LIBOR and other events may cause our securitization transactions to amortize earlier than scheduled, which could accelerate our need for additional funding from other sources. |
| • | We have increased our reliance on deposit funding over the past several years, in particular with the acquisition of ING Direct, and an inability to accept or maintain deposits or to obtain other sources of funding could materially affect our liquidity position and our ability to fund our business. Many other financial institutions have also increased their reliance on deposit funding and, as such, we expect continued competition in the deposit markets. We cannot predict how this competition will affect our costs. If we are required to offer higher interest rates to attract or maintain deposits, our funding costs will be adversely impacted. |
| • | Interest rates have remained at historically low levels for a prolonged period of time, and the flat yield curve associated with current interest rates generally leads to lower revenue and reduced margins because it limits our opportunity to increase the spread between asset yields and funding costs. The continued presence of a flat yield curve for a sustained period of time could have a material adverse effect on our earnings and our net interest margin. |
| • | The historically low interest rate environment also increases our exposure to prepayment risk, particularly with respect to the originated mortgage portfolio we acquired from ING Direct. Increased prepayments, refinancing or other factors would reduce expected revenue associated with mortgage assets and could also lead to a reduction in the value of our mortgage servicing rights, which could have a negative impact on our financial results. |
Compliance With New And Existing Laws, Regulations And Regulatory Expectations May Increase Our Costs, Reduce Our Revenue, Limit Our Ability To Pursue Business Opportunities, And Increase Compliance Challenges.
There has been increased legislation and regulation with respect to the financial services industry in the last few years, and we expect that oversight of our business will continue to expand in scope and complexity. A wide and increasing array of banking and consumer lending laws apply to almost every aspect of our business. Failure to comply with these laws and regulations could result in financial, structural and operational penalties, including receivership, and could result in negative publicity or damage to our reputation with regulators or the public. In addition, establishing systems and processes to achieve compliance with these laws and regulations may increase our costs and limit our ability to pursue certain business opportunities.
The Dodd-Frank Act, as well as the related rules and regulations adopted by various regulatory agencies, could have a significant adverse impact on our business, results of operations or financial condition. The Dodd-Frank Act is a comprehensive financial reform act that requires, among other things, enhanced prudential standards
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(including capital and liquidity requirements), enhanced supervision (including stress testing), recovery and resolution planning (often referred to as “living wills”), prohibitions on proprietary trading and increased transparency and regulation of derivatives trading. The Dodd-Frank Act also provides heightened expectations for risk management and regulatory oversight of all aspects of large financial institutions, including us. Many aspects of the law remain to be implemented under the rulemaking and regulatory authority of the SEC, the CFTC and federal banking regulators. Although it is clear that the Dodd-Frank Act and implementing regulations materially impact large financial institutions like us, the rulemaking process has been progressing slowly, and we may not experience the ultimate impact of the Dodd-Frank Act for years. Though some aspects of the Dodd-Frank Act may significantly impact our financial condition or results of operations, other aspects of the law may not apply to us. Nevertheless, the law has increased our need to build new compliance processes and infrastructure and to otherwise enhance our risk management throughout all aspects of our business. The cumulative impact includes higher expectations for capital and liquidity, as discussed in more detail below under the header “We May Not Be Able to Maintain Adequate Capital Levels or Liquidity, Which Could have a Negative Impact on Our Financial Results,” and higher operational costs, which may further increase once regulators fully implement the law. In addition, U.S. government agencies charged with adopting rules and regulations under the Dodd-Frank Act may do so in an unforeseen manner, including ways that potentially expand the reach of the legislation more than was initially contemplated.
There are a number of other provisions in the Dodd-Frank Act that directly or through implementing regulations may impact our business, including:
| • | The Dodd-Frank Act will likely subject us to the supervision of regulatory agencies that historically have not regulated our businesses, such as the Commodity Futures Trading Commission with respect to our derivatives activities. The Dodd-Frank Act also created the Consumer Financial Protection Bureau (the “CFPB”), who regulates our businesses with respect to our compliance with certain consumer laws and regulations. The cost of complying with applicable laws and regulations could have an adverse impact on our financial condition. |
| • | The Dodd-Frank Act requires the Federal Reserve to establish enhanced prudential standards governing capital, liquidity, risk management, stress testing, single-counterparty credit exposure limits, early remediation, and resolution planning for bank holding companies and certain foreign banking organizations with $50 billion or more in consolidated total assets (“covered companies”). In December 2011, the Federal Reserve requested comment on proposed rules that would implement most of these requirements for domestic covered companies, including us. The Federal Reserve and the FDIC issued a final rule in November 2011 implementing the resolution planning requirements, and under the rule, we are required to submit our resolution plan by December 31, 2013. The cost of complying with final rules implementing enhanced prudential standards could have a negative impact on our financial results. |
The Credit CARD Act (amending the Truth-in-Lending Act) and related changes to Regulation Z impose a number of restrictions on credit card practices impacting rates and fees and also update the disclosures required for open-end credit. Overlimit fees may not be imposed without prior consent of the customer, and the number of such fees that can be charged for the same violation is constrained. The amount of any penalty fee or charge must be “reasonable and proportional” to the violation. In addition, the ability of a card issuer to increase rates charged on pre-existing card balances has been significantly restricted. Card issuers are generally prohibited from raising rates on pre-existing balances when generally prevailing interest rates change. Moreover, the circumstances under which a card issuer can raise the interest rate on pre-existing balances of a customer whose risk of default increases are restricted. As a result, the rules implementing the Credit CARD Act could make the card business generally less resilient in future economic downturns.
Under the various state and federal statutes and regulations, we are required to observe various data security and privacy-related requirements, including establishing information security and data security breach response programs and properly authenticating customers before processing or enabling certain types of transactions or interactions. Future federal and state legislation and regulation could further restrict how we collect, use, share
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and secure customer information. The failure to observe any one or more of these requirements could subject us to litigation or enforcement actions and impact some of our current or planned business initiatives.
In 2012, we were party to several consent orders and settlement agreements with certain federal agencies. On July 17, 2012, COBNA entered into consent orders with each of the OCC and the CFPB relating to oversight of our vendor sales practices of payment protection and credit monitoring products. On July 26, 2012, the Banks each entered into consent orders with each of the Department of Justice and the OCC relating to compliance with the Servicemembers Civil Relief Act, or the SCRA, and, in the case of the OCC orders, third-party management.
In addition, in the first quarter of 2012, we closed the ING Direct acquisition. In its order approving the acquisition, the Federal Reserve Board required Capital One to enhance our risk-management systems and policies enterprise-wide to account for the changes to our business lines that would result from the acquisitions of ING Direct and HSBC’s credit card operations in the U.S. Among other things, we are implementing enhancements to our compliance risk management programs on an enterprise-wide basis in the following primary areas:
| • | Compliance with laws, rules and regulations regarding unfair and deceptive practices; |
| • | Compliance with the SCRA; |
| • | Compliance monitoring and transaction testing capabilities to detect any instances of non-compliance with consumer compliance laws and regulations; |
| • | Third-party management, especially in the context of compliance with consumer laws and regulations; and |
| • | Internal controls, policies and procedures and oversight by the Board and senior management. |
We are continuing to make significant changes to our systems and processes in order to enhance our enterprise-wide compliance risk management programs. There will continue to be heightened regulatory oversight by the federal banking regulators to ensure that we build systems and processes that are commensurate with the nature of our business, and we expect this heightened oversight will continue for the foreseeable future until we meet the expectations of our regulators and can demonstrate that such systems and processes are sustainable.
The legislative and regulatory environment is beyond our control, may change rapidly and unpredictably and may negatively influence our revenue, costs, earnings, growth and capital levels. Certain laws and regulations, and any interpretations and applications with respect thereto, may benefit consumers, borrowers and depositors, but not stockholders. Our success depends on our ability to maintain compliance with both existing and new laws and regulations. For a description of the laws and regulations to which we are subject, please refer to “Supervision and Regulation” in “Item 1. Business.”
We May Experience Increased Delinquencies And Credit Losses.
Like other lenders, we face the risk that our customers will not repay their loans. Rising losses or leading indicators of rising losses (such as higher delinquencies, higher rates of non-performing loans, higher bankruptcy rates, lower collateral values or elevated unemployment rates) may require us to increase our allowance for loan and lease losses, which may degrade our profitability if we are unable to raise revenue or reduce costs to compensate for higher losses. In particular, we face the following risks in this area:
| • | Missed Payments. Our customers may miss payments. Loan charge-offs (including from bankruptcies) are generally preceded by missed payments or other indications of worsening financial condition for our customers. Customers are more likely to miss payments during an economic downturn or prolonged periods of slow economic growth. In addition, we face the risk that consumer and commercial customer behavior may change (for example, an increase in the unwillingness or inability of customers to repay debt), causing a long-term rise in delinquencies and charge-offs. |
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| • | Estimates of Inherent Losses. The credit quality of our portfolio can have a significant impact on our earnings. We allow for and reserve against credit risks based on our assessment of credit losses inherent in our loan portfolios. This process, which is critical to our financial results and condition, requires complex judgments, including forecasts of economic conditions. We may underestimate our inherent losses and fail to hold a loan loss allowance sufficient to account for these losses. Incorrect assumptions could lead to material underestimates of inherent losses and inadequate allowance for loan and lease losses. In addition, our estimate of inherent losses impacts the amount of allowances we build to account for those losses. In cases where we modify a loan, if the modifications do not perform as anticipated we may be required to build additional allowance on these loans. The increase or release of allowances impacts our current financial results. |
| • | Underwriting. Our ability to assess the credit worthiness of our customers may diminish. If the models and approaches we use to select, manage and underwrite our consumer and commercial customers become less predictive of future charge-offs (due, for example, to rapid changes in the economy, including the unemployment rate), our credit losses may increase and our returns may deteriorate. |
| • | Business Mix. Our business mix could change in ways that could adversely affect credit losses. We engage in a diverse mix of businesses with a broad range of credit loss characteristics. Consequently, changes in our business mix may change our charge-off rate. |
| • | Charge-off Recognition. The rules governing charge-off recognition could change. We record charge-offs according to accounting and regulatory guidelines and rules. These guidelines and rules, including FASB standards and the FFIEC Account Management Guidance, could require changes in our account management or loss allowance practices and cause our charge-offs and/or allowance for loan and lease losses to increase for reasons unrelated to the underlying performance of our portfolio. Such changes could have an adverse impact on our financial condition or results of operation. |
| • | Industry Developments. Our charge-off and delinquency rates may be negatively impacted by industry developments, including new regulations applicable to our industry. |
| • | Collateral. Collateral, when we have it, could be insufficient to compensate us for loan losses. When customers default on their loans and we have collateral, we attempt to seize it where permissible and appropriate. However, the value of the collateral may not be sufficient to compensate us for the amount of the unpaid loan, and we may be unsuccessful in recovering the remaining balance from our customers. Particularly with respect to our commercial lending and home loan activities, decreases in real estate values adversely affect the value of property used as collateral for our loans and investments. Thus, the recovery of such property could be insufficient to compensate us for the value of these loans. Borrowers may be less likely to continue making payments on loans if the value of the property used as collateral for the loan is less than what the borrower owes, even if the borrower is still financially able to make the payments. |
| • | New York Concentration. Although our lending is geographically diversified, approximately 37% of our commercial loan portfolio is concentrated in the New York metropolitan area. The regional economic conditions in the New York area affect the demand for our commercial products and services as well as the ability of our customers to repay their commercial loans and the value of the collateral securing these loans. An economic downturn or prolonged period of slow economic growth in, or a catastrophic event that disproportionately affects, the New York region could have a material adverse effect on the performance of our commercial loan portfolio and our results of operations. |
We May Experience Increased Losses Associated With Mortgage Repurchases and Indemnification Obligations.
Certain of our subsidiaries, including GreenPoint Mortgage Funding, Inc. (“GreenPoint”), Capital One Home Loans and Capital One, N.A., as successor to Chevy Chase Bank, may be required to repurchase mortgage loans that have been sold to investors in the event there are breaches of certain representations and warranties contained within the sales agreements. We may be required to repurchase mortgage loans that we sell to investors in the event that there
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was improper underwriting or fraud or in the event that the loans become delinquent shortly after they are originated. These subsidiaries also may be required to indemnify certain purchasers and others against losses they incur in the event of breaches of representations and warranties and in various other circumstances, including securities fraud or other public disclosure-related claims, and the amount of such losses could exceed the repurchase amount of the related loans. Consequently, we may be exposed to credit risk associated with sold loans.
We have established reserves in our consolidated financial statements for potential losses that are considered to be both probable and reasonably estimable related to the mortgage loans sold by our originating subsidiaries. The adequacy of the reserve and the ultimate amount of losses incurred will depend on, among other things, the actual future mortgage loan performance, the actual level of future repurchase and indemnification requests, the actual success rate of claimants, developments in litigation related to us and the industry, actual recoveries on the collateral and macroeconomic conditions (including unemployment levels and housing prices). Due to uncertainties relating to these factors, there can be no assurance that our reserves will be adequate or that the total amount of losses incurred will not have a material adverse effect upon our financial condition or results of operations. For additional information related to our mortgage loan repurchase and indemnification obligations and related reserves and our estimate of the reasonably possible future losses from representation and warranty claims beyond the current accrual levels as of December 31, 2012, see “Note 21—Commitments, Contingencies and Guarantees.”
We May Not Be Able to Maintain Adequate Capital Levels or Liquidity, Which Could Have a Negative Impact on Our Financial Results.
As a result of the Dodd-Frank Act and international accords, financial institutions will become subject to new and increased capital and liquidity requirements. Although U.S. regulators have proposed regulations for some of these requirements, there remains uncertainty as to the form the new requirements will take or how and when they will apply to us. As a result, it is possible that we could be required to increase our capital levels above the levels in our current financial plans. These new requirements could have a negative impact on our ability to lend, grow deposit balances or make acquisitions and on our ability to make capital distributions in the form of increased dividends or share repurchases. Higher capital levels could also lower our return on equity.
Recent developments in capital and liquidity requirements that may impact us include the following:
| • | In December 2010, the Basel Committee on Banking Supervision published a final framework on capital and in January 2013 published a revised framework on liquidity, together commonly known as Basel III. The key elements of the capital proposal include: raising the quality, consistency and transparency of the capital base; strengthening the risk coverage of the capital framework; introducing a leverage ratio that is different from the U.S. leverage ratio measures; promoting the build-up of capital buffers; and imposing a capital surcharge for global systemically important institutions. The liquidity framework includes two standards for liquidity risk supervision, one standard promoting short-term resilience (included in the liquidity framework), and the other promoting longer-term resilience (still under development by the Basel Committee). In June 2012, U.S. banking regulators published proposed regulations that, among other things, implement the Basel capital requirements; update the prompt corrective action framework to reflect the higher Basel capital minimums; and revise the federal banking agencies’ general approach for calculating risk-weighted assets. These rules have not yet been finalized. Proposed U.S. rules implementing the Basel III liquidity framework are expected at a later date. |
| • | Because we are a consolidated bank holding company with consolidated assets of $50 billion or greater, we are subject to certain heightened prudential standards under the Dodd-Frank Act, including requirements that may be recommended by the Financial Stability Oversight Council and implemented by the Federal Reserve. As a result, we expect to be subject to more stringent standards and requirements than those applicable for smaller institutions, including risk-based capital requirements, leverage limits and liquidity requirements. In December 2011, the Federal Reserve released proposed rules beginning to implement the enhanced prudential requirements, including a detailed liquidity framework. If finalized as proposed, these |
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| requirements would increase our liquidity requirements and associated compliance and operational costs. The Federal Reserve also indicated that it plans to adopt a capital surcharge for certain larger institutions, but it is not clear to what extent the capital surcharge would apply to us. |
| • | In November 2011, the Federal Reserve finalized capital planning rules applicable to large bank holding companies like us (commonly referred to as Comprehensive Capital Analysis and Review or CCAR). Under the rules, bank holding companies with consolidated assets of $50 billion or more must submit capital plans to the Federal Reserve on an annual basis and must obtain approval from the Federal Reserve before making most capital distributions. The purpose of the rules is to ensure that large bank holding companies have robust, forward-looking capital planning processes that account for their unique risks and capital needs to continue operations through times of economic and financial stress. As part of its evaluation of a capital plan, the Federal Reserve will consider the comprehensiveness of the plan, the reasonableness of assumptions and analysis and methodologies used to assess capital adequacy and the ability of the bank holding company to maintain capital above each minimum regulatory capital ratio and above a Tier 1 common ratio of 5% on a pro forma basis under expected and stressful conditions throughout a planning horizon of at least nine quarters. |
| • | The Basel II final rules as implemented in the United States are mandatory for those institutions with consolidated total assets of $250 billion or more or consolidated total on-balance-sheet foreign exposure of $10 billion or more. We became subject to these rules at the end of 2012 primarily as a result of the acquisition of ING Direct. Prior to full implementation of the Basel II framework, organizations must complete a qualification period of four consecutive quarters, known as the parallel run, during which they must meet the requirements of the rule to the satisfaction of their primary U.S. banking regulator. We are preparing to enter parallel run January 1, 2015. This will require completing a written implementation plan and building processes and systems to comply with the rules. Compliance with the Basel II rules will require a material investment of resources. In addition, although we have current estimates of risk weight calculations, there remains uncertainty around future regulatory interpretations of certain of those calculations. Therefore, we cannot assure you that our current estimates will be correct and we may need to hold significantly more regulatory capital than we currently estimate in order to maintain a given capital ratio. |
See “Item 1. Business—Supervision and Regulation” for additional information.
We Face Risk Related To Our Operational, Technological And Organizational Infrastructure.
Our ability to grow and compete is dependent on our ability to build or acquire necessary operational, technological and organizational infrastructure. We are in the process of completing significant development projects to complete the systems integration of prior acquisitions and to build a scalable infrastructure in both our Retail Banking and Commercial Banking businesses. For example, we are investing in infrastructure in the Commercial Banking business intended to assist with effective execution of key analytical processes and improve loan origination and underwriting platforms. In addition, we have made and anticipate continuing to make additional infrastructure changes and upgrades in connection with the integrations of both the ING Direct and 2012 U.S. card acquisitions. The 2012 U.S. card acquisition involved the transfer of intellectual property, servicing platforms, infrastructure, contact centers and a significant number of employees. The decoupling and transitioning of these assets, infrastructure and systems from HSBC’s current systems and operations and integrating them into our own business operations has been, and we expect it to continue to be, a highly complex process. These infrastructure changes, upgrades and integrations may cause disruptions to our existing and acquired businesses, including, but not limited to, systems interruptions, transaction processing errors, interruptions to collection processes and system conversion delays, all of which could have a negative impact on us. In addition, we have entered into numerous transitional service arrangements with HSBC entities that will provide for services associated with the decoupling and transition of the business. Under these arrangements, HSBC provides certain services to us and we provide certain services to HSBC. These transitional service arrangements will continue for various dates until the separation of the business from HSBC is complete,
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and during that time we will rely on the ability of the applicable HSBC entities to provide these services. The complexities and requirements of these arrangements will increase the operational risk associated with the transition and integration of the business, and this increased risk could lead to unanticipated expenses, disruptions to our operations or other adverse consequences.
Similar to other large corporations, we are exposed to operational risk that can manifest itself in many ways, such as errors related to failed or inadequate processes, inaccurate models, faulty or disabled computer systems, fraud by employees or persons outside of our company and exposure to external events. In addition, we are heavily dependent on the strength and capability of our technology systems which we use to manage our internal financial and other systems, interface with our customers and develop and implement effective marketing campaigns. We also depend on models to measure risks, estimate certain financial values and determine pricing on certain products. Our ability to develop and deliver new products that meet the needs of our existing customers and attract new ones and to run our business in compliance with applicable laws and regulations depends on the functionality and reliability of our operational and technology systems. Any disruptions, failures or inaccuracies of our operational and technology systems and models, including those associated with improvements or modifications to such systems and models, could cause us to be unable to market and manage our products and services, manage our risk or to report our financial results in a timely and accurate manner, all of which could have a negative impact on our results of operations.
In some cases, we and the businesses we are acquiring outsource the maintenance and development of operational and technological functionality to third parties. These third parties may experience errors or disruptions that could adversely impact us and over which we may have limited control. Any increase in the amount of our infrastructure that we outsource to third parties may increase our exposure to these risks.
In addition, our on-going investments in infrastructure, which may be necessary to maintain a competitive business, integrate recent acquisitions, such as ING Direct and the 2012 U.S. card acquisitions, and establish scalable operations, may increase our expenses. Further, as our business develops, changes or expands, additional expenses can arise as a result of a reevaluation of business strategies, management of outsourced services, asset purchases or other acquisitions, structural reorganization, compliance with new laws or regulations or the integration of newly acquired businesses. If we are unable to successfully manage our expenses, our financial results will be negatively affected.
We Could Incur Increased Costs or Reductions In Revenue Or Suffer Reputational Damage And Business Disruptions In the Event Of The Theft, Loss or Misuse Of Information, Including As A Result Of A Cyber-Attack.
Our products and services involve the gathering, storage and transmission of sensitive information regarding our customers and their accounts. Our ability to provide such products and services, many of which are web-based, relies upon the management and safeguarding of information, software, methodologies and business secrets. To provide these products and services, we use information systems and infrastructure that we and third party service providers operate. We also have arrangements in place with retail partners and other third parties where we share and receive information about their customers who are or may become our customers. As a financial institution, we also are subject to and examined for compliance with an array of data protection laws, regulations and guidance, as well as to our own internal privacy and information security policies and programs. If unauthorized persons were somehow to get access to personal, confidential or proprietary information, including customer information, in our possession or to our proprietary information, software, methodologies and business secrets, it could result in significant legal and financial exposure, supervisory liability, damage to our reputation or a loss of confidence in the security of our systems, products and services that could adversely affect our business.
Information security risks for large financial institutions like us have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to
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conduct financial transactions and the increased sophistication and activities of organized crime, perpetrators of fraud, hackers, terrorists, activists, formal and informal instrumentalities of foreign governments and other external parties. As noted above, our operations rely on the secure processing, transmission and storage of confidential information in our computer systems and networks. Our businesses rely on our digital technologies, computer and email systems, software and networks to conduct their operations. In addition, to access our products and services, our customers may use computers, smartphones, tablet PCs and other mobile devices that are beyond our security control systems. Although we believe we have a robust suite of authentication and layered information security controls, our technologies, systems, networks and our customers’ devices may become the target of cyber-attacks or other attacks that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our or our customers’ confidential, proprietary or other information, including their access credential to accounts with online functionality, or that could result in disruptions to the business operations of us or our customers or other third parties. For example, Capital One and other U.S. financial services providers were targeted recently on several occasions with distributed denial-of-service attacks from sophisticated third parties. On at least one occasion, these attacks successfully disrupted consumer online banking services for a period of time. If these attacks are successful, or if customers are unable to access their accounts online for other reasons, it could adversely impact our ability to service customer accounts or loans, complete financial transactions for our customers or otherwise operate any of our businesses or services online. In addition, a breach or attack affecting one of our third-party service providers or partners could impact us through no fault of our own.
Because the methods and techniques employed by perpetrators of fraud and others to attack, disable, degrade or sabotage platforms, systems and applications change frequently and often are not fully recognized or understood until after they have been launched, we and our third-party service providers and partners may be unable to anticipate certain attack methods in order to implement effective preventative measures. Should a cyber-attack against us succeed on any material scale, market perception of the effectiveness of our security measures could be harmed, and we could face the aforementioned risks. Though we have insurance against some cyber-risks and attacks, it may not be sufficient to offset the impact of a material loss event.
The Growth Of Our Direct Banking Business Presents Certain Risks.
As a result of our strategic decisions and acquisition of ING Direct, we have grown our direct banking business significantly over the past few years. Today, we operate the largest online direct banking institution in the U.S., with approximately $109 billion in deposits as of December 31, 2012. While direct banking represents a significant opportunity to attract new customers that value greater and more flexible access to banking services at reduced costs, it also presents significant risks. In addition to the software, infrastructure and cyber-attack risks discussed above, we face risks related to direct banking, including:
| • | We face strong competition in the direct banking market. Aggressive pricing throughout the industry may adversely affect the retention of existing balances and the cost-efficient acquisition of new deposit funds and may affect our growth and profitability. In addition, the effects of a competitive environment may be exacerbated by the flexibility of direct banking and the increasing financial and technological sophistication of our customer base. We have transitioned from the “ING Direct” brand to a new brand, “Capital One 360,” which may not be readily accepted by customers, and these customers may not accept our branding, image, name, reputation, policies or level of service or may be dissatisfied with perceived differences regarding how they manage their online accounts after the transition, and as a result may transfer their accounts and business to a competitor. Customers could also close their online accounts or reduce balances or deposits in favor of products and services offered by competitors for other reasons. These shifts, which could be rapid, could result from general dissatisfaction with our products or services, including concerns over pricing, online security or our reputation. |
Our direct banking business is dependent on our ability to process, record and monitor a large number of complex transactions. If any of our financial, accounting, or other data processing systems fail or have other
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significant shortcomings, we could be materially adversely affected. Third parties with which we do business could also be sources of operational risk, particularly in the event of breakdowns or failures of such parties’ own systems. We may also be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control, which may include, for example, computer viruses or electrical or telecommunications outages, cyber-attacks, including distributed denial-of-service attacks discussed above, natural disasters, other damage to property or physical assets or events arising from local or larger scale politics, including terrorist acts. Any of these occurrences could diminish our ability to operate our direct banking business, service customer accounts, and protect customers’ information, or result in potential liability to customers, reputational damage, regulatory intervention and customers’ loss of confidence in our direct banking business, any of which could result in a material adverse effect.
We May Fail To Realize All Of The Anticipated Benefits Of Our Mergers And Acquisitions.
We have engaged in merger and acquisition activity over the past several years and may continue to engage in such activity in the future. For example, in 2012, we closed the ING Direct and 2012 U.S. card acquisitions. We continue to evaluate and anticipate engaging in, among other merger and acquisition activity, additional strategic partnerships and selected acquisitions of financial institutions and other financial assets, including credit card and other loan portfolios.
Any merger, acquisition or strategic partnership we undertake will entail certain risks, which may materially and adversely affect our results of operations. If we experience greater than anticipated costs to integrate acquired businesses into our existing operations or are not able to achieve the anticipated benefits of any merger, acquisition or strategic partnership, including cost savings and other synergies, our business could be negatively affected. In addition, it is possible that the ongoing integration processes could result in the loss of key employees, errors or delays in systems implementation, the disruption of our ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect our ability to maintain relationships with partners, clients, customers, depositors and employees or to achieve the anticipated benefits of any merger, acquisition or strategic partnership. Integration efforts also may divert management attention and resources. These integration matters may have an adverse effect on us during any transition period.
In addition, we may face the following risks in connection with any merger, acquisition or strategic partnership:
| • | New Businesses and Geographic or Other Markets. Our merger, acquisition or strategic partnership activity may involve our entry into new businesses and new geographic areas or other markets which present risks resulting from our relative inexperience in these new businesses or markets. These new businesses or markets may change the overall character of our consolidated portfolio of businesses and could react differently to economic and other external factors. We face the risk that we will not be successful in these new businesses or in these new markets. |
| • | Identification and Assessment of Merger and Acquisition Targets and Deployment of Acquired Assets. We cannot assure you that we will identify or acquire suitable financial assets or institutions to supplement our organic growth through acquisitions or strategic partnerships. In addition, we may incorrectly assess the asset quality and value of the particular assets or institutions we acquire. Further, our ability to achieve the anticipated benefits of any merger, acquisition or strategic partnership will depend on our ability to assess the asset quality and value of the particular assets or institutions we partner with, merge with or acquire. We may be unable to profitably deploy any assets we acquire. |
| • | Accuracy of Assumptions. In connection with any merger, acquisition or strategic partnership, we may make certain assumptions relating to the proposed merger or acquisition that may be, or may prove to be, inaccurate, including as the result of the failure to realize the expected benefits of any merger, acquisition or strategic partnership. The inaccuracy of any assumptions we may make could result in unanticipated consequences that could have a material adverse effect on our results of operations or financial condition. Assumptions we might make when considering a proposed merger, acquisition or strategic partnership may relate to numerous matters, including: |
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| • | projections of a target or partner company’s future net income and our earnings per share; |
| • | our ability to issue equity and debt to complete any merger or acquisition; |
| • | our expected capital structure and capital ratios after any merger, acquisition or strategic partnership; |
| • | projections as to the amount of future loan losses in any target or partner company’s portfolio; |
| • | the amount of goodwill and intangibles that will result from any merger, acquisition or strategic partnership; |
| • | certain purchase accounting adjustments that we expect will be recorded in our financial statements in connection with any merger, acquisition or strategic partnership; |
| • | cost, deposit, cross-selling and balance sheet synergies in connection with any merger, acquisition or strategic partnership; |
| • | merger, acquisition or strategic partnership costs, including restructuring charges and transaction costs; |
| • | our ability to maintain, develop and deepen relationships with customers of a target or partner company; |
| • | our ability to grow a target or partner company’s customer deposits and manage a target or partner company’s assets and liabilities; |
| • | higher than expected transaction and integration costs and unknown liabilities as well as general economic and business conditions that adversely affect the combined company following any merger or acquisition transaction; |
| • | the extent and nature of regulatory oversight over a target or partner company; |
| • | projected or expected tax benefits or assets; |
| • | accounting matters related to the target or partner company, including accuracy of assumptions and estimates used in preparation of financial statements such as those used to determine allowance for loan losses, fair value of certain assets and liabilities, securities impairment and realization of deferred tax assets; |
| • | our expectations regarding macroeconomic conditions, including the unemployment rate, housing prices, the interest rate environment, the shape of the yield curve, inflation and other economic indicators; and other financial and strategic risks associated with any merger or acquisition. |
| • | Target Specific Risk. Assets and companies that we acquire will have their own risks that are specific to a particular asset or company. These risks include, but are not limited to, particular or specific regulatory, accounting, operational, reputational and industry risks, any of which could have a material adverse effect on our results of operations or financial condition. Indemnification rights, if any, may be insufficient to compensate us for any losses or damages resulting from such risks. In addition to regulatory approvals discussed above, certain of our merger, acquisitions or partnership activity may require third-party consents in order for us to fully realize the anticipated benefits of any such transaction. |
Reputational Risk and Social Factors May Impact Our Results.
Our ability to originate and maintain accounts is highly dependent upon the perceptions of consumer and commercial borrowers and deposit holders and other external perceptions of our business practices or our financial health. Adverse perceptions regarding our reputation in the consumer, commercial and funding markets could lead to difficulties in generating and maintaining accounts as well as in financing them. In particular, negative perceptions regarding our reputation could lead to decreases in the levels of deposits that consumer and commercial customers and potential customers choose to maintain with us. Negative public opinion could result from actual or alleged conduct in any number of activities or circumstances, including lending practices,
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regulatory compliance, inadequate protection of customer information, or sales and marketing, and from actions taken by regulators or other persons in response to such conduct. In addition, third parties with whom we have important relationships may take actions over which we have limited control that could negatively impact perceptions about us.
In addition, a variety of social factors may cause changes in borrowing activity, including credit card use, payment patterns and the rate of defaults by accountholders and borrowers domestically and internationally. These social factors include changes in consumer confidence levels, the public’s perception regarding consumer debt, including credit card use, and changing attitudes about the stigma of bankruptcy. If consumers develop or maintain negative attitudes about incurring debt, or if consumption trends decline, our business and financial results will be negatively affected.
Damage To Our Brands Could Impact Our Financial Performance.
Our brands have historically been very important to us. As with many financial services institutions, maintaining and enhancing our brand will depend largely on our ability to be a technology leader and to continue to provide high-quality products and services. Negative public perception of our brands could result from actual or alleged conduct in any number of activities, including lending practices, corporate governance, regulatory compliance and the use and protection of customer information, as well as from actions taken by government regulators and community organizations in response to that conduct. If we fail to maintain and enhance our brands, or if we incur excessive expenses in this effort, our business, results of operations and financial condition could be materially and adversely affected. Our online banking brands may also be negatively impacted by a number of factors, including service outages, including as a result of a cyber-attack, integration difficulties from recent acquisitions, product malfunctions, data privacy, lack of training and security issues.
We Face Intense Competition in All of Our Markets.
We operate in a highly competitive environment, and we expect competitive conditions to continue to intensify. We face intense competition both in making loans and attracting deposits. We compete on the basis of the rates we pay on deposits and the rates and other terms we charge on the loans we originate or purchase, as well as the quality of our customer service. Price competition for loans might result in origination of fewer loans or earning less on our loans. We expect that competition will continue to increase with respect to most of our products. Some of our competitors are substantially larger than we are, which may give those competitors advantages, including a more diversified product and customer base, the ability to reach out to more customers and potential customers, operational efficiencies, more versatile technology platforms, broad-based local distribution capabilities, lower-cost funding and larger existing branch networks. In addition, some of our competitors, including new and emerging competitors in the digital and mobile payments space, are not subject to the same regulatory requirements or legislative scrutiny to which we are subject, which also could place us at a competitive disadvantage.
We have significantly expanded our partnership business over the past several years with the additions of a number of credit card partnerships from the 2012 U.S. card acquisition and credit card partnerships with Kohl’s, HBC and Sony. The market for key business partners, especially in the Card business, is very competitive, and we cannot assure you that we will be able to grow or maintain these partner relationships. We face the risk that we could lose partner relationships, even after we have invested significant resources, time and expense in acquiring and developing the relationships. The loss of any of our business partners could have a negative impact on our results of operations, including lower returns, excess operating expense and excess funding capacity.
In such a competitive environment, we may lose entire accounts or may lose account balances to competing firms, or we may find it more costly to maintain our existing customer base. Customer attrition from any or all of our lending products, together with any lowering of interest rates or fees that we might implement to retain
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customers, could reduce our revenues and therefore our earnings. Similarly, customer attrition from our deposit products, in addition to an increase in rates or services that we may offer to retain those deposits, may increase our expenses and therefore reduce our earnings.
If We Do Not Adjust to Rapid Changes in the Financial Services Industry, Our Financial Performance May Suffer.
Our ability to deliver to stockholders strong financial performance and returns on investment will depend in part on our ability to expand the scope of available financial services to meet the needs and demands of our customers. With our recent ING Direct and 2012 U.S. card acquisitions, we have begun to market new products to our larger customer base. Our ability to meet our customers’ needs and expectations is key to our ability to grow revenue and earnings. Many of our competitors are focusing on cross-selling their products and developing new products or technologies, which could affect our ability to maintain or grow existing customer relationships or require us to offer lower interest rates or fees on our lending products or higher interest rates on deposits. This increasingly competitive environment is primarily a result of changes in regulation, changes in technology and product delivery systems, as well as the accelerating pace of consolidation among financial service providers, all of which may affect our customers’ expectations and demands. If we do not successfully anticipate and adjust to changes in the financial service industry, our business and financial results will be negatively affected.
Fluctuations in Market Interest Rates Or Volatility in the Capital Markets Could Adversely Affect Our Revenue and Expense, the Value of Assets and Obligations, Our Cost of Capital or Our Liquidity.
Like other financial institutions, our business may be sensitive to market interest rate movement and the performance of the capital markets. Changes in interest rates or in valuations in the debt or equity markets could directly impact us. For example, we borrow money from other institutions and depositors, which we use to make loans to customers and invest in debt securities and other earning assets. We earn interest on these loans and assets and pay interest on the money we borrow from institutions and depositors. Fluctuations in interest rates, including changes in the relationship between short-term rates and long-term rates and in the relationship between our funding basis rate and our lending basis rate, may have negative impacts on our net interest income and therefore our earnings. In addition, interest rate fluctuations and competitor responses to those changes may affect the rate of customer prepayments for mortgage, auto and other term loans and may affect the balances customers carry on their credit cards. These changes can reduce the overall yield on our earning asset portfolio. Changes in interest rates and competitor responses to these changes may also impact customer decisions to maintain balances in the deposit accounts they have with us. In addition, changes in valuations in the debt and equity markets could have a negative impact on the assets we hold in our investment portfolio. Finally, such market changes could also have a negative impact on the valuation of assets for which we provide servicing.
We assess our interest rate risk by estimating the effect on our earnings under various scenarios that differ based on assumptions about the direction and the magnitude of interest rate changes. We take risk mitigation actions based on those assessments. We face the risk that changes in interest rates could materially reduce our net interest income and our earnings, especially if actual conditions turn out to be materially different than those we assumed. See “MD&A—Market Risk Management” for additional information.
Our Business Could Be Negatively Affected If We Are Unable to Attract, Retain and Motivate Skilled Senior Leaders.
Our success depends, in large part, on our ability to retain key senior leaders, and competition for such senior leaders can be intense in most areas of our business. The executive compensation provisions of the Dodd-Frank Act and the regulations issued thereunder, and any further legislation, regulation or regulatory guidance restricting executive compensation, may limit the types of compensation arrangements that we may enter into with our most senior leaders and could have a negative impact on our ability to attract, retain and motivate such
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leaders in support of our long-term strategy. These laws and regulations may not apply in the same manner to all financial institutions, and we therefore may face more restrictions than other institutions and companies with whom we compete for talent. If we are unable to retain talented senior leadership, our business could be negatively affected.
Our Businesses are Subject to the Risk of Increased Litigation.
Our businesses are subject to increased litigation risks as a result of a number of factors and from various sources, including the highly regulated nature of the financial services industry, the focus of state and federal prosecutors on banks and the financial services industry, the structure of the credit card industry and business practices in the mortgage lending business. Substantial legal liability against us could have a material adverse effect or cause significant reputational harm to us, which could seriously harm our business. For a description of the litigation risks that we face, see “Note 21—Commitments, Contingencies and Guarantees.”
We Face Risks from Unpredictable Catastrophic Events.
Despite our substantial business contingency plans, the impact from natural disasters and other catastrophic events, including terrorist attacks, may have a negative effect on our business and infrastructure, including our information technology systems. In addition, if a natural disaster or other catastrophic event occurs in certain regions where our business and customers are concentrated, such as the New York metropolitan area, we could be disproportionately impacted as compared to our competitors. The impact of such events and other catastrophes on the overall economy may also adversely affect our financial condition and results of operations.
We Face Risks from the Use of or Changes to Estimates in Our Financial Statements.
Pursuant to generally accepted accounting principles in the U.S. (“U.S. GAAP”), we are required to use certain assumptions and estimates in preparing our financial statements, including, but not limited to, estimating our allowance for loan and lease losses and the fair value of certain assets and liabilities. In addition, the Financial Accounting Standards Board (“FASB”), the SEC and other regulatory bodies may change the financial accounting and reporting standards, including those related to assumptions and estimates we use to prepare our financial statements, in ways that we cannot predict and that could impact our financial statements. If the assumptions or estimates underlying our financial statements are incorrect or if financial accounting and reporting standards are changed, we may experience unexpected material losses. For a discussion of our use of estimates in the preparation of our consolidated financial statements, see “Note 1—Summary of Significant Accounting Policies.”
Our Ability To Receive Dividends From Our Subsidiaries Could Affect Our Liquidity And Ability To Pay Dividends.
We are a separate and distinct legal entity from our subsidiaries. Dividends to us from our direct and indirect subsidiaries, including our bank subsidiaries, have represented a major source of funds for us to pay dividends on our common stock, make payments on corporate debt securities and meet other obligations. There are various federal law limitations on the extent to which the Banks can finance or otherwise supply funds to us through dividends and loans. These limitations include minimum regulatory capital requirements, federal banking law requirements concerning the payment of dividends out of net profits or surplus, Sections 23A and 23B of the Federal Reserve Act and Regulation W governing transactions between an insured depository institution and its affiliates, as well as general federal regulatory oversight to prevent unsafe or unsound practices. If our subsidiaries’ earnings are not sufficient to make dividend payments to us while maintaining adequate capital levels, our liquidity may be affected and we may not be able to make dividend payments to our common stockholders, to make payments on outstanding corporate debt securities or meet other obligations, each and any of which could have a material adverse impact on our results of operations, financial position or perception of financial health.
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The Soundness of Other Financial Institutions Could Adversely Affect Us.
Our ability to engage in routine funding and other transactions could be adversely affected by the stability and actions of other financial services institutions. Financial services institutions are interrelated as a result of trading, clearing, servicing, counterparty and other relationships. With our recent ING Direct and 2012 U.S. card acquisitions, we have increased exposure to financial institutions and counterparties. These counterparties include institutions and counterparties that may be exposed to various risks over which we have little or no control, including European or U.S. sovereign debt that is currently or may become in the future subject to significant price pressure, rating agency downgrade or default risk.
In addition, we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds and other institutional clients, resulting in a significant credit concentration with respect to the financial services industry overall. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions.
Likewise, adverse developments affecting the overall strength and soundness of our competitors, the financial services industry as a whole and the general economic climate or sovereign debt could have a negative impact on perceptions about the strength and soundness of our business even if we are not subject to the same adverse developments. In addition, adverse developments with respect to third parties with whom we have important relationships also could negatively impact perceptions about us. These perceptions about us could cause our business to be negatively affected and exacerbate the other risks that we face.
Item 1B. Unresolved Staff Comments
None.
Our corporate and banking real estate portfolio consists of a combined total of approximately 15.6 million square feet of owned or leased office and retail space, used to support our business segments. Of this overall portfolio, approximately 9.9 million square feet of space are dedicated for various corporate office uses (with an additional 824,000 square feet currently under construction in Virginia and Texas) and approximately 5.7 million square feet of space are for bank branches and related offices.
Our 9.9 million square feet of corporate office space consists of approximately 5.4 million square feet of leased space and 4.5 million square feet of owned space and such corporate office space is located in Virginia, Texas, Maryland, New York, Louisiana, Florida, Washington, and Delaware and various other locations, and includes the following owned corporate campuses:
| • | McLean, Virginia: Approximately 587,000 square foot headquarters building housing our executive offices and northern Virginia staff. |
| • | Goochland County, Virginia: Approximately 316 acres of land, which contains approximately 1.2 million square feet of office space to house various business and staff groups. |
| • | Plano, Texas: Approximately 139 acres of land, which contains approximately 678,000 square feet of office space to support various staff groups, including our auto finance and home loan businesses. |
| • | Glen Allen, Virginia: Approximately 453,000 square feet of office space to house various business and staff groups. |
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Our 5.7 million square feet of banking branch and branch/office space consists of approximately 2.7 million square feet of leased space and 3 million square feet of owned space, including branches in locations across the District of Columbia, Louisiana, Maryland, New Jersey, New York, and Virginia.
The information required by Item 3 is included in “Note 21—Commitments, Contingencies and Guarantees.”
Item 4. Mine Safety Disclosures
Not applicable.
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PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Our common stock is listed on the NYSE and is traded under the symbol “COF.” As of January 31, 2013, there were 14,059 holders of record of our common stock. The table below presents the high and low closing sales prices of our common stock as reported by the NYSE and cash dividends per common share declared by us during each quarter indicated.
| Sales Price | Cash Dividends |
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| Quarter ended |
High | Low | ||||||||||
| 2012: |
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| December 31 |
$ | 61.40 | $ | 54.77 | $ | 0.05 | ||||||
| September 30 |
59.37 | 53.36 | 0.05 | |||||||||
| June 30 |
56.36 | 48.40 | 0.05 | |||||||||
| March 31 |
57.15 | 43.75 | 0.05 | |||||||||
| 2011: |
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| December 31 |
$ | 47.07 | $ | 37.75 | $ | 0.05 | ||||||
| September 30 |
54.31 | 37.63 | 0.05 | |||||||||
| June 30 |
56.21 | 47.87 | 0.05 | |||||||||
| March 31 |
52.76 | 43.68 | 0.05 | |||||||||
Dividend Restrictions
For information regarding our ability to pay dividends, see the discussion under “Item 1. Business—Supervision and Regulation—Dividends and Transfers of Funds,” “MD&A—Capital Management—Dividend Policy,” and “Note 13—Regulatory and Capital Adequacy,” which we incorporate herein by reference.
Securities Authorized for Issuance Under Equity Compensation Plans
Information relating to compensation plans under which our equity securities are authorized for issuance is presented in Part III of this report under “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
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Common Stock Performance Graph
The following graph shows the cumulative total stockholder return on our common stock compared with an overall stock market index, the S&P Composite 500 Stock Index (“S&P 500 Index”), and a published industry index, the S&P Financial Composite Index (“S&P Financial Index”), over the five-year period commencing December 31, 2007, and ending December 31, 2012. The stock performance graph assumes that $100 was invested in our common stock and each index and that all dividends were reinvested. The stock price performance on the graph below is not necessarily indicative of future performance.
Comparison of 5-Year Cumulative Total Return
(Capital One, S&P 500 Index and S&P Financial Index)
| 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | |||||||||||||||||||
| Capital One |
$ | 100.00 | $ | 69.81 | $ | 86.51 | $ | 96.52 | $ | 96.32 | $ | 132.44 | ||||||||||||
| S&P 500 Index |
100.00 | 61.51 | 75.94 | 85.65 | 85.65 | 97.13 | ||||||||||||||||||
| S&P Financial Index |
100.00 | 43.05 | 49.42 | 54.78 | 44.69 | 56.43 | ||||||||||||||||||
Recent Sales of Unregistered Securities
On February 17, 2012, in connection with the closing of the ING Direct acquisition, we issued 54,028,086 shares of common stock to ING Bank N.V. as partial consideration for the acquisition in reliance on the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended. On September 10, 2012, one of the ING Sellers sold 54,028,086 shares of our common stock in an underwritten public offering, representing all of the shares of common stock we issued to the ING Sellers in connection with the ING Direct acquisition. We did not receive any proceeds from this offering.
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Issuer Purchases of Equity Securities
The following table presents information related to repurchases of shares of our common stock during the fourth quarter of 2012.
| Total Number of Shares Purchased(1) |
Average Price Paid per Share |
Total Number of Shares Purchased as Part of Publicly Announced Plans |
Maximum Amount That May Yet be Purchased Under the Plan or Program |
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| October 1-31, 2012 |
13,601 | $ | 58.82 | — | $ | — | ||||||||||
| November 1-30, 2012 |
— | — | — | — | ||||||||||||
| December 1-31, 2012 |
— | — | — | — | ||||||||||||
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| Total |
13,601 | $ | 58.82 | — | — | |||||||||||
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| (1) | Shares purchased represent shares purchased and share swaps made in connection with stock option exercises and the withholding of shares to cover taxes on restricted stock awards whose restrictions have lapsed. |
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Item 6. Selected Financial Data
The following table presents selected consolidated financial data and performance metrics for the five-year period ended December 31, 2012. Certain prior period amounts have been reclassified to conform to the current period presentation. We prepare our consolidated financial statements based on generally accepted accounting principles in the U.S. (“U.S. GAAP”), which we refer to as our reported results. This data should be reviewed in conjunction with our audited consolidated financial statements and related notes and with the Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) included in this Report. The historical financial information presented may not be indicative of our future performance. The acquisitions of ING Direct on February 17, 2012 and the 2012 U.S. card acquisition on May 1, 2012 had a significant impact on our results and selected metrics for the year ended December 31, 2012 and our financial condition as of December 31, 2012.
We use the term “acquired loans” to refer to a limited portion of the credit card loans acquired in the 2012 U.S. card acquisition and the substantial majority of consumer and commercial loans acquired in the ING Direct and Chevy Chase Bank (“CCB”) acquisitions, which were recorded at fair value at acquisition and subsequently accounted for based on expected cash flows to be collected (under the accounting standard formerly known as “Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer,” commonly referred to as “SOP 03-3”). The loans acquired in the 2012 U.S. card acquisition accounted for based on expected cash flows consisted of loans with a fair value at acquisition of approximately $651 million that were deemed to be credit impaired because they were delinquent and revolving cardholder privileges had been revoked. The difference between the fair value and initial expected cash flows represents the accretable yield, which is recognized into interest income over the life of the loans. The difference between the contractual payments on the loans and the expected cash flows represents the nonaccretable difference or the amount not considered collectible, which approximates what we refer to as the “credit mark.” The credit mark established under the accounting for these loans takes into consideration future expected credit losses over the life of the loans. Accordingly, there are no charge-offs or an allowance associated with these loans unless the estimated cash flows expected to be collected decrease subsequent to acquisition. In addition, these loans are not classified as delinquent or nonperforming even though the customer may be contractually past due because we expect that we will fully collect the carrying value of these loans. The accounting and classification of these loans may significantly alter some of our reported credit quality metrics. We therefore supplement certain reported credit quality metrics with metrics adjusted to exclude the impact of these acquired loans.
Of the $27.8 billion in outstanding receivables that we acquired in the 2012 U.S. card acquisition that were designated as held for investment, $26.2 billion had existing revolving privileges at acquisition and were therefore excluded from the acquired loan accounting guidance described above. These loans were recorded at fair value of $26.9 billion at acquisition, which resulted in a net premium of $705 million that is being amortized against interest income over the remaining life of the loans. In the second quarter of 2012, we recorded a provision for credit losses of $1.2 billion, which is included in our total provision for credit losses of $4.4 billion for 2012, to establish an initial allowance related to these loans. For additional information, see “Credit Risk Profile” and “Note 5—Loans—Acquired Loans.”
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Five-Year Summary of Selected Financial Data
| Change | ||||||||||||||||||||||||||||
| Year Ended December 31, | 2012 vs. 2011 |
2011 vs. 2010 |
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| (Dollars in millions, except per share data) |
2012 | 2011 | 2010(1) | 2009(2) | 2008 | |||||||||||||||||||||||
| Income statement |
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| Interest income |
$ | 18,964 | $ | 14,987 | $ | 15,353 | $ | 10,664 | $ | 11,112 | 27 | % | (2 | )% | ||||||||||||||
| Interest expense |
2,375 | 2,246 | 2,896 | 2,967 | 3,963 | 6 | (22 | ) | ||||||||||||||||||||
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| Net interest income(3) |
16,589 | 12,741 | 12,457 | 7,697 | 7,149 | 30 | 2 | |||||||||||||||||||||
| Non-interest income(4) |
4,807 | 3,538 | 3,714 | 5,286 | 6,744 | 36 | (5 | ) | ||||||||||||||||||||
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| Total net revenue(5) |
21,396 | 16,279 | 16,171 | 12,983 | 13,893 | 31 | 1 | |||||||||||||||||||||
| Provision for credit losses(6) |
4,415 | 2,360 | 3,907 | 4,230 | 5,101 | 87 | (40 | ) | ||||||||||||||||||||
| Non-interest expense(7)(8) |
11,946 | 9,332 | 7,934 | 7,417 | 8,210 | 28 | 18 | |||||||||||||||||||||
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| Income from continuing operations before income taxes |
5,035 | 4,587 | 4,330 | 1,336 | 582 | 10 | 6 | |||||||||||||||||||||
| Income tax provision |
1,301 | 1,334 | 1,280 | 349 | 497 | (2 | ) | 4 | ||||||||||||||||||||
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| Income from continuing operations, net of tax |
3,734 | 3,253 | 3,050 | 987 | 85 | 15 | 7 | |||||||||||||||||||||
| Loss from discontinued operations, net of tax(9) |
(217 | ) | (106 | ) | (307 | ) | (103 | ) | (131 | ) | 105 | (65 | ) | |||||||||||||||
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| Net income (loss) |
3,517 | 3,147 | 2,743 | 884 | (46 | ) | 12 | 15 | ||||||||||||||||||||
| Dividends and undistributed earnings allocated to participating securities |
(15 | ) | (26 | ) | — | — | — | 11 | ** | |||||||||||||||||||
| Preferred stock dividends(10) |
(15 | ) | — | — | (564 | ) | (33 | ) | ** | — | ||||||||||||||||||
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| Net income (loss) available to common stockholders |
$ | 3,487 | $ | 3,121 | $ | 2,743 | $ | 320 | $ | (79 | ) | 12 | % | 14 | % | |||||||||||||
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| Common share statistics |
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| Basic earnings per common share: |
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| Income from continuing operations, net of tax |
$ | 6.60 | $ | 7.08 | $ | 6.74 | $ | 0.99 | $ | 0.14 | (7 | )% | 5 | % | ||||||||||||||
| Loss from discontinued operations, net of tax(9) |
(0.39 | ) | (0.23 | ) | (0.67 | ) | (0.24 | ) | (0.35 | ) | 70 | (66 | ) | |||||||||||||||
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| Net income (loss) per common share |
$ | 6.21 | $ | 6.85 | $ | 6.07 | $ | (0.75 | ) | $ | (0.21 | ) | (9 | )% | 13 | % | ||||||||||||
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| Diluted earnings per common share: |
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| Income from continuing operations, net of tax |
$ | 6.54 | $ | 7.03 | $ | 6.68 | $ | 0.98 | $ | 0.14 | (7 | )% | 5 | % | ||||||||||||||
| Loss from discontinued operations, net of tax(9) |
(0.38 | ) | (0.23 | ) | (0.67 | ) | (0.24 | ) | (0.35 | ) | 65 | (66 | ) | |||||||||||||||
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| Net income (loss) per common share |
$ | 6.16 | $ | 6.80 | $ | 6.01 | $ | 0.74 | $ | (0.21 | ) | (9 | )% | 13 | % | |||||||||||||
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| Dividends per common share |
$ | 0.20 | $ | 0.20 | $ | 0.20 | $ | 0.53 | $ | 1.50 | — | % | — | % | ||||||||||||||
| Common dividend payout ratio |
3.22 | % | 2.92 | % | 3.32 | % | 66.80 | % | 722.06 | % | 30 | bps | (40 | )bps | ||||||||||||||
| Stock price per common share at period end |
$ | 57.93 | $ | 42.29 | $ | 42.56 | $ | 38.34 | $ | 31.89 | 37 | % | (1 | )% | ||||||||||||||
| Book value per common share at period end |
69.56 | 64.51 | 58.62 | 59.04 | 68.38 | 8 | 10 | |||||||||||||||||||||
| Total market capitalization at period end |
33,727 | 19,301 | 19,271 | 17,268 | 12,412 | 75 | ** | |||||||||||||||||||||
| Average balances |
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| Loans held for investment(11) |
$ | 187,915 | $ | 128,424 | $ | 128,526 | $ | 99,787 | $ | 98,971 | 46 | % | ** | % | ||||||||||||||
| Interest-earning assets |
255,079 | 175,265 | 175,683 | 145,552 | 133,282 | 46 | ** | |||||||||||||||||||||
| Total assets |
286,602 | 199,718 | 200,114 | 171,598 | 156,292 | 44 | ** | |||||||||||||||||||||
| Interest-bearing deposits |
183,314 | 109,644 | 104,743 | 103,078 | 82,736 | 67 | 5 | |||||||||||||||||||||
| Total deposits |
203,055 | 126,694 | 119,010 | 115,601 | 93,508 | 60 | 6 | |||||||||||||||||||||
| Borrowings |
38,025 | 38,022 | 49,620 | 23,522 | 31,096 | ** | (23 | ) | ||||||||||||||||||||
| Stockholders’ equity |
37,327 | 28,579 | 24,941 | 26,606 | 25,278 | 31 | 15 | |||||||||||||||||||||
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| Change | ||||||||||||||||||||||||||||
| Year Ended December 31, | 2012 vs. 2011 |
2011 vs. 2010 |
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|
2012 | 2011 | 2010(1) | 2009(2) | 2008 | |||||||||||||||||||||||
| Selected performance metrics |
||||||||||||||||||||||||||||
| Purchase volume(12) |
$ | 180,599 | $ | 135,120 | $ | 106,912 | $ | 102,068 | $ | 113,835 | 34 | % | 26 | % | ||||||||||||||
| Total net revenue margin(13) |
8.39 | % | 9.28 | % | 9.20 | % | 8.94 | % | 10.44 | % | (89 | )bps | 8 | bps | ||||||||||||||
| Net interest margin(14) |
6.50 | 7.27 | 7.09 | 5.30 | 5.38 | (77 | ) | 18 | ||||||||||||||||||||
| Net charge-offs |
$ | 3,555 | $ | 3,771 | $ | 6,651 | $ | 4,568 | $ | 3,478 | (6 | )% | (43 | )% | ||||||||||||||
| Net charge-off rate(15) |
1.89 | % | 2.94 | % | 5.18 | % | 4.58 | % | 3.51 | % | (105 | )bps | (224 | )bps | ||||||||||||||
| Net charge-off rate (excluding acquired |
2.34 | 3.06 | 5.45 | 4.94 | 3.51 | (72 | ) | (239 | ) | |||||||||||||||||||
| Return on average assets(17) |
1.30 | 1.63 | 1.52 | 0.58 | 0.05 | (33 | ) | 11 | ||||||||||||||||||||
| Return on average stockholders’ equity(18) |
10.00 | 11.38 | 12.23 | 3.71 | 0.34 | (138 | ) | (85 | ) | |||||||||||||||||||
| Equity-to-assets ratio(19) |
13.02 | 14.31 | 12.46 | 15.50 | 16.17 | (129 | ) | 185 | ||||||||||||||||||||
| Non-interest expense as a % of average loans held for investment(20) |
6.36 | 7.27 | 6.17 | 7.43 | 8.30 | (91 | ) | 110 | ||||||||||||||||||||
| Efficiency ratio(21) |
55.83 | 57.33 | 49.06 | 56.21 | 52.29 | (150 | ) | 827 | ||||||||||||||||||||
| Effective income tax rate |
25.84 | 29.08 | 29.56 | 26.16 | 85.47 | (324 | ) | (48 | ) | |||||||||||||||||||
| Change | ||||||||||||||||||||||||||||
| December 31, | 2012 vs. 2011 |
2011 vs. 2010 |
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2012 | 2011 | 2010(1) | 2009(2) | 2008 | |||||||||||||||||||||||
| Balance sheet (period end) |
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| Loans held for |
$ | 205,889 | $ | 135,892 | $ | 125,947 | $ | 90,619 | $ | 101,018 | 52 | % | 8 | % | ||||||||||||||
| Interest-earning assets |
280,096 | 179,878 | 172,071 | 139,751 | 141,471 | 56 | 5 | |||||||||||||||||||||
| Total assets |
312,918 | 206,019 | 197,503 | 169,646 | 165,913 | 52 | 4 | |||||||||||||||||||||
| Interest-bearing deposits |
190,018 | 109,945 | 107,162 | 102,370 | 97,327 | 73 | 3 | |||||||||||||||||||||
| Total deposits |
212,485 | 128,226 | 122,210 | 115,809 | 108,621 | 66 | 5 | |||||||||||||||||||||
| Borrowings |
49,910 | 39,561 | 41,796 | 21,014 | 23,178 | 26 | (5 | ) | ||||||||||||||||||||
| Stockholders’ equity |
40,499 | 29,666 | 26,541 | 26,590 | 26,612 | 37 | 12 | |||||||||||||||||||||
| Credit quality metrics (period end) |
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| Allowance for loan and lease losses |
$ | 5,156 | $ | 4,250 | $ | 5,628 | $ | 4,127 | $ | 4,524 | 21 | % | (24 | )% | ||||||||||||||
| Allowance as a % of loans held for investment |
2.50 | % | 3.13 | % | 4.47 | % | 4.55 | % | 4.48 | % | (63 | )bps | (134 | )bps | ||||||||||||||
| Allowance as a % of loans held for investment (excluding acquired loans) (16) |
3.02 | 3.22 | 4.67 | 4.95 | 4.48 | (20 | ) | (145 | ) | |||||||||||||||||||
| 30+ day performing delinquency rate |
2.70 | 3.35 | 3.52 | 3.98 | 4.21 | (65 | ) | (17 | ) | |||||||||||||||||||
| 30+ day performing delinquency rate (excluding acquired loans) (16) |
3.29 | 3.47 | 3.68 | 4.32 | 4.21 | (18 | ) | (21 | ) | |||||||||||||||||||
| 30+ day delinquency rate |
3.09 | 3.95 | 4.23 | N/A | N/A | (86 | ) | (28 | ) | |||||||||||||||||||
| 30+ day delinquency rate (excluding acquired loans) (16) |
3.77 | 4.09 | 4.43 | N/A | N/A | (32 | ) | (34 | ) | |||||||||||||||||||
| Capital ratios |
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| Tier 1 common ratio(22) |
11.0 | % | 9.7 | % | 8.8 | % | 10.6 | % | 12.5 | % | 130 | bps | 90 | bps | ||||||||||||||
| Tier 1 risk-based capital ratio(23) |
11.3 | 12.0 | 11.6 | 13.8 | 13.8 | (60 | ) | 40 | ||||||||||||||||||||
| Total risk-based capital ratio(24) |
13.6 | 14.9 | 16.8 | 17.7 | 16.7 | (130 | ) | (190 | ) | |||||||||||||||||||
| Tangible common equity ratio (“TCE” ratio”)(25) |
7.9 | 8.2 | 6.9 | 8.0 | 9.2 | (30 | ) | 130 | ||||||||||||||||||||
| Associates |
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| Full-time equivalent employees (in thousands) |
39.6 | 30.5 | 25.7 | 25.9 | 23.7 | 30 | % | 19 | % | |||||||||||||||||||
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| Change | ||||||||||||||||||||||||||||
| December 31, | 2010 vs. 2011 |
2011 vs. 2010 |
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|
|
2012 | 2011 | 2010(1) | 2009(2) | 2008 | |||||||||||||||||||||||
| Managed metrics(26) |
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| Average loans held for investment |
$ | 187,915 | $ | 128,424 | $ | 128,622 | $ | 143,514 | $ | 147,812 | 46 | % | * | *% | ||||||||||||||
| Average interest-earning assets |
255,079 | 175,341 | 175,815 | 185,976 | 179,348 | 46 | * | * | ||||||||||||||||||||
| Period-end loans: |
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| Period-end on-balance sheet loans held for investment |
$ | 205,889 | $ | 135,892 | $ | 125,947 | $ | 90,619 | $ | 101,018 | 52 | 8 | ||||||||||||||||
| Period-end off-balance sheet securitized loans |
— | — | — | 46,184 | 45,919 | — | — | |||||||||||||||||||||
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| Total period-end managed loans |
$ | 205,889 | $ | 135,892 | $ | 125,947 | $ | 136,803 | $ | 146,937 | 52 | 8 | ||||||||||||||||
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| Period-end total loan accounts (in millions) |
122.1 | 70.0 | 37.4 | 37.8 | 45.4 | 74 | 87 | |||||||||||||||||||||
| 30+ day performing delinquency rate |
2.70 | % | 3.35 | % | 3.52 | % | 4.62 | % | 4.38 | % | (65 | )bps | (17 | )bps | ||||||||||||||
| Net charge-off rate |
1.89 | 2.94 | 5.18 | 5.87 | 4.35 | (105 | ) | (224 | ) | |||||||||||||||||||
| Non-interest expense as a % of average loans held for investment(20) |
6.36 | 7.27 | 6.17 | 5.17 | 5.01 | (91 | ) | 110 | ||||||||||||||||||||
| Efficiency ratio |
55.83 | 57.33 | 49.06 | 43.35 | 43.14 | (150 | ) | 827 | ||||||||||||||||||||
N/A—Information is not readily available.
| ** | Change is less than one percent or not meaningful. |
| (1) | Effective January 1, 2010, we prospectively adopted two accounting standards related to the transfer and servicing of financial assets and consolidations that changed how we account for securitized loans. The adoption of these accounting standards, which we refer o in this Report as “consolidation accounting standards,” resulted in the consolidation of our credit card securitization trusts and certain other trusts, which added $41.9 billion of assets, consisting primarily of credit card loan receivables underlying the consolidated securitization trusts, along with $44.3 billion of related debt issued by these trusts to third-party investors to our reported consolidated balance sheet and reduced our stockholders’ equity by $2.9 billion and reduced our Tier 1 risk-based capital ratio to 9.9% from 13.8%. The reduction to stockholders’ equity was driven by the establishment of an allowance for loan and lease losses of $4.3 billion (pre-tax) primarily related to receivables held in credit card securitization trusts that were consolidated at the adoption date. Prior period reported amounts have not been restated as the accounting standards were adopted prospectively. Prior to January 1, 2010, in addition to our reported U.S. GAAP results, we presented and analyzed our results on a non-GAAP “managed basis.” Our managed-basis presentation included certain reclassification adjustments that assumed securitized loans accounted for as sales remained on balance sheet, and the earnings from the off-balance sheet securitized loans were reported in our results of operations in the same manner as earnings on retained loans recorded on our consolidated balance sheet. While our managed presentation resulted in differences in the classification of revenues in our income statement, net income on a managed basis was the same as our reported net income. We believe this managed-basis information was useful to investors because it enabled them to understand both the credit risks associated with loans reported on our consolidated balance sheets and our retained interests in securitized loans. As a result of the adoption of the consolidation accounting standards, our reported and managed based presentations are generally comparable for periods beginning after January 1, 2010. See “MD&A—Supplemental Tables” and “Exhibit 99.1” for additional information on our non-GAAP managed presentation and other non-GAAP measures. |
| (2) | Effective February 27, 2009, we acquired Chevy Chase Bank. Our financial results subsequent to February 27, 2009 include the operations of Chevy Chase Bank. While our 2012, 2011 and 2010 results include the full year impact of the Chevy Chase Bank acquisition, our 2009 results include only a partial year impact. |
| (3) | Premium amortization related to the ING Direct and 2012 U.S. card acquisitions reduced net interest income by $391 million in 2012. |
| (4) | Includes a bargain purchase gain of $594 million attributable to the ING Direct acquisition recognized in non-interest income in 2012. The bargain purchase gain represents the excess of the fair value of the net assets acquired from ING Direct as of the acquisition date over the consideration transferred. See “Note 2—Acquisitions” for additional information. |
| (5) | Total net revenue was reduced by $937 million, $371 million, $950 million, $2.1 billion and $1.9 billion in 2012, 2011, 2010, 2009 and 2008, respectively, for the estimated uncollectible amount of billed finance charges and fees. |
| (6) | Provision for credit losses for 2012 includes expense of $1.2 billion to establish an initial allowance for the receivables acquired in the 2012 U.S. card acquisition accounted for based on contractual cash flows. |
| (7) | Includes merger-related expenses, including transaction costs, attributable to acquisitions of $336 million and $45 million in 2012 and 2011, respectively. Also includes intangible amortization expense related to purchased credit card relationships (“PCCR”) from the 2012 U.S. card acquisition of $334 million in 2012, and other asset and intangible amortization expense related to the ING Direct and 2012 U.S. card acquisitions of $147 million in 2012. |
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| (8) | Non-interest expense for 2008 includes goodwill impairment of $811 million related to the Auto Finance division of our Consumer Banking business. |
| (9) | Discontinued operations reflect ongoing costs related to the mortgage origination operations of GreenPoint’s wholesale mortgage banking unit, GreenPoint Mortgage Funding, Inc. (“Greenpoint”), which we closed in 2007. |
| (10) | Preferred stock dividends in 2009 and 2008 were attributable to our participation in the U.S. Department of Treasury’s Troubled Asset Relief Program (“TARP”). |
| (11) | Loans held for investment includes loans acquired in the Chevy Chase Bank, ING Direct and 2012 U.S. card acquisitions. The average carrying value of acquired loans accounted for subsequent to acquisition based on expected cash flows to be collected was $37.1 billion, $4.7 billion, $5.6 billion, $7.3 billion and none as of December 31, 2012, 2011, 2010, 2009 and 2008, respectively. The average balance of loans held for investment, excluding the carrying value of acquired loans, was $151.7 billion, $123.4 billion, $122.2 billion, $92.5 billion and $99.0 billion in 2012, 2011, 2010, 2009 and 2008, respectively. See “Note 5—Loans” for additional information. |
| (12) | Consists of credit card purchase transactions for the period, net of returns. Excludes cash advance transactions. |
| (13) | Calculated based on total net revenue for the period divided by average interest-earning assets for the period. |
| (14) | Calculated based on net interest income for the period divided by average interest-earning assets for the period. |
| (15) | Calculated based on net charge-offs for the period divided by average loans held for investment for the period. |
| (16) | Calculation of ratio adjusted to exclude from the denominator acquired loans accounted for subsequent to acquisition based on expected cash flows to be collected. See “Business Segment Financial Performance,” “Credit Risk Profile” and “Note 5—Loans—Credit Quality” for additional information on the impact of acquired loans on our credit quality metrics. |
| (17) | Calculated based on income from continuing operations, net of tax, for the period divided by average total assets for the period. |
| (18) | Calculated based on income from continuing operations, net of tax, for the period divided by average stockholders’ equity for the period. |
| (19) | Calculated based on average stockholders’ equity for the period divided by average total assets for the period. |
| (20) | Calculated based on non-interest expense, excluding goodwill impairment charges, for the period divided by average loans held for investment for the period. |
| (21) | Calculated based on non-interest expense, excluding goodwill impairment charges, for the period divided by total net revenue for the period. |
| (22) | Tier 1 common ratio is a regulatory capital measure calculated based on Tier 1 common equity divided by risk-weighted assets. See “MD&A—Capital Management” and “MD&A—Supplemental Tables—Table F: Reconciliation of Non-GAAP Measures and Calculation of Regulatory Capital Measures Under Basel I” for additional information, including the calculation of this ratio. |
| (23) | Tier 1 risk-based capital ratio is a regulatory measure calculated based on Tier 1 capital divided by risk-weighted assets. See “MD&A—Capital Management” and “MD&A—Supplemental Tables—Table F: Reconciliation of Non-GAAP Measures and Calculation of Regulatory Capital Measures Under Basel I” for additional information, including the calculation of this ratio. |
| (24) | Total risk-based capital ratio is a regulatory measure calculated based on total risk-based capital divided by risk-weighted assets. See “MD&A—Capital Management” and “MD&A—Supplemental Tables—Table F: Reconciliation of Non-GAAP Measures and Calculation of Regulatory Capital Measures Under Basel I” for additional information, including the calculation of this ratio. |
| (25) | TCE ratio is a non-GAAP measure calculated based on tangible common equity divided by tangible assets. See “MD&A—Supplemental Tables—Table F: Reconciliation of Non-GAAP Measures and Calculation of Regulatory Capital Measures Under Basel I” for the calculation of this measure and reconciliation to the comparative GAAP measure. |
| (26) | See “MD&A—Supplemental Tables” and Exhibit 99.1 for a reconciliation of non-GAAP managed measures to comparable U.S. GAAP measures. |
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This discussion contains forward-looking statements that are based upon management’s current expectations and are subject to significant uncertainties and changes in circumstances. Please review “Forward-Looking Statements” for more information on the forward-looking statements in this Report. Our actual results may differ materially from those included in these forward-looking statements due to a variety of factors including, but not limited to, those described in this Report in “Item 1A. Risk Factors.” Unless otherwise specified, references to Notes to our consolidated financial statements are to the Notes to our audited consolidated financial statements as of December 31, 2012 included in this 2012 Annual Report on Form 10-K (“2012 Form 10-K).
Management monitors a variety of key indicators to evaluate our business results and financial condition. The following MD&A is intended to provide the reader with an understanding of our results of operations, financial condition and liquidity by focusing on changes from year to year in certain key measures used by management to evaluate performance, such as profitability, growth and credit quality metrics. MD&A is provided as a supplement to, and should be read in conjunction with, our audited consolidated financial statements as of December 31, 2012 and accompanying notes. MD&A is organized in the following sections:
| • Overview
• Executive Summary and Business Outlook
• Critical Accounting Policies and Estimates
• Accounting Changes and Developments
• Consolidated Results of Operations
• Business Segment Financial Performance
• Consolidated Balance Sheet Analysis |
• Off-Balance Sheet Arrangements and Variable Interest Entities | |
| • Capital Management | ||
| • Risk Management | ||
| • Credit Risk Profile | ||
| • Liquidity Risk Profile | ||
| • Market Risk Profile | ||
| • Supplemental Tables |
We are a diversified financial services holding company with banking and non-banking subsidiaries that offer a broad array of financial products and services to consumers, small businesses and commercial clients through branches, the internet and other distribution channels. Our principal subsidiaries included Capital One Bank (USA), National Association (“COBNA”) and Capital One, National Association (“CONA”) as of December 31, 2012. On November 1, 2012, we merged ING Bank, fsb into CONA, with CONA surviving the merger. The Company and its subsidiaries are hereafter collectively referred to as “we,” “us” or “our.” CONA and COBNA are hereafter collectively referred to as the “Banks.”
Period-end loans held for investment increased to $205.9 billion and deposits increased to $212.5 billion as of December 31, 2012, from period-end loans of $135.9 billion and deposits of $128.2 billion as of December 31, 2011. The closing of the ING Direct acquisition on February 17, 2012 resulted in the addition of loans of $40.4 billion and other assets of $53.9 billion at acquisition. The ING Direct acquisition, which added over seven million customers and approximately $84.4 billion in deposits to our Consumer Banking business segment as of the acquisition date, strengthens our customer franchise. With the ING Direct acquisition, we have grown to become the sixth largest depository institution and the largest direct banking institution in the United States. The closing of the 2012 U.S. card acquisition on May 1, 2012 added approximately 27 million new active accounts and approximately $27.8 billion in outstanding credit card receivables as of the acquisition date that we designated as held for investment.
Our consolidated total net revenues are derived primarily from lending to consumer and commercial customers and by deposit-taking activities net of the costs associated with funding our assets, which generate net interest income, and by activities that generate non-interest income, such as fee-based services provided to customers and
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merchant interchange fees with respect to certain credit card transactions. Our expenses primarily consist of the provision for credit losses, operating expenses (including associate salaries and benefits, occupancy and equipment costs, professional services, infrastructure enhancements and branch operations and expansion costs), marketing expenses and income taxes.
Our principal operations are currently organized for management reporting purposes into three primary business segments, which are defined primarily based on the products and services provided or the type of customer served: Credit Card, Consumer Banking and Commercial Banking. The operations of acquired businesses have been integrated into our existing business segments. The acquired ING Direct business is primarily reflected in our Consumer Banking business, while the business acquired in the 2012 U.S. card acquisition is reflected in our Credit Card business. Certain activities that are not part of a segment are included in our “Other” category.
| • | Credit Card: Consists of our domestic consumer and small business card lending, national small business lending, national closed end installment lending and the international card lending businesses in Canada and the United Kingdom. |
| • | Consumer Banking: Consists of our branch-based lending and deposit gathering activities for consumers and small businesses, national deposit gathering, national auto lending and consumer home loan lending and servicing activities. |
| • | Commercial Banking: Consists of our lending, deposit gathering and treasury management services to commercial real estate and commercial and industrial customers. Our commercial and industrial customers typically include companies with annual revenues between $10 million to $1.0 billion. |
In the first quarter of 2012, we re-aligned the loan categories reported by our Commercial Banking business and the loan customer and product types included within each category. Prior period amounts have been recast to conform to the current period presentation. Table 1 summarizes our business segment results, which we report based on income from continuing operations, net of tax, for 2012, 2011 and 2010. We provide additional information on the realignment of our Commercial Banking business segment below under “Business Segment Results” and in “Note 20—Business Segments” of this Report. We also provide additional information on the allocation methodologies used to derive our business segment results and a reconciliation of our total business segment results to our consolidated U.S. GAAP results in “Note 20—Business Segments.”
Table 1: Business Segment Results
| Year Ended December 31, | ||||||||||||||||||||||||||||||||||||||||||||||||
| 2012 | 2011 | 2010 | ||||||||||||||||||||||||||||||||||||||||||||||
| Total
Net Revenue(1) |
Net
Income (Loss)(2) |
Total
Net Revenue(1) |
Net
Income (Loss)(2) |
Total
Net Revenue(1) |
Net
Income (Loss)(2) |
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| (Dollars in millions) |
Amount | % of Total |
Amount | % of Total |
Amount | % of Total |
Amount | % of Total |
Amount | % of Total |
Amount | % of Total |
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| Credit Card |
$ | 13,260 | 62 | % | $ | 1,530 | 41 | % | $ | 10,431 | 64 | % | $ | 2,277 | 70 | % | $ | 10,614 | 66 | % | $ | 2,274 | 75 | % | ||||||||||||||||||||||||
| Consumer Banking |
6,570 | 30 | 1,363 | 37 | 4,956 | 30 | 809 | 25 | 4,597 | 28 | 905 | 30 | ||||||||||||||||||||||||||||||||||||
| Commercial Banking |
2,080 | 10 | 835 | 22 | 1,879 | 12 | 595 | 18 | 1,635 | 10 | 204 | 6 | ||||||||||||||||||||||||||||||||||||
| Other(3) |
(514 | ) | (2 | ) | 6 | — | (987 | ) | (6 | ) | (428 | ) | (13 | ) | (669 | ) | (4 | ) | (333 | ) | (11 | ) | ||||||||||||||||||||||||||
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| Total from continuing operations |
$ | 21,396 | 100 | % | $ | 3,734 | 100 | % | $ | 16,279 | 100 | % | $ | 3,253 | 100 | % | $ | 16,177 | 100 | % | $ | 3,050 | 100 | % | ||||||||||||||||||||||||
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| (1) | Total net revenue consists of net interest income and non-interest income. |
| (2) | Net income (loss) for our business segments is reported based on income from continuing operations, net of tax. |
| (3) | Includes the residual impact of the allocation of our centralized Corporate Treasury group activities, such as management of our corporate investment portfolio and asset/liability management, to our business segments as well as other items as described in “Note 20—Business Segments.” |
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EXECUTIVE SUMMARY AND BUSINESS OUTLOOK
In 2012, we completed two major acquisitions—ING Direct and the 2012 U.S. card acquisition. Certain purchase accounting adjustments and other charges related to these acquisitions had a significant impact on our earnings in 2012 and resulted in volatility among quarterly results. The impact of the acquisition-related adjustments, however, had diminished considerably by the end of the year. Our 2012 results reflected strong contributions from the acquired businesses, as well as solid performance in our legacy businesses, despite the industry-wide challenges of an uncertain and fragile economy, prolonged low interest rates and elevated regulatory expectations facing all banks. Purchase volumes, revenues and credit performance remained strong in 2012, and our earnings, together with capital raised from equity issuances during the year, further bolstered our liquidity and regulatory capital position.
We continue to devote significant effort to integrating the operations of these acquired businesses and investing in franchise enhancements. The combination of the ING Direct and 2012 U.S. card acquisitions has shifted the mix of our interest-earning assets and driven substantial growth in our total net revenues, putting us in what we believe is a strong position to generate capital and deliver sustained shareholder value, even in the current environment of low industry growth and prolonged low interest rates.
Financial Highlights
We reported net income of $3.5 billion ($6.16 per diluted share) on total net revenue of $21.4 billion in 2012, with each of our three business segments contributing to our earnings. In comparison, we reported net income of $3.1 billion ($6.80 per diluted share) on total net revenue of $16.3 billion in 2011 and net income of $2.7 billion ($6.01 per diluted share) on total net revenue of $16.2 billion in 2010.
Our Tier 1 common ratio, as calculated under Basel I, increased to 11.0% as of December 31, 2012, up from 9.7% as of December 31, 2011. The increase in our Tier 1 common ratio reflected strong internal capital generation from earnings, as well as capital raised from equity issuances during the year. Based on our current interpretation of the proposed rules for implementing Basel III, we believe we are well positioned to meet our fully phased-in assumed Tier 1 common ratio target under Basel III of approximately 8.0% in early 2013. Our Tier 1 risk-based capital ratio, as calculated under Basel I, was 11.3% as of December 31, 2012, down from 12.0% as of December 31, 2011. The decrease was primarily driven by the significant increase in risk-weighted assets resulting from the ING Direct and 2012 U.S. card acquisitions, which more than offset the benefit of an increase in Tier 1 capital. See “Capital Management” below for additional information.
Below are additional highlights of our performance in 2012. These highlights generally are based on a comparison between our 2012 and 2011 results, except as otherwise noted. The changes in our financial condition and credit performance are generally based on our financial condition and credit performance as of December 31, 2012, compared with our financial condition and credit performance as of December 31, 2011. We provide a more detailed discussion of our financial performance in the sections following this “Executive Summary and Business Outlook.”
Total Company
| • | Earnings: Our net income of $3.5 billion in 2012 increased by $370 million, or 12%, from 2011. The increase in net income reflected the favorable impact of higher total net revenue from our legacy businesses, increased revenues from acquired businesses and a bargain purchase gain of $594 million recorded at closing of the ING Direct acquisition. The increase in net revenue was largely offset by post-acquisition charges related to the 2012 U.S. card acquisition, including a provision for credit losses of $1.2 billion to establish an initial allowance for the approximately $26.2 billion in outstanding credit card receivables from the 2012 U.S. card acquisition designated as held for investment that had existing revolving privileges at acquisition and an initial charge of $174 million to establish a reserve for estimated uncollectible billed |
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| finance charges and fees for these loans. In addition, non-interest expense grew substantially due to higher operating expenses and merger-related expenses related to our recent acquisitions, as well as higher infrastructure expenses resulting from continued investments in our home and auto loan businesses. |
| • | Total Loans: Period-end loans held for investment increased by $70.0 billion, or 52%, in 2012 to $205.9 billion as of December 31, 2012, from $135.9 billion as of December 31, 2011. The increase was primarily attributable to the addition of the acquired ING Direct loan portfolio of $40.4 billion and the receivables acquired in the 2012 U.S. card acquisition designated as held for investment of $27.8 billion. Excluding the impact of the addition of these loans, period-end loans held for investment increased by $1.8 billion, or 1%. The increase reflected strong commercial loan growth and continued growth in auto loans, which was partially offset by the continued expected run-off of installment loans in our Credit Card business and home loans in our Consumer Banking business. |
| • | Charge-off and Delinquency Statistics: Our net charge-off rate decreased to 1.89% in 2012, from 2.94% in 2011. The 30+ day delinquency rate also declined during the year to 3.09% as of December 31, 2012, from 3.95% as of December 31, 2011. As discussed above, the accounting and classification of acquired loans accounted for based on estimated cash flows expected to be collected may significantly alter some of our reported credit quality metrics. The “credit mark” established in conjunction with acquired loans from the ING Direct and 2012 U.S. card acquisitions absorbed a significant portion of the uncollectible amounts that we would have recorded as charge-offs on these portfolios in the second and third quarters of 2012, resulting in unusually low net-charge off rates in each of these quarters. By the fourth quarter of 2012, the credit mark impact related to the 2012 U.S. card acquisition had diminished, with no meaningful impact on net charge-offs in the quarter. We provide information on our credit quality metrics, excluding the impact of acquired loans accounted for based on estimated cash flows expected to be collected, below under “Business Segments” and “Credit Risk Profile.” |
| • | Allowance for Loan and Lease Losses: We increased our allowance by $906 million in 2012 to $5.2 billion as of December 31, 2012. In comparison, we reduced our allowance by $1.4 billion in 2011. The increase in the allowance in 2012 was primarily attributable to the initial allowance build of $1.2 billion in the second quarter of 2012 that we established for the approximately $26.2 billion in outstanding credit card receivables from the 2012 U.S. card acquisition that had existing revolving privileges at acquisition, as well as growth in auto loan balances. Excluding the initial allowance build of $1.2 billion established for the receivables acquired in the 2012 U.S. card acquisition, we recorded an allowance release of $294 million in 2012 primarily attributable to a significant improvement in underlying credit performance trends in our Commercial Banking business. Although the allowance increased in 2012, the coverage ratio of the allowance to total loans held for investment fell to 2.50% as of December 31, 2012, from 3.13% as of December 31, 2011. The decrease in the allowance coverage ratio was largely due to the (i) addition of the receivables acquired in the ING Direct and 2012 U.S. card acquisitions accounted for based on estimated cash flows expected to be collected, for which we did not record an allowance in accordance with the required accounting guidance for these loans, and (ii) improved credit performance for our commercial loan portfolio. |
| • | Representation and Warranty Reserve: We recorded a provision for mortgage representation and warranty losses of $349 million in 2012, compared with a provision of $212 million in 2011. The increase in the provision in 2012 was primarily driven by updated estimates of anticipated outcomes from various litigation and threatened litigation in the insured securitization segment based on relevant factual and legal developments and settlements during the year with a government-sponsored enterprise (“GSE”) to resolve present and future claims. Our representation and warranty reserve decreased to $899 million as of December 31, 2012, from $943 million as of December 31, 2011, largely due to settlements during 2012. As of December 31, 2012, our best estimate of reasonably possible future losses from representation and warranty claims beyond what is in our reserve was approximately $2.7 billion, an increase from our previous estimates of $1.7 billion as of September 30, 2012, and $1.5 billion as of December 31, 2011. We provide additional information on the representation and warranty reserve in “Critical Accounting Policies |
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| and Estimates—Representation and Warranty Reserve” and “Note 21—Commitments, Contingencies and Guarantees.” |
Business Segments
| • | Credit Card: Our Credit Card business generated net income from continuing operations of $1.5 billion in 2012, compared with net income from continuing operations of $2.3 billion in 2011. The decrease in earnings in 2012 was largely due to significant post-acquisition charges related to the 2012 U.S. card acquisition, including a provision for credit losses of $1.2 billion to establish an initial allowance for outstanding credit card receivables from the 2012 U.S. card acquisition with existing revolving privileges at acquisition, PCCR intangible amortization expense of $334 million and higher operating expenses resulting from the 2012 U.S. card acquisition. The unfavorable impact of these charges diminished the favorable impact of the substantial increase in total net revenue resulting from the addition of credit card receivables from the 2012 U.S. card acquisition. Period-end loans in our Credit Card business increased by $26.7 billion, or 41%, in 2012, to $91.8 billion as of December 31, 2012. The increase was primarily due to the addition of the $27.8 billion in outstanding receivables classified as held for investment. Excluding the addition of the acquired receivables, period-end loans held for investment decreased by $1.1 billion, or 2%, due to the expected continued run-off of our installment loan portfolio. |
| • | Consumer Banking: Our Consumer Banking business generated net income from continuing operations of $1.4 billion in 2012, compared with net income from continuing operations of $809 million in 2011. The increase in earnings was attributable to growth in total net revenue, which was partially offset by higher non-interest expense and an increase in the provision for credit losses. Growth in revenue stemmed from higher average loan balances resulting from increased auto loan originations and added home loans from the ING Direct acquisition, coupled with the significant increase in deposits from the ING Direct acquisition. The increase in non-interest expense was largely due to operating expenses associated with ING Direct, higher infrastructure expenditures related to our home loan business and growth in auto originations and higher marketing expenditures in our retail banking operations. The increase in the provision for credit losses was largely due to higher auto loan balances resulting from growth in auto loan originations. Period-end loans in our Consumer Banking business increased by $38.8 billion, or 107%, in 2012 to $75.1 billion as of December 31, 2012, primarily due to the acquisition of $40.4 billion of ING Direct home loans and growth in auto loan originations. Excluding the addition of the acquired ING Direct loans, period-end loans held for investment decreased by $1.6 billion, or 4%, due to the expected continued run-off of our acquired home loan portfolios. |
| • | Commercial Banking: Our Commercial Banking business generated net income from continuing operations of $835 million in 2012, compared with net income from continuing operations of $595 million in 2011. The improvement in results for Commercial Banking was attributable to an increase in revenues driven by increased average loan balances as well as a decrease in the provision for credit losses due to improving credit trends. These factors were partially offset by higher non-interest expense resulting from operating costs associated with the increased volume of loan originations in our commercial real estate and commercial and industrial businesses, increased infrastructure expenditures and the expansion into new markets. Period-end loans increased by $4.5 billion, or 13%, in 2012 to $38.8 billion as of December 31, 2012. The increase was driven by stronger loan originations in the commercial and industrial and commercial real estate businesses, which was partially offset by the run-off and sale of a portion of the small-ticket commercial real estate loan portfolio. |
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Recent Developments
Redemption of Trust Preferred Securities
As of December 31, 2012, we had outstanding trust preferred securities with a combined aggregate principal amount of $3.65 billion that previously qualified as Tier 1 capital. On January 2, 2013, we redeemed all of our outstanding trust preferred securities, which generally carried a higher coupon cost, ranging from 3.36% to 10.25%, than other funding sources available to us. Pursuant to the Dodd-Frank Act, the Tier 1 capital treatment of trust preferred securities is to be phased out over a three year period starting on January 1, 2013.
Subordinated Note Exchange
On January 23, 2013, we announced the commencement of an “any and all” exchange offer for COBNA’s $1.5 billion of outstanding 8.80% subordinated notes due 2019. The transaction involved offering current holders market value plus an exchange premium for these outstanding notes, which was consideration paid through a combination of new 10-year subordinated bank notes and cash. The exchange offer expired on February 20, 2013. Pursuant to the exchange offer, COBNA exchanged approximately 80% of its outstanding 8.80% subordinated notes due 2019 for new 3.375% subordinated notes due 2023.
Credit Card Securitization
On February 1, 2013, we executed our first credit card securitization transaction since 2009 by issuing $750 million of 3-year, AAA-rated fixed-rate notes from our credit card securitization trust.
Sale of Best Buy Card Portfolio
On February 19, 2013, we announced an agreement to sell the portfolio of Best Buy Stores, L.P. (“Best Buy”) private label and co-branded credit card accounts that we acquired in the 2012 U.S. card acquisition to Citibank, N.A. (“Citi”). At the time of the announcement, the portfolio had loan balances of approximately $7 billion. In addition, we and Best Buy have agreed to end our contractual credit card relationship early. The sale of the loans to Citi, which is subject to customary closing conditions, and early termination of the Best Buy partnership are expected to be finalized in the third quarter of 2013. In the first quarter of 2013, the assets subject to the sale agreement were transferred to the held for sale category. Upon closing, we expect that the proceeds from the sale will approximate the book value of the accounts, resulting in no significant gain or loss on the transaction. For additional information, see “Note 24—Subsequent Events.”
Business Outlook
We discuss below our current expectations regarding our total company performance and the performance of each of our business segments over the near-term based on market conditions, the regulatory environment and our business strategies as of the time we filed this Annual Report on Form 10-K. The statements contained in this section are based on our current expectations regarding our outlook for our financial results and business strategies. Our expectations take into account, and should be read in conjunction with, our expectations regarding economic trends and analysis of our business as discussed in “Item 1. Business” and “Item 7. MD&A” of this Report. Certain statements are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those in our forward-looking statements. Forward-looking statements do not reflect: (i) any change in current dividend or repurchase strategies, (ii) the effect of any acquisitions, divestitures or similar transactions, except for the forward-looking statements specifically discussing the ING Direct and 2012 U.S. card acquisitions, or (iii) any changes in laws, regulations or regulatory interpretations, in each case after the date as of which such statements are made. See “Item 1. Business—Forward-Looking Statements” for more information on the forward-looking statements in this Report and “Item 1A. Risk Factors” in this Report for factors that could materially influence our results.
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Total Company Expectations
Our strategies and actions are designed to deliver and sustain strong returns and capital generation through the acquisition and retention of franchise-enhancing customer relationships across our businesses. We believe that franchise-enhancing customer relationships create and sustain significant long-term value through low credit costs, long and loyal customer relationships and a gradual build in loan balances and revenues over time. Examples of franchise-enhancing customer relationships include rewards customers and new partnerships in our Credit Card business, retail deposit customers in our Consumer Banking business and primary banking relationships with commercial customers in our Commercial Banking business. We intend to grow these customer relationships by continuing to invest in scalable infrastructure and operating platforms that are appropriate for a bank of our size and business mix so that we can meet the rising regulatory and compliance expectations facing all banks and deliver a “brand-defining” customer experience that builds and sustains a valuable, long-term customer franchise. The ING Direct and 2012 U.S. card acquisitions strengthened and expanded our customer base, and, over time, we expect to expand and deepen our customer relationships with new products and services.
We expect average interest-earning assets will decline in 2013. We expect average loan balances for full-year 2013 to decline from average loan balances in the fourth quarter of 2012, as significant run-off of mortgage and card loans we acquired, coupled with the sale of the Best Buy loan portfolio, is partially offset by growth in our businesses. We expect run-off and sales of approximately $18 billion in ending loan balances in 2013, primarily comprised of approximately $9 billion in run-off of mortgage loans acquired from ING Direct and Chevy Chase Bank, approximately $7 billion from the sale of the Best Buy loan portfolio and approximately $2 billion in run-off of other credit card loans purchased in the 2012 U.S. card acquisition. We expect this decline to be partially offset by growth in certain of our businesses, including parts of Domestic Card, Auto and Commercial Banking. However, we expect continued weak consumer demand across our Credit Card and Auto lending businesses, as well as intensifying competition in several businesses, particularly Auto and Commercial and Industrial lending.
We expect net interest margin to be modestly higher in 2013 versus 2012 levels, with steady yield on average earning assets and an expected reduction in interest expense.
We expect overall non-interest expense in 2013 to total approximately $12.5 billion, or just over $3.1 billion on average per quarter. We expect total annual non-interest expense, excluding marketing, to be approximately $11 billion dollars in 2013 and marketing expense for 2013 to be approximately $1.5 billion. We believe our actions have created a well-positioned balance sheet with strong capital and liquidity levels, and a strong capital generation trajectory. We expect to exceed an assumed Basel III Tier 1 common ratio internal target of 8 percent in early 2013. Our estimated Basel III capital trajectory includes the estimated impact of implementing the Basel II Advanced Approaches to calculate regulatory capital, which we expect will apply to us in 2016 or later. The assumed 8% Basel III Tier 1 common ratio target assumes a buffer of 50 basis points for a systemically important financial institution (“SIFI”) under applicable rules and regulations and a further buffer of 50 basis points to cover potential volatility in both the numerator and denominator of the Tier 1 common ratio. Our actual operating levels for capital will vary over time depending on our outlook on near-to-medium term growth, our view of where we are in the economic cycle and our resilience under ongoing stress-testing processes. The assumed Basel III Tier 1 common level is estimated based on our current interpretation, expectations and understanding of the Basel III capital rules and other capital regulations proposed by U.S. regulators and the application of such rules to our businesses as currently conducted. Basel III calculations are necessarily subject to change based on, among other things, the scope and terms of the final rules and regulations, model calibration and other implementation guidance, changes in our businesses and certain actions of management, including those affecting the composition of our balance sheet. We believe this ratio provides useful information to investors and others by measuring our progress against expected future regulatory capital standards.
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Business Segment Expectations
Credit Card Business
As noted above, in Domestic Card, the closing of the 2012 U.S. card acquisition has impacted and will continue to affect quarterly trends in loan growth, revenue margin and credit metrics. We anticipate that the run-off of parts of the portfolio acquired in the 2012 U.S. card acquisition as well as anticipated run-off of in our installment loan portfolio will more than offset the underlying growth trajectory in other parts of our Domestic Card business resulting in a modest decline in full-year average loan balances in 2013 from average loan balances in the fourth quarter of 2012. In addition, the sale of the Best Buy loan portfolio will result in an incremental reduction in loans held for investment of approximately $7 billion. We expect charge-off levels to remain relatively stable with normal seasonal patterns in 2013.
As we have disclosed in the past, we are taking actions that we believe will enhance our franchise, such as aligning customer practices related to the 2012 U.S. card acquisition with our own, and ending the sale of products like payment protection, which will have a modest negative impact on revenue margin. We also expect that the run-off of higher-margin, higher-loss receivables purchased in the 2012 U.S. card acquisition will change the mix of loans in our Domestic Card business, driving a further modest reduction of revenue margin in 2013. We expect the sale of the Best Buy portfolio, which resulted in our transferring these loans to held for sale from held for investment in the first quarter of 2013, and the related held-for-sale loan accounting will increase our revenue margins until the sale of the loans. Other factors which we are unable to accurately predict will also affect revenue margin. These factors, which include market and pricing dynamics, credit trends, and competitive intensity, could have positive or negative impacts on the Domestic Card revenue margin.
Consumer Banking Business
In our Consumer Banking business, we expect the ING Direct acquisition to continue to have a significant impact on Consumer Banking loan volumes as we anticipate that run-off in the acquired Home Loans portfolio will more than offset growth in auto loans.
Commercial Banking Business
Our Commercial Banking business continues to grow loans, deposits, and revenues as we attract new customers and deepen relationships with existing customers. Although we anticipate some quarterly fluctuations in nonperforming loan and charge-off rates, we expect our Commercial Banking business to continue strong and relatively steady performance trends throughout 2013.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in accordance with U.S. GAAP requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management judgment and estimates in applying these policies is integral to understanding our financial statements. We provide a summary of our significant accounting policies in “Note 1—Summary of Significant Accounting Policies.”
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We have identified the following accounting policies as critical because they require significant judgments and assumptions about highly complex and inherently uncertain matters and the use of reasonably different estimates and assumptions could have a material impact on our reported results of operations or financial condition. These critical accounting policies govern:
| • | Loan loss reserves |
| • | Asset impairment |
| • | Fair value |
| • | Representation and warranty reserve |
| • | Customer rewards reserve |
| • | Income taxes |
We evaluate our critical accounting estimates and judgments on an ongoing basis and update them, as necessary, based on changing conditions. Management has reviewed and approved these critical accounting policies and has discussed judgments and assumptions with the Audit and Risk Committee of the Board of Directors.
Loan Loss Reserves
We maintain an allowance for loan and lease losses that represents management’s estimate of incurred loan and lease losses inherent in our held-for-investment credit card, consumer banking and commercial banking loan portfolios as of each balance sheet date. We maintain a separate reserve for the uncollectible portion of billed finance charges and fees on credit card loans.
Allowance for Loan and Lease Losses
We have an established process, using analytical tools, benchmarks and management judgment, to determine our allowance for loan and lease losses. We calculate the allowance for loan and lease losses by estimating incurred losses for segments of our loan portfolio with similar risk characteristics and record a provision for credit losses. We build our allowance for loan and lease losses and unfunded lending commitment reserves through the provision for credit losses. Our provision for credit losses in each period is driven by charge-offs and the level of allowance for loan and lease losses that we determine is necessary to provide for probable loan and lease losses incurred that are inherent in our loan portfolio as of each balance sheet date. We recorded a provision for credit losses of $4.4 billion, $2.4 billion and $3.9 billion in 2012, 2011, and 2010, respectively. The allowance totaled $5.2 billion as of December 31, 2012, compared with $4.3 billion as of December 31, 2011.
We review and assess our allowance methodologies and adequacy of the allowance for loan and lease losses on a quarterly basis. Our assessment involves evaluating many factors including, but not limited to, historical loss and recovery experience, recent trends in delinquencies and charge-offs, risk ratings, the impact of bankruptcy filings, the value of collateral underlying secured loans, account seasoning, changes in our credit evaluation, underwriting and collection management policies, seasonality, general economic conditions, changes in the legal and regulatory environment and uncertainties in forecasting and modeling techniques used in estimating our allowance for loan and lease losses. Key factors that have a significant impact on our allowance for loan and lease losses include assumptions about unemployment rates, home prices, and the valuation of commercial properties, consumer real estate, and autos.
Although we examine a variety of externally available data, as well as our internal loan performance data, to determine our allowance for loan and lease losses, our estimation process is subject to risks and uncertainties, including a reliance on historical loss and trend information that may not be representative of current conditions and indicative of future performance. Accordingly, our actual credit loss experience may not be in line with our expectations. For example, excluding the initial allowance build of $1.2 billion established for certain loans related to the 2012 U.S. card acquisition, we recorded an allowance release of $294 million in 2012, attributable to a significant improvement in underlying credit performance trends in our Commercial Banking business. Similarly, as a result of improving credit performance trends during 2011, charge-offs began to decrease across all of our business segments, and we recorded a significant allowance release of $1.4 billion in 2011.
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We provide additional information on the methodologies and key assumptions used in determining our allowance for loan and lease losses for each of our loan portfolio segments in “Note 1—Summary of Significant Accounting Policies.” We provide information on the components of our allowance, disaggregated by impairment methodology, and changes in our allowance in “Note 6—Allowance for Loan and Lease Losses.”
Finance Charge and Fee Reserve
We recognize finance charges and fees on credit card loans as revenue when the amounts are billed to the customer and include these amounts in the loan balance, net of the estimated uncollectible amount of billed finance charges and fees. We continue to accrue finance charges and fees on credit card loans until the account is charged-off; however, when we do not expect full payment of billed finance charges and fees, we reduce the balance of our credit card loan receivables by the amount of finance charges and fees billed but not expected to be collected and exclude this amount from revenue. Total net revenue was reduced by $937 million, $371 million and $950 million in 2012, 2011, 2010, respectively, for the estimated uncollectible amount of billed finance charges and fees. The finance charge and fee reserve totaled $307 million as of December 31, 2012, compared with $74 million as of December 31, 2011.
We review and assess the adequacy of the uncollectible finance charge and fee reserve on a quarterly basis. Our methodology for estimating the uncollectible portion of billed finance charges and fees is primarily based on the use of a roll-rate methodology and consistent with the methodology we use to estimate the allowance for incurred principal losses on our credit card loan receivables. Accordingly, the estimation process is subject to similar risks and uncertainties, including a reliance on historical loss and trend information that may not be representative of current conditions and indicative of future performance. We refine our estimation process and key assumptions used in determining our loss reserves as additional information becomes available. Changes in key assumptions may have a material impact on the amount of billed finance charges and fees we estimate as uncollectible in each period. For example, in the third quarter of 2011, we revised the manner in which we estimate expected recoveries of finance charge and fee amounts previously considered to be uncollectible. Our revised recovery assumptions better reflected the post-recession pattern of relatively low delinquency roll-rates combined with increased recoveries of finance charges and fees previously considered uncollectible. This change in assumptions resulted in a reduction in our uncollectible finance charge and fee reserves of approximately $83 million and a corresponding increase in revenues. We also applied these revised assumptions to the estimated recovery of principal charge-offs in determining our allowance for loan and lease losses.
Asset Impairment
In addition to our loan portfolio, we review other assets for impairment on a regular basis in accordance with applicable impairment accounting guidance. This process requires significant management judgment and involves various estimates and assumptions. Our investment securities and goodwill and intangible assets represent a significant portion of our other assets. Accordingly, below we describe our process for assessing impairment of these assets and the key estimates and assumptions involved in this process.
Investment Securities
We regularly review investment securities for other-than-temporary impairment using both quantitative and qualitative criteria. If we intend to sell a security in an unrealized loss position or it is more likely than not that we will be required to sell the security prior to recovery of its amortized cost basis, the entire difference between the amortized cost basis of the security and its fair value is recognized in earnings. If we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of our amortized cost, we evaluate other qualitative criteria to determine whether a credit loss exists. Our evaluation requires significant management judgment and a consideration of many factors, including, but not limited to, the extent and duration of the impairment; the health of and specific prospects for the issuer, including whether the issuer has failed to make scheduled interest or principal payments; recent events specific to the issuer and/or
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industry to which the issuer belongs; the payment structure of the security; external credit ratings; the value of underlying collateral and current market conditions. Quantitative criteria include assessing whether there has been an adverse change in expected future cash flows. See “Note 4—Investment Securities” for additional information.
Goodwill and Other Intangible Assets
As a result of our acquisitions, including Hibernia Corporation in 2005, North Fork Bancorporation in 2006, Chevy Chase Bank in 2009, and the 2012 U.S. card acquisition we have goodwill and other intangible assets. Goodwill resulting from business combinations prior to January 1, 2009 represents the excess of the purchase price over the fair value of the net assets of businesses acquired. Goodwill resulting from business combinations after January 1, 2009, is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date.
Goodwill totaled $13.9 billion and $13.6 billion as of December 31, 2012 and 2011, respectively. Other intangible assets, which we report on our consolidated balance sheets as a component of other assets, consist primarily of PCCR and core deposit intangibles. The net carrying value of other intangible assets increased to $2.6 billion as of December 31, 2012, from $610 million as of December 31, 2011. The increase was primarily due to the PCCR intangible of $2.2 billion recorded in connection with the 2012 U.S. card acquisition on May 1, 2012. Goodwill and other intangible assets together represented 5% and 7% of our total assets as of December 31, 2012 and 2011, respectively.
Goodwill
Goodwill is not amortized but must be allocated to reporting units and tested for impairment on an annual basis or in interim periods if events or circumstances indicate potential impairment. A reporting unit is a business segment or one level below. Our reporting units for purposes of goodwill impairment testing are Domestic Card, International Card, Auto Finance, other Consumer Banking and Commercial Banking. We perform our annual goodwill impairment test for all reporting units as of October 1 each year using a two-step process. First, we compare the fair value of each reporting unit to its current carrying amount, including goodwill. If the fair value of the reporting unit is in excess of the carrying value, the related goodwill is considered not to be impaired and no further analysis is necessary. If, however, the carrying value of the reporting unit exceeds the fair value, there is an indication of potential impairment and a second step of testing is performed to measure the amount of impairment, if any, for that reporting unit.
We do not maintain separate balance sheets at the reporting unit level; therefore, we determine the carrying values of our reporting units based on an economic capital approach, in which we calculate each reporting unit’s capital requirements based on the individual reporting units’ capital allocation rates applied to their outstanding loans and deposits plus specifically assigned goodwill and intangible assets. The capital allocation rates are approved by our Chief Executive Officer and executive team on an annual basis and are based on our current regulatory requirements and reporting unit specific risks and capital structures. The economic capital approach appropriately reflects the carrying value of each our reporting units based on the capital allocated to and managed at each of those reporting units. We compare the total reporting unit carrying values to our total consolidated stockholders’ equity, as discussed further in “Note 8—Goodwill and Other Intangible Assets,” to assess the appropriateness of our methodology. If the second step of goodwill impairment testing is required for a reporting unit, we undertake an extensive effort to build the specific reporting unit’s balance sheet for the test based on applicable accounting guidance.
Estimating the fair value of reporting units and the assets, liabilities and intangible assets of a reporting unit is a subjective process that involves the use of estimates and judgments, particularly related to cash flows, the appropriate discount rates and an applicable control premium. Management judgment is required to assess
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whether the carrying value of the reporting unit can be supported by the fair value of the individual reporting unit. There are widely accepted valuation methodologies, such as the market approach (earnings multiples and/or transaction multiples) and/or income approach (discounted cash flow methods), that are used to estimate the fair value of reporting units. In applying these methodologies, we utilize a number of factors, including actual operating results, future business plans, economic projections, and market data. We also may engage an independent valuation specialist to assist in our valuation process.
In estimating the fair value of the reporting units in step one of the goodwill impairment analyses, fair values can be sensitive to changes in the projected cash flows and assumptions. In some instances, minor changes in the assumptions could impact whether the fair value of a reporting unit is greater than its carrying amount. Furthermore, a prolonged decrease or increase in a particular assumption could eventually lead to the fair value of a reporting unit being less than its carrying amount. Also, to the extent step two of the goodwill analyses is required, changes in the estimated fair values of individual assets and liabilities may impact other estimates of fair value for assets or liabilities and result in a different amount of implied goodwill, and ultimately the amount of goodwill impairment, if any.
In conducting our goodwill impairment test for 2012, we determined the fair value of our reporting units using a discounted cash flow analysis, a form of the income approach. Our discounted cash flow analysis required management to make judgments about future loan and deposit growth, revenue growth, loan and lease losses, and capital rates. We relied on each reporting unit’s internal cash flow forecast and calculated a terminal value using a growth rate that reflected the nominal growth rate of the economy as a whole and appropriate discount rates for the respective reporting units. We adjusted cash flows as necessary to maintain each reporting unit’s equity capital requirements. The cash flows were discounted to present value using reporting unit specific discount rates that were largely based on our external cost of equity, adjusted for risks inherent in each reporting unit. We corroborated the key inputs used in our discounted cash flow analysis with market data, where available, to validate that our assumptions were within a reasonable range of observable market data.
Based on the results of step one of our 2012 goodwill impairment test, we determined that the fair value of each of our reporting units, including goodwill, significantly exceeded the carrying value for each reporting unit. Fair value as a percentage of carrying value for our five reporting units ranged from 117% to 188%, with the International reporting unit being at the low end of this range. As such, none of our reporting units was at risk of failing step one of the impairment test. Accordingly, the goodwill for each of our reporting units was considered not impaired. Therefore, the second step of impairment testing was not required.
As part of the annual goodwill impairment test, we assessed our market capitalization based on the average market price relative to the aggregate fair value of our reporting units and determined that any excess fair value in our reporting units at that time could be attributed to a reasonable control premium compared to historical control premiums seen in the industry. We will continue to regularly monitor our market capitalization in 2013, overall economic conditions and other events or circumstances that may result in an impairment of goodwill in the future. We did not recognize goodwill impairment in either 2011 or 2010.
Other Intangible Assets
Intangible assets with definitive useful lives are amortized over their estimated lives and evaluated for potential impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable. An impairment loss, generally calculated as the difference between the estimated fair value and the carrying value of an asset or asset group, is recognized if the sum of the estimated undiscounted cash flows relating to the asset or asset group is less than the corresponding carrying value. We did not recognize impairment on other intangible assets in 2012, 2011 or 2010.
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We provide additional information on the nature of and accounting for goodwill and other intangible assets, including the process and methodology used to conduct goodwill impairment testing, in “Note 8—Goodwill and Other Intangible Assets.”
Fair Value
Fair value is defined as the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date (also referred to as an exit price). The fair value accounting guidance provides a three-level fair value hierarchy for classifying financial instruments. This hierarchy is based on whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. Fair value measurement of a financial asset or liability is assigned to a level based on the lowest level of any input that is significant to the fair value measurement in its entirety. The three levels of the fair value hierarchy are described below:
Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities
Level 2: Observable market-based inputs, other than quoted prices in active markets for identical assets or
liabilities
Level 3: Unobservable inputs
The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted prices in active markets or observable market parameters. When quoted prices and observable data in active markets are not fully available, management judgment is necessary to estimate fair value. Changes in market conditions, such as reduced liquidity in the capital markets or changes in secondary market activities, may reduce the availability and reliability of quoted prices or observable data used to determine fair value.
We have developed policies and procedures to determine when markets for our financial assets and liabilities are inactive if the level and volume of activity has declined significantly relative to normal conditions. If markets are determined to be inactive, it may be appropriate to adjust price quotes received. When significant adjustments are required to price quotes or inputs, it may be appropriate to utilize an estimate based primarily on unobservable inputs.
Significant judgment may be required to determine whether certain financial instruments measured at fair value are included in Level 2 or Level 3. In making this determination, we consider all available information that market participants use to measure the fair value of the financial instrument, including observable market data, indications of market liquidity and orderliness, and our understanding of the valuation techniques and significant inputs used. Based upon the specific facts and circumstances of each instrument or instrument category, judgments are made regarding the significance of the Level 3 inputs to the instruments’ fair value measurement in its entirety. If Level 3 inputs are considered significant, the instrument is classified as Level 3. The process for determining fair value using unobservable inputs is generally more subjective and involves a high degree of management judgment and assumptions.
Our financial instruments recorded at fair value on a recurring basis represented approximately 21% of our total reported assets of $312.9 billion as of December 31, 2012, compared with 20% of our total reported assets of $206.0 billion as of December 31, 2011. Financial assets for which the fair value was determined using significant Level 3 inputs represented approximately 5% and 2% of these financial instruments (less than 1% of total assets) as of December 31, 2012 and 2011, respectively.
We discuss changes in the valuation inputs and assumptions used in determining the fair value of our financial instruments, including the extent to which we have relied on significant unobservable inputs to estimate fair value and our process for corroborating these inputs, in “Note 19—Fair Value of Financial Instruments.”
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Key Controls Over Fair Value Measurement
We have a governance framework and a number of key controls that are intended to ensure that our fair value measurements are appropriate and reliable. Our governance framework provides for independent oversight and segregation of duties. Our control processes include review and approval of new transaction types, price verification and review of valuation judgments, methods, models, process controls and results. Groups independent from our trading and investing functions, including our Valuations Group, Model Validation Group and Fair Value Committee (“FVC”), participate in the review and validation process. The fair valuation governance process is set up in a manner that allows the Chairperson of the FVC to escalate valuation disputes that cannot be resolved at the FVC to a more senior committee called the Valuations Advisory Committee (“VAC”) for resolution. The VAC is chaired by the Chief Financial Officer. Membership of the VAC includes the Chief Risk Officer.
Our Valuations Group performs periodic independent verification of fair value measurements by using independent analytics and other available market data to determine if assigned fair values are reasonable. For example, in cases where we rely on third party pricing services to obtain fair value measures, we analyze pricing variances among different pricing sources and validate the final price used by comparing the information to additional sources, including dealer pricing indications in transaction results and other internal sources, where necessary. Additional validation procedures performed by the Valuations Group include reviewing (either directly or indirectly through the reasonableness of assigned fair values) valuation inputs and assumptions, and monitoring acceptable variances between recommended prices and validation prices. The validation group periodically evaluates alternative methodologies and recommends improvements to valuation techniques. We perform due diligence reviews of the third party pricing services by comparing their prices with prices from other sources and reviewing other control documentation. Additionally, when necessary, we challenge prices from third party vendors to ensure reasonableness of prices through a pricing challenge process. This may include a request for a transparency of the assumptions used by the third party.
The FVC, which includes representation from business areas, our Risk Management division and our Finance division, is a forum for discussing fair valuations, inputs, assumptions, methodologies, variance thresholds, valuation control environment and material risks or concerns related to fair valuations. Additionally, the FVC is empowered to resolve valuation disputes between the primary valuation providers and the valuations control group. It provides guidance and oversight to ensure an appropriate valuation control environment. The FVC regularly reviews and approves our valuation methodologies to ensure that our methodologies and practices are consistent with industry standards and adhere to regulatory and accounting guidance. The Chief Financial Officer determines when material issues or concerns regarding valuations shall be raised to the Audit and Risk Committee or other delegated committee of the Board of Directors.
We have a model policy, established by an independent Model Risk Office, which governs the validation of models and related supporting documentation to ensure the appropriate use of models for pricing.
Representation and Warranty Reserve
In connection with their sales of mortgage loans, certain subsidiaries entered into agreements containing varying representations and warranties about, among other things, the ownership of the loan, the validity of the lien securing the loan, the loan’s compliance with any applicable loan criteria established by the purchaser, including underwriting guidelines and the ongoing existence of mortgage insurance, and the loan’s compliance with applicable federal, state and local laws. We may be required to repurchase the mortgage loan, indemnify the investor or insurer, or reimburse the investor for loan and lease losses incurred on the loan in the event of a material breach of contractual representations or warranties.
We have established representation and warranty reserves for losses that we consider to be both probable and reasonably estimable associated with the mortgage loans sold by each subsidiary, including both litigation and
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non-litigation liabilities. The reserve-setting process relies heavily on estimates, which are inherently uncertain, and requires the application of judgment. In establishing the representation and warranty reserves, we consider a variety of factors, depending on the category of purchaser and rely on historical data. These factors include, but are not limited to, the historical relationship between loan losses and repurchase outcomes; the percentage of current and future loan defaults that we anticipate will result in repurchase requests over the lifetime of the loans; the percentage of those repurchase requests that we anticipate will result in actual repurchases; and estimated collateral valuations. We evaluate these factors and update our loss forecast models on a quarterly basis to estimate our lifetime liability.
Our aggregate representation and warranty mortgage repurchase reserves, which we report as a component of other liabilities in our consolidated balance sheets, totaled $899 million as of December 31, 2012, compared with $943 million as of December 31, 2011. The adequacy of the reserves and the ultimate amount of losses incurred by us or one of our subsidiaries will depend on, among other things, actual future mortgage loan performance, the actual level of future repurchase and indemnification requests, the actual success rates of claimants, developments in litigation, actual recoveries on the collateral and macroeconomic conditions (including unemployment levels and housing prices).
As part of our business planning processes, we have considered various outcomes relating to the potential future representation and warranty liabilities of our subsidiaries that are reasonably possible but do not rise to the level of being both probable and reasonably estimable outcomes justifying an incremental accrual under applicable accounting standards. As of December 31, 2012, our best estimate of reasonably possible future losses from representation and warranty claims beyond what is in our reserve was approximately $2.7 billion, an increase from our previous estimates of $1.7 billion as of September 30, 2012, and $1.5 billion as of December 31, 2011. Notwithstanding our ongoing attempts to estimate a reasonably possible amount of future losses beyond our current accrual levels based on current information, it is possible that actual future losses will exceed both the current accrual level and our current estimate of the amount of reasonably possible losses. This estimate involves considerable judgment, and reflects that there is still significant uncertainty regarding the numerous factors that may impact the ultimate loss levels, including, but not limited to, anticipated litigation outcomes, future repurchase and indemnification claim levels, ultimate repurchase and indemnification rates, future mortgage loan performance levels, actual recoveries on the collateral and macroeconomic conditions (including unemployment levels and housing prices). In light of the significant uncertainty as to the ultimate liability our subsidiaries may incur from these matters, an adverse outcome in one or more of these matters could be material to our results of operations or cash flows for any particular reporting period. See “Note 21—Commitments, Contingencies and Guarantees” for additional information.
Customer Rewards Reserve
We offer products, primarily credit cards, which offer reward program members with various rewards, such as cash, airline tickets or merchandise. The majority of our rewards do not expire and there is no limit on the number of reward points an eligible card member may earn. Customer rewards costs, which we generally record as an offset to interchange income, are driven by various factors, such as card member charge volume, customer participation in the rewards program and contractual arrangements with redemption partners. We establish a customer rewards reserve that reflects management’s judgment regarding rewards earned that are expected to be redeemed and the estimated redemption cost.
We use financial models to estimate ultimate redemption rates of rewards earned to date by current card members based on historical redemption trends, current enrollee redemption behavior, card product type, year of program enrollment, enrollment tenure and card spend levels. Our current assumption is that the vast majority of all rewards earned will eventually be redeemed. We use a weighted-average cost per reward redeemed during the previous twelve months, adjusted as appropriate for recent changes in redemption costs, including mix of rewards redeemed, to estimate future redemption costs.
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We continually evaluate our reserve methodology and assumptions based on developments in redemption patterns, cost per point redeemed, contract changes and other factors. Changes in the ultimate redemption rate and weighted-average cost per point have the effect of either increasing or decreasing the reserve through the current period provision by an amount estimated to cover the cost of all points previously earned but not yet redeemed by card members as of the end of the reporting period. We recognized customer rewards expense of $1.3 billion, $1.0 billion and $760 million in 2012, 2011 and 2010, respectively. Our customer rewards liability, which is included in other liabilities in our consolidated balance sheets, totaled $2.1 billion and $1.7 billion as of December 31, 2012 and 2011, respectively.
Income Taxes
Our annual provision for income tax expense is based on our income, statutory tax rates and other provisions of tax law applicable to us in the various jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment, including evaluating uncertainties, is required in determining our tax positions and calculating our tax expense. We review our tax positions quarterly and adjust the balances as new information becomes available.
Our income tax expense consists of two components: current and deferred taxes. Our current income tax expense approximates taxes to be paid or refunded for the current period. It also includes income tax expense related to our uncertain tax positions and revisions of our estimate of accrued income taxes resulting from the resolution of income tax controversies. Our deferred income tax expense results from changes in our deferred tax assets and liabilities between periods.
Deferred tax assets and liabilities represent decreases or increases in taxes expected to be paid in the future because of future reversals of temporary differences between the financial reporting and tax bases of assets and liabilities, as well as from net operating loss and tax credit carryforwards. Deferred tax assets are recognized subject to management’s judgment that realization is “more likely than not.” We evaluate the recoverability of these future tax deductions by assessing the adequacy of expected taxable income from all sources, including taxable income in carryback years, reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income rely heavily on estimates. We use our historical experience and our short- and long-range business forecasts to provide insight.
We had deferred tax assets, net of deferred tax liabilities and valuation allowances, of $2.9 billion as of December 31, 2012, compared with $2.3 billion at December 31, 2011. We had a valuation allowance of $123 million and $89 million as of December 31, 2012 and 2011, respectively. We expect to fully realize in future periods the net deferred tax asset of $2.9 billion recorded as of December 31, 2012. If changes in circumstances lead us to change our judgment about our ability to realize deferred tax assets in future years, we will adjust our valuation allowances in the period that our change in judgment occurs and record a corresponding increase or charge to income.
We provide additional information on income taxes in “Consolidated Results of Operations” and in “Note 18—Income Taxes.”
ACCOUNTING CHANGES AND DEVELOPMENTS
See “Note 1—Summary of Significant Accounting Policies” for information on accounting standards adopted in 2012, as well as recently issued accounting standards not yet required to be adopted and the expected impact of these changes in accounting standards. To the extent we believe the adoption of new accounting standards has had or will have a material impact on our results of operations, financial condition or liquidity, we discuss the impacts in the applicable sections(s) of MD&A.
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CONSOLIDATED RESULTS OF OPERATIONS
The section below provides a comparative discussion of our reported consolidated results of operations between 2012 and 2011 and between 2011 and 2010. Following this section, we provide a discussion of our business segment results. You should read this section together with our “Executive Summary and Business Outlook,” where we discuss trends and other factors that we expect will affect our future results of operations.
Net Interest Income
Net interest income represents the difference between the interest income and applicable fees earned on our interest-earning assets, which include loans held for investment and investment securities, and the interest expense on our interest-bearing liabilities, which include interest-bearing deposits, senior and subordinated notes, securitized debt and other borrowings. We include in interest income any past due fees on loans that we deem are collectible. Our net interest margin represents the difference between the yield on our interest-earning assets and the cost of our interest-bearing liabilities, including the impact of non-interest bearing funding. We expect net interest income and our net interest margin to fluctuate based on changes in interest rates and changes in the amount and composition of our interest-earning assets and interest-bearing liabilities.
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Table 2 below presents, for each major category of our interest-earning assets and interest-bearing liabilities, the average outstanding balances, interest income earned or interest expense incurred, and average yield or cost for 2012, 2011 and 2010.
Table 2: Average Balances, Net Interest Income and Net Interest Yield(1)
| Year Ended December 31, | ||||||||||||||||||||||||||||||||||||
| 2012 | 2011 | 2010 | ||||||||||||||||||||||||||||||||||
| (Dollars in millions) |
Average Balance |
Interest
Income/ Expense(2) |
Yield/ Rate |
Average Balance |
Interest
Income/ Expense(2) |
Yield/ Rate |
Average Balance |
Interest Income/ Expense(2) |
Yield/ Rate |
|||||||||||||||||||||||||||
| Assets: |
||||||||||||||||||||||||||||||||||||
| Interest-earning assets: |
||||||||||||||||||||||||||||||||||||
| Credit card:(3) |
||||||||||||||||||||||||||||||||||||
| Domestic |
$ | 71,754 | $ | 10,153 | 14.15 | % | $ | 53,465 | $ | 7,562 | 14.14 | % | $ | 55,133 | $ | 7,951 | 14.42 | % | ||||||||||||||||||
| International |
8,255 | 1,292 | 15.66 | 8,645 | 1,359 | 15.72 | 7,499 | 1,212 | 16.16 | |||||||||||||||||||||||||||
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||
| Credit card |
80,009 | 11,445 | 14.31 | 62,110 | 8,921 | 14.36 | 62,632 | 9,163 | 14.63 | |||||||||||||||||||||||||||
| Consumer banking(4) |
71,836 | 4,509 | 6.28 | 34,838 | 3,343 | 9.60 | 35,925 | 3,245 | 9.11 | |||||||||||||||||||||||||||
| Commercial banking |
35,913 | 1,528 | 4.25 | 31,274 | 1,482 | 4.74 | 29,764 | 1,503 | 5.05 | |||||||||||||||||||||||||||
| Other |
157 | 55 | 35.03 | 202 | 28 | 13.86 | 205 | 23 | 11.22 | |||||||||||||||||||||||||||
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||
| Total loans held for investment |
187,915 | 17,537 | 9.33 | 128,424 | 13,774 | 10.73 | 128,526 | 13,934 | 10.84 | |||||||||||||||||||||||||||
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|
|
|
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|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||
| Investment securities |
57,424 | 1,329 | 2.31 | 39,513 | 1,137 | 2.88 | 39,489 | 1,342 | 3.40 | |||||||||||||||||||||||||||
| Other interest-earning assets |
9,740 | 98 | 1.01 | 7,328 | 76 | 1.04 | 7,668 | 77 | 1.00 | |||||||||||||||||||||||||||
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||
| Total interest-earning assets |
$ | 255,079 | $ | 18,964 | 7.43 | % | $ | 175,265 | $ | 14,987 | 8.55 | % | $ | 175,683 | $ | 15,353 | 8.74 | % | ||||||||||||||||||
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||
| Cash and due from banks |
4,573 | 1,926 | 2,132 | |||||||||||||||||||||||||||||||||
| Allowance for loan and lease losses |
(4,640 | ) | (4,865 | ) | (7,257 | ) | ||||||||||||||||||||||||||||||
| Premises and equipment, net |
3,342 | 2,731 | 2,718 | |||||||||||||||||||||||||||||||||
| Other assets |
28,248 | 24,661 | 26,838 | |||||||||||||||||||||||||||||||||
|
|
|
|
|
|
|
|||||||||||||||||||||||||||||||
| Total assets |
$ | 286,602 | $ | 199,718 | $ | 200,114 | ||||||||||||||||||||||||||||||
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|
|
|
|
|
|
|||||||||||||||||||||||||||||||
| Liabilities and stockholders’ equity: |
||||||||||||||||||||||||||||||||||||
| Interest-bearing liabilities: |
||||||||||||||||||||||||||||||||||||
| Deposits |
$ | 183,314 | $ | 1,403 | 0.77 | % | $ | 109,644 | $ | 1,187 | 1.08 | % | $ | 104,743 | $ | 1,465 | 1.40 | % | ||||||||||||||||||
| Securitized debt obligations |
14,138 | 271 | 1.92 | 20,715 | 422 | 2.04 | 34,185 | 809 | 2.37 | |||||||||||||||||||||||||||
| Senior and subordinated notes |
11,012 | 345 | 3.13 | 9,244 | 300 | 3.25 | 8,571 | 276 | 3.22 | |||||||||||||||||||||||||||
| Other borrowings |
12,875 | 356 | 2.77 | 8,063 | 337 | 4.18 | 6,864 | 346 | 5.04 | |||||||||||||||||||||||||||
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|
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|
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| Total interest-bearing liabilities |
$ | 221,339 | $ | 2,375 | 1.07 | % | $ | 147,666 | $ | 2,246 | 1.52 | % | $ | 154,363 | $ | 2,896 | 1.88 | % | ||||||||||||||||||
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|
|
|||||||||||||||||||
| Non-interest bearing deposits |
19,741 | 17,050 | 14,267 | |||||||||||||||||||||||||||||||||
| Other liabilities |
8,196 | 6,423 | 6,543 | |||||||||||||||||||||||||||||||||
|
|
|
|
|
|
|
|||||||||||||||||||||||||||||||
| Total liabilities |
249,275 | 171,139 | 175,173 | |||||||||||||||||||||||||||||||||
| Stockholders’ equity |
37,327 | 28,579 | 24,941 | |||||||||||||||||||||||||||||||||
|
|
|
|
|
|
|
|||||||||||||||||||||||||||||||
| Total liabilities and stockholders’ equity |
$ | 286,602 | $ | 199,718 | $ | 200,114 | ||||||||||||||||||||||||||||||
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|
|
|
|
|
|
|||||||||||||||||||||||||||||||
| Net interest income/spread |
$ | 16,589 | 6.36 | % | $ | 12,741 | 7.03 | % | $ | 12,457 | 6.86 | % | ||||||||||||||||||||||||
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|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||||||||
| Impact of non-interest bearing funding |
0.14 | 0.24 | 0.23 | |||||||||||||||||||||||||||||||||
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|
|
|
|
|
|
|||||||||||||||||||||||||||||||
| Net interest margin |
6.50 | % | 7.27 | % | 7.09 | % | ||||||||||||||||||||||||||||||
|
|
|
|
|
|
|
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| (1) | Certain prior period amounts have been reclassified to conform to the current period presentation. |
| (2) | Past due fees included in interest income totaled approximately $1.7 billion, $1.1 billion and $1.1 billion in 2012, 2011 and 2010, respectively. Premium amortization related to the ING Direct and 2012 U.S. card acquisitions reduced net interest income by $391 million in 2012. |
| (3) | Credit card loans consist of domestic and international credit card loans and installment loans. |
| (4) | Consumer banking loans consist of auto, home and retail banking loans. |
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Table 3 displays the change in our net interest income between periods and the extent to which the variance is attributable to: (i) changes in the volume of our interest-earning assets and interest-bearing liabilities or (ii) changes in the interest rates of these assets and liabilities.
Table 3: Rate/Volume Analysis of Net Interest Income(1)
| 2012 vs. 2011 | 2011 vs. 2010 | |||||||||||||||||||||||
| Total Variance |
Variance Due to | Total Variance |
Variance Due to | |||||||||||||||||||||
| (Dollars in millions) |
Volume | Rate | Volume | Rate | ||||||||||||||||||||
| Interest income: |
||||||||||||||||||||||||
| Loans held for investment: |
||||||||||||||||||||||||
| Credit card |
$ | 2,524 | $ | 2,561 | $ | (37 | ) | $ | (242 | ) | $ | (76 | ) | $ | (166 | ) | ||||||||
| Consumer banking |
1,166 | 2,624 | (1,458 | ) | 98 | (100 | ) | 198 | ||||||||||||||||
| Commercial banking |
46 | 207 | (161 | ) | (21 | ) | 74 | (95 | ) | |||||||||||||||
| Other |
27 | (7 | ) | 34 | 5 | — | 5 | |||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Total loans held for investment |
3,763 | 5,385 | (1,622 | ) | (160 | ) | (102 | ) | (58 | ) | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Investment securities |
192 | 445 | (253 | ) | (205 | ) | 1 | (206 | ) | |||||||||||||||
| Other |
22 | 24 | (2 | ) | (1 | ) | (3 | ) | 2 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Total interest income |
3,977 | 5,854 | (1,877 | ) | (366 | ) | (105 | ) | (261 | ) | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Interest expense: |
||||||||||||||||||||||||
| Deposits |
216 | 635 | (419 | ) | (278 | ) | 66 | (344 | ) | |||||||||||||||
| Securitized debt obligations |
(151 | ) | (127 | ) | (24 | ) | (387 | ) | (286 | ) | (101 | ) | ||||||||||||
| Senior and subordinated notes |
45 | 56 | (11 | ) | 24 | 22 | 2 | |||||||||||||||||
| Other borrowings |
19 | 158 | (139 | ) | (9 | ) | 55 | (64 | ) | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Total interest expense |
129 | 722 | (593 | ) | (650 | ) | (143 | ) | (507 | ) | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Net interest income |
$ | 3,848 | $ | 5,132 | $ | (1,284 | ) | $ | 284 | $ | 38 | $ | 246 | |||||||||||
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|
|
|
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|
|||||||||||||
| (1) | We calculate the change in interest income and interest expense separately for each item. The change in net interest income attributable to both volume and rates is allocated based on the relative dollar amount of each item. |
Net interest income of $16.6 billion for 2012 increased by $3.8 billion, or 30%, from 2011, driven by a 46% increase in average interest-earning assets, which was partially offset by an 11% (77 basis points) decline in our net interest margin to 6.50%.
| • | Average Interest-Earning Assets: The significant increase in average interest-earning assets reflects the addition of the ING Direct loan portfolio of $40.4 billion in the first quarter of 2012 and the addition of the $27.8 billion in outstanding receivables acquired in the 2012 U.S. card acquisition and designated as held for investment in the second quarter of 2012. Growth in average-interest earning assets also was driven by strong commercial loan growth and continued growth in auto loans, which was partially offset by the continued expected run-off of installment loans in our Credit Card business and home loans in our Consumer Banking business, as well as the expected run-off of higher-margin, higher-loss receivables acquired in the 2012 U.S. card acquisition. The run-off of home loans has accelerated slightly as a result of the low mortgage interest rate environment. |
| • | Net Interest Margin: The decrease in our net interest margin was attributable to a decline in the average yield on our interest-earning assets, largely due to the shift in the mix of our interest-earning assets to a larger proportion of lower yielding assets resulting from the acquired ING Direct home loan and investment security portfolios and temporarily higher cash balances from the recent equity and debt offerings. The ING Direct interest-earning assets generally have lower yields than our legacy loan and investment security portfolios. In addition, the establishment of a finance charge and fee reserve of $174 million in the second quarter of 2012 for the receivables acquired in the 2012 U.S. card acquisition and premium amortization related to the ING |
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| Direct and 2012 U.S. card acquisitions of $391 million in 2012 contributed to the reduction in the average yield on interest-earning assets. The decrease in the average yield on interest-earnings assets was partially offset by a reduction in our cost of funds. We have continued to benefit from the shift in the mix of our funding to lower cost consumer and commercial banking deposits from higher cost wholesale sources and a decline in deposit interest rates as a result of the continued overall low interest rate environment. |
Net interest income of $12.7 billion for 2011 increased by $284 million, or 2%, from 2010, driven by a 3% (18 basis points) expansion in our net interest margin to 7.27%, which was partially offset by a modest decrease in average interest-earning assets.
| • | Average Interest-Earning Assets: The decrease in average interest-earning assets in 2011 reflected the continued run-off of businesses that we exited or repositioned, including our installment, home loan and small-ticket commercial real estate loan portfolios, which was slightly offset by the impact of modest revolving credit card loan growth, the addition of the existing HBC credit card loan portfolio of $1.4 billion in the first quarter of 2011 and the addition of the existing Kohl’s private-label credit card loan portfolio of $3.7 billion in the second quarter of 2011. |
| • | Net Interest Margin: The increase in our net interest margin in 2011 reflected the favorable impact of a reduction in cost of funds, which was partially offset by the unfavorable impact of a decrease in the average yield on interest-earning assets. The improvement in our cost of funds was attributable the shift in the mix of our funding to lower cost consumer and commercial banking deposits from higher cost wholesale sources and a decline in deposit interest rates as a result of the overall low interest rate environment. The decrease in the average yield on interest-earning assets was largely due to the addition of the Kohl’s portfolio. Under our partnership agreement with Kohl’s, we share a fixed percentage of revenues, consisting of finance charges and late fees. We report revenues related to Kohl’s credit card loans on a net basis in our consolidated financial statements, which has the effect of reducing the yield on our average interest-earning assets. The reduction in the average yield due to the addition of the Kohl’s portfolio was partially offset by the run-off of lower margin installment loans, a reduced level of new accounts with low introductory promotional rates and an increase in the recognition of billed finance charges and fees due to improved credit performance as well as a change we made in the third quarter of 2011 in our estimation of the uncollectible finance charge and fee reserve. |
Non-Interest Income
Non-interest income primarily consists of service charges and other customer-related fees, interchange income (net of rewards expense), other non-interest income and, in 2012, the bargain purchase gain attributable to the ING Direct acquisition. The “other” component of non-interest income includes the provision for mortgage representation and warranty losses related to continuing operations. Other also includes gains and losses from the sale of investment securities, gains and losses on derivatives not accounted for in hedge accounting relationships and hedge ineffectiveness, which we generally do not allocate to our business segments because they relate to centralized asset/liability and market risk management activities undertaken by our Corporate Treasury group.
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Table 4 displays the components of non-interest income for 2012, 2011 and 2010.
| Year Ended December 31, | ||||||||||||
| (Dollars in millions) |
2012 | 2011 | 2010 | |||||||||
| Service charges and other customer-related fees |
$ | 2,106 | $ | 1,979 | $ | 2,073 | ||||||
| Interchange fees, net |
1,647 | 1,318 | 1,340 | |||||||||
| Bargain purchase gain(1) |
594 | — | — | |||||||||
| Net other-than-temporary impairment (“OTTI”) |
(52 | ) | (21 | ) | (65 | ) | ||||||
| Other non-interest income: |
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| Provision for mortgage representation and warranty losses(2) |
(42 | ) | (43 | ) | (204 | ) | ||||||
| Net gains from the sale of investment securities |
45 | 259 | 141 | |||||||||
| Net fair value gains (losses) on free-standing derivatives(3) (4) |
(36 | ) | (197 | ) | 51 | |||||||
|
Other(5) |
545 | 243 | 378 | |||||||||
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| Other non-interest income |
512 | 262 | 366 | |||||||||
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| Total non-interest income |
$ | 4,807 | $ | 3,538 | $ | 3,714 | ||||||
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| (1) | Represents the amount by which the fair value of the net assets acquired in the ING Direct acquisition, as of the acquisition date of February 17, 2012, exceeded the consideration transferred. |
| (2) | We recorded a total provision for mortgage representation and warranty losses of $349 million, $212 million and $636 million in 2012, 2011 and 2010, respectively. The remaining portion of the provision for mortgage representation and warranty losses is included, net of tax, in discontinued operations. |
| (3) | Includes mark-to-market derivative losses of $78 million and $277 million in 2012 and 2011, respectively, related to interest-rate swaps we entered into in 2011 to partially hedge the interest rate risk of the net assets associated with the expected ING Direct acquisition. |
| (4) | Excludes net cumulative credit risk valuation adjustments of $9 million, $23 million and $20 million as of December 31, 2012, 2011, and 2010, respectively, related to derivatives in a gain position. See “Note 11—Derivative Instruments and Hedging Activities” for additional information. |
| (5) | Other includes derivative hedge ineffectiveness losses of $36 million in 2012 and gains of $15 million and $50 million in 2011 and 2010, respectively. Other also includes income of $162 million in 2012 related to the sale of Visa stock shares. |
Non-interest income of $4.8 billion in 2012 increased by $1.3 billion, or 36%, from non-interest income of $3.5 billion in 2011. This increase reflected the combined impact of: (i) the bargain purchase gain of $594 million recorded at acquisition of ING Direct; (ii) increased net interchange and other fees resulting from continued growth and market share from new account originations, due in part to the ING Direct and the 2012 U.S. card acquisitions; (iii) income of $162 million from the sale of Visa stock shares in the first quarter of 2012; and (iv) mark-to-market gains of $85 million recognized on retained interests in mortgage-related securities. The favorable impact of these items was partially offset by expected customer refunds of approximately $115 million related to cross-sell activities in our Domestic Card business, approximately $214 million lower net gains from the sale of AFS securities recorded in 2012 versus 2011, and a mark-to-market derivative loss of $78 million recognized in the first quarter of 2012 related to the settlement of interest-rate swaps we entered into in 2011 to partially hedge the interest rate risk of the net assets associated with the ING Direct acquisition.
Non-interest income of $3.5 billion in 2011 decreased by $176 million, or 5%, from non-interest income of $3.7 billion in 2010. This decrease was attributable to: (i) the absence of a one-time pre-tax gain of $128 million recorded in the first quarter of 2010 and net gains on the sale of securities in 2010; and (ii) the impact of contra-revenue amounts recorded in the second and fourth quarters of 2011, including a provision of $102 million for anticipated refunds to U.K. customers related to retrospective regulatory requirements pertaining to payment protection insurance (“PPI”) in our U.K. business. The decrease was partially offset by increased customer fees related to treasury management and public financing activities, and the decrease in the provision for mortgage loan repurchases.
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We recorded net OTTI losses of $52 million, $21 million and $65 million in 2012, 2011, and 2010, respectively. These OTTI losses resulted from the deterioration in the credit quality of certain non-agency mortgage-backed securities due to the prolonged weakness in the housing market and fragile economic recovery. We provide additional information on other-than-temporary impairment recognized on our available-for-sale securities in “Note 4—Investment Securities.”
Provision for Credit Losses
We build our allowance for loan and lease losses and unfunded lending commitment reserves through the provision for credit losses. Our provision for credit losses in each period is driven by charge-offs and the level of allowance for loan and lease losses that we determine is necessary to provide for probable loan and lease losses incurred that are inherent in our loan portfolio as of each balance sheet date. We recorded a provision for credit losses of $4.4 billion in 2012, compared with $2.4 billion in 2011 and $3.9 billion in 2010. The provision for credit losses as a percentage of net interest income was 26.6%, 18.5% and 31.4% in 2012, 2011 and 2010, respectively.
The increase in the provision for credit losses of $2.0 billion in 2012 from 2011 was primarily related to the addition of the $26.2 billion in outstanding receivables acquired in the 2012 U.S. card acquisition designated as held for investment that had existing revolving privileges at acquisition. These loans were recorded at a fair value of $26.9 billion, resulting in a net premium of $705 million at acquisition. Fair value was determined by discounting all expected cash flows (contractual principal, interest, finance charges and fees of $33.3 billion less those amounts not expected to be collected of $3.0 billion) at a market discount rate.
Under applicable accounting guidance, we are required to amortize the net premium of $705 million over the contractual principal amount as an adjustment to interest income over the remaining life of the loans. Given the guidance applicable to revolving loans, it is necessary to record an allowance through provision for credit losses to properly recognize an estimate of incurred losses on the existing principal balances, which represents a portion of the total amounts not expected to be collected described above. In the second quarter of 2012, we recorded a provision for credit losses of $1.2 billion to establish an initial allowance primarily related to these loans. The allowance was calculated using the same methodology utilized for determining the allowance for our existing credit card loan portfolio. The provision for credit losses, excluding the initial allowance build of $1.2 billion related to the 2012 U.S. card acquisition, was $3.2 billion in 2012. The increase in the provision for credit losses, excluding the impact of the initial allowance build related to the 2012 U.S. card acquisition, was largely attributable to the growth in auto and commercial loan originations, coupled with the absence of the allowance release for our Credit Card business recorded in 2011.
The decrease in the provision for credit losses of $1.5 billion in 2011 from 2010 was largely driven by a substantial decline in net charge-offs across all of our business segments, reflecting a continued improvement in the credit performance of our loan portfolio.
On October 29, 2012, Hurricane Sandy made landfall on the New Jersey coast, resulting in severe disaster in coastal counties in Connecticut, New Jersey and New York and varying degrees of damage and disruption in other Northeast and Mid-Atlantic states. Because we have significant consumer and commercial loan exposure in Connecticut, New Jersey and New York, the storm and its aftermath resulted in an elevated risk of loss for us within this region. Based on our assessment of the impact of Hurricane Sandy on our loan portfolio, we recorded an allowance of $39 million as of December 31, 2012, which is included in our total allowance for loan and lease losses of $5.2 billion as of December 31, 2012.
We provide additional information on the provision for credit losses and changes in the allowance for loan and lease losses under the “Credit Risk Profile—Summary of Allowance for Loan and Lease Losses” and “Note 6—Allowance for Loan and Lease Losses.” For information on our allowance methodology, see “Note 1—Summary of Significant Accounting Policies.”
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Non-Interest Expense
Non-interest expense consists of ongoing operating costs, such as salaries and associate benefits, occupancy and equipment costs, professional services, communications and data processing technology expenses, and other miscellaneous expenses. Non-interest expense also includes marketing costs, merger-related expense and amortization of intangibles. Table 5 displays the components of non-interest expense for 2012, 2011 and 2010.
| (Dollars in millions) |
Year Ended December 31, | |||||||||||
| 2012 | 2011 | 2010 | ||||||||||
| Salaries and associate benefits |
$ | 3,876 | $ | 3,023 | $ | 2,594 | ||||||
| Occupancy and equipment |
1,327 | 1,025 | 1,001 | |||||||||
| Marketing |
1,364 | 1,337 | 958 | |||||||||
| Professional services |
1,270 | 1,198 | 919 | |||||||||
| Communications and data processing |
778 | 681 | 693 | |||||||||
| Amortization of intangibles |
609 | 222 | 220 | |||||||||
| Merger-related expense |
336 | 45 | 81 | |||||||||
| Other non-interest expense: |
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| Collections |
544 | 563 | 626 | |||||||||
| Fraud losses |
190 | 122 | 80 | |||||||||
| Bankcard, regulatory and other fee assessments |
525 | 394 | 352 | |||||||||
| Other |
1,127 | 722 | 410 | |||||||||
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| Total other non-interest expense |
2,386 | 1,801 | 1,468 | |||||||||
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| Total non-interest expense |
$ | 11,946 | $ | 9,332 | $ | 7,934 | ||||||
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Non-interest expense of $11.9 billion for 2012 increased $2.6 billion, or 28%, from 2011. The increase was primarily due to higher operating expenses and merger-related costs related to our recent acquisitions, increased salaries and associate benefits attributable to increased headcount, higher infrastructure costs attributable to acquired businesses and our continued investment in our auto loan business and increased amortization of intangibles resulting from the ING Direct and 2012 U.S. card acquisitions. We recorded PCCR intangible amortization expense related to the 2012 U.S. card acquisition of $334 million in 2012. We recorded other asset and intangible amortization expense related to the ING Direct and 2012 U.S. card acquisitions of $147 million in 2012.
Non-interest expense of $9.3 billion for 2011 increased $1.4 billion, or 18%, from 2010. The increase was attributable to increased marketing expenditures as we expanded our marketing efforts to attract and support targeted customers and new business volume through a variety of channels, higher legal expenses and increased operating expenses. The increase in operating expenses was largely due to the integration of the acquisitions of the Sony, HBC and Kohl’s loan portfolios and continued investment in our infrastructure.
Income Taxes
We recorded an income tax provision based on income from continuing operations of $1.3 billion (25.8% effective income tax rate) in 2012, compared with an income tax provision of $1.3 billion (29.1% effective income tax rate) in 2011 and income tax provision of $1.3 billion (29.6% effective tax rate) in 2010. Our effective tax rate on income from continuing operations varies between periods due, in part, to fluctuations in our pre-tax earnings, which affects the relative tax benefit of tax-exempt income, tax credits and other permanent tax items.
The decrease in our effective income tax rate in 2012 from 2011 reflected an increase in the amount of one-time tax benefits recorded in 2012 compared with the prior year. In 2012, we recorded discrete tax benefits of $252
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million, primarily related to the non-taxable ING Direct bargain purchase gain of $594 million, a one-time deferred tax benefit for changes in our state tax position resulting from the assets and operations of the 2012 U.S. card acquisition and consolidation of ING Bank, fsb with our existing banking operations, and the resolution of certain tax issues and audits. In comparison, in 2011 we recorded discrete tax benefits of $121 million, primarily related to the release of valuation allowances against certain state deferred tax assets and net operating loss carry-forwards, as well as the resolution of certain tax issues and audits.
Similarly, the decrease in our effective income tax rate in 2011 from 2010 reflected an increase in the amount of one-time tax benefits recorded in 2011 compared with the prior year. In 2011, we recorded discrete tax benefits of $121 million, primarily related to the release of valuation allowances against certain state deferred tax assets and net operating loss carry-forwards, as well as the resolution of certain tax issues and audits. In 2010, we recorded discrete tax benefits of $84 million, primarily related to adjustments for the resolution of certain tax issues and audits.
Our effective income tax rate excluding the benefit from these discrete tax items was 30.9%, 31.7% and 31.5% for 2012, 2011 and 2010, respectively. The decrease in our effective income tax rate excluding the impact of discrete items in 2012 from 2011 was primarily due to an increase in affordable housing and other business tax credits.
We provide additional information on items affecting our income taxes and effective tax rate in “Note 18—Income Taxes.”
Loss from Discontinued Operations, Net of Tax
Loss from discontinued operations reflects ongoing costs, which primarily consist of mortgage loan repurchase representation and warranty charges related to the mortgage origination operations of GreenPoint’s wholesale mortgage banking unit, which we closed in 2007.
We recorded a loss from discontinued operations, net of tax, of $217 million, $106 million and $307 million in 2012, 2011 and 2010, respectively. The variance in the loss from discontinued operations between 2012 and 2011 and between 2011 and 2010 is attributable to the provision for mortgage representation and warranty losses. We recorded a total pre-tax provision for mortgage representation and warranty losses of $349 million, $212 million and $636 million in 2012, 2011 and 2010, respectively. The portion of these amounts included in loss from discontinued operations totaled $307 million ($194 million net of tax) in 2012, $169 million ($120 million net of tax) in 2011 and $432 million ($304 million net of tax) in 2010.
We provide additional information on the provision for mortgage representation and warranty losses and the related reserve for potential representation and warranty claims in “Critical Accounting Polices and Estimates” and “Note 21—Commitments, Contingencies and Guarantees.”
BUSINESS SEGMENT FINANCIAL PERFORMANCE
Our principal operations are currently organized into three major business segments, which are defined based on the products and services provided or the type of customer served: Credit Card, Consumer Banking and Commercial Banking. The operations of acquired businesses have been integrated into our existing business segments. Certain activities that are not part of a segment, such as management of our corporate investment portfolio and asset/liability management by our centralized Corporate Treasury group, are included in the “Other” category.
The results of our individual businesses, which we report on a continuing operations basis, reflect the manner in which management evaluates performance and makes decisions about funding our operations and allocating
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resources. Our business segment results are intended to reflect each segment as if it were a stand-alone business. We use an internal management and reporting process to derive our business segment results. Our internal management and reporting process employs various allocation methodologies, including funds transfer pricing, to assign certain balance sheet assets, deposits and other liabilities and their related revenue and expenses directly or indirectly attributable to each business segment. Total interest income and net fees are directly attributable to the segment in which they are reported. The net interest income of each segment reflects the results of our funds transfer pricing process, which is primarily based on a matched maturity method that takes into consideration market rates. Our funds transfer pricing process provides a funds credit for sources of funds, such as deposits generated by our Consumer Banking and Commercial Banking businesses, and a funds charge for the use of funds by each segment. The allocation process is unique to each business segment and acquired businesses.
We may periodically change our business segments or reclassify business segment results based on modifications to our management reporting methodologies and changes in organizational alignment. In the first quarter of 2012, we re-aligned the loan categories reported by our Commercial Banking business and the loan customer and product types included within each category. As a result of this re-alignment, we now report three product categories: commercial and multifamily real estate, commercial and industrial loans and small-ticket commercial real estate, which is a run-off portfolio. We previously reported four categories within our Commercial Banking business: commercial and multifamily real estate, middle market, specialty lending and small-ticket commercial real estate. Middle market and specialty lending related products are included in commercial and industrial loans. All affordable housing tax-related investments, some of which were previously included in the “Other” segment, are now included in the commercial and multifamily real estate category of our Commercial Banking business. Prior period amounts have been recast to conform to the current period presentation.
We refer to the business segment results derived from our internal management accounting and reporting process as our “managed” presentation, which differs in some cases from our reported results prepared based on U.S. GAAP. There is no comprehensive, authoritative body of guidance for management accounting equivalent to U.S. GAAP; therefore, the managed basis presentation of our business segment results may not be comparable to similar information provided by other financial service companies. In addition, our individual business segment results should not be used as a substitute for comparable results determined in accordance with U.S. GAAP.
Below we summarize our business segment results for 2012, 2011 and 2010 and provide a comparative discussion of these results. We also discuss changes in our financial condition and credit performance statistics as of December 31, 2012, compared with December 31, 2011. We provide additional information on the allocation methodologies used to derive our business segment results and a reconciliation of our total business segment results to our reported consolidated results in “Note 20—Business Segments.” We provide information on the outlook for each of our business segments above under “Executive Summary and Business Outlook.”
Credit Card Business
Our Credit Card business generated income from continuing operations of $1.5 billion in 2012 and $2.3 billion in both 2011 and 2010. The primary sources of revenue for our Credit Card business are interest income and non-interest income from customers and interchange fees. Expenses primarily consist of ongoing operating costs, such as salaries and associate benefits, occupancy and equipment, professional services, communications and data processing technology expenses, as well as marketing expenses.
Significant acquisitions affecting the results of our Credit Card business include: (i) the 2012 U.S. card acquisition, which added approximately $27.8 billion in outstanding credit card receivables designated as held for investment to our Domestic Card business at closing; (ii) the acquisition of the existing Kohl’s credit card loan portfolio, which added approximately $3.7 billion of loans to our Domestic Card business at acquisition; and (iii) the acquisition of the existing HBC loan portfolio, which added approximately $1.4 billion of loans to our International Card business at acquisition. These acquisitions include partnership agreements with third parties to
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offer private-label-credit cards, a substantial majority of which are not for general use and are limited to the products and services sold by the private-label partner. We provide information on the accounting for acquisitions and partnership agreements in “Note 1—Summary of Significant Accounting Policies.”
Table 6 summarizes the financial results of our Credit Card business, which is comprised of Domestic Card, including installment loans, and International Card operations, and displays selected key metrics for the periods indicated.
Table 6: Credit Card Business Results
| (Dollars in millions) |
Year Ended December 31, | Change | ||||||||||||||||||
| 2012 vs. 2011 |
2011 vs. 2010 |
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| 2012 | 2011 | 2010 | ||||||||||||||||||
| Selected income statement data: |
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| Net interest income(1) |
$ | 10,182 | $ | 7,822 | $ | 7,894 | 30 | % | (1 | )% | ||||||||||
| Non-interest income |
3,078 | 2,609 | 2,720 | 18 | (4 | ) | ||||||||||||||
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| Total net revenue(2) |
13,260 | 10,431 | 10,614 | 27 | ||||||||||||||||