DBRS Morningstar Confirms Capital One at A (low); Trend Revised to Negative from Stable

DBRS, Inc. (DBRS Morningstar) confirmed the ratings of Capital One Financial Corporation (Capital One or the Company), including its Long-Term Issuer Rating of A (low) and Short-Term Issuer Rating of R-1 (low). At the same time, DBRS confirmed the ratings of its banking subsidiaries, Capital One Bank (USA), National Association and Capital One, National Association (the Banks). The trend for all long-term ratings has been revised to Negative from Stable. The Intrinsic Assessment (IA) for the Banks is ‘A’, while the Support Assessment remains SA1. The Company’s Support Assessment is SA3 and Capital One’s Long-Term Issuer Rating is positioned one notch below the Banks’ IA.

KEY RATING CONSIDERATIONS
The Negative trend reflects our expectation that the abrupt and severe economic contraction related to the Coronavirus Disease (COVID-19) along with the uncertainty of the magnitude and the duration of this downturn will likely continue to have a significant impact to the Company’s financial results. Specifically, we anticipate continued profitability pressures due to waning loan originations, lower fees and increased credit costs as a result of deteriorating credit performance. Nevertheless, in our view, the unprecedented support measures have been put in place through monetary and fiscal stimulus, along with the relaxed mandates from regulators could help mitigate some of the negative impact of the economic downfall in the near-term. On the other hand, if the coronavirus-induced downturn lasts for a prolonged period or the recovery is anemic, the Company’s ratings would likely come under additional pressure.

The confirmation of the ratings reflects the Company’s strong franchise, distinct and highly profitable business model, disciplined credit risk management, strong and diversified funding profile, and sound capitalization. The ratings also consider Capital One’s revenue concentration and the sizeable exposures to subprime borrowers in its credit card and auto loan portfolios.

RATING DRIVERS
Given the Negative trend, an upgrade of ratings is unlikely. Nonetheless, if the Company were to demonstrate resilient earnings generation and sound balance sheet fundamentals and manageable asset quality deterioration through the coronavirus-related downturn, the trend of the ratings could revert back to Stable. Conversely, a prolonged adverse economic downturn resulting in significantly higher credit losses and a material deterioration in the Company’s earnings, the ratings would be downgraded.

RATING RATIONALE
The Company has a solid franchise with strong brand recognition that operates a regional bank coupled with a national consumer lending franchise. The Company is the third largest U.S. credit card issuer and one of largest online direct banking institutions by deposits in the U.S. The franchise is also supported by the Company’s ongoing efforts in technology infrastructure investments and digital transformation that enhance the depth of its customer relationships. In 2019, Capital One was highly ranked in various J.D. Power customer satisfaction studies related to digital offerings for banking and credit card providers.

We anticipate Capital One’s earnings will remain pressured in the near term due to the economic fallout from the coronavirus pandemic. Historically, the Company’s earnings power has been supported by solid earnings generation and a peer-leading net interest margin, stemming from its highly profitable credit card businesses and disciplined expense management. Nonetheless, non-interest income is more limited compared to other peer banks accounting for 18% of revenues in 2019, relative to the peer average of 28%. As a result of its ongoing digitalization efforts, the Company has made significant strides in improving its operating efficiency (defined as adjusted operating expenses as a percentage of total net revenue) from 49.1% in 2014 to 44.0% in 1Q20. In 2019, the Company reported net income of $5.5 billion, down from $6.0 billion in 2018. After adjusting for acquisition related expenses and other one-time items (incl. gains, reserves), net income was $6.0 billion for 2019, up 8.5% year-over-year (YoY), equating to a strong return on average assets of 1.6%. In 1Q20, Capital One reported a net loss of $1.3 billion, down sharply from $1.4 billion earned in 1Q19, largely due to the reserve build for potential credit losses and the implementation of the Current Expected Credit Loss (CECL) reserve methodology. The Company has also curtailed its marketing expenses in the short-term.

Capital One is highly exposed to the U.S. consumer, including a notable portion in subprime borrowers, a segment that is more susceptible in a downturn, especially if protracted. Further, the Company’s exposure in the oil and gas industry, even though limited (4% of C&I portfolio, or 1% of total loans), is likely to further pressure credit performance. Net charge-offs (NCOs) of $1.8 billion in 1Q20 increased modestly from recent periods to an annualized NCO rate of 2.72%. The allowance for loan and leases at March 31, 2020 represented 5.35% of loans, up significantly from 2.71% of loans at YE19, reflecting the deteriorating economic outlook as well as the CECL adoption on January 1, 2020. The NCO rate of the domestic credit card portfolio was 4.68% in 1Q20, above the industry average of nearly 3.7%, yet well below the peak of 10.48% the Company registered during the Financial Crisis. The loans loss reserve allowance for the domestic card portfolio stood at 8.95% of balances at March 31, 2020. Lastly, the 2019 cybersecurity incident, while a minor setback for operational risk management, the Company’s swift response in identifying and fixing the underlying vulnerability has better positioned it to prevent similar occurrences in the future.

The Company has a strong and diversified funding profile underpinned by a large, defensible regional deposit franchise along with national online deposit gathering capabilities. As of March 31, 2020, Capital One’s deposit funding of $269.7 billion is mostly comprised of consumer deposits and accounted for 83% of its total funding. The Company’s funding sources are supplemented by senior unsecured debt and asset backed securitizations accounting for 12% and 5% of its total funding, respectively. The Company has ample liquidity sources totaling $105.9 billion including cash and cash equivalents of $24.9 billion and unencumbered investment securities of $75.7 billion. Further, Capital One maintains an elevated level of high-quality liquid assets as evidenced by the liquidity coverage ratio (LCR) of 145% at March 31, 2020, that is well above of the minimum requirement of 100%.

Capital One’s common equity Tier 1 ratio was a sound 12.0% at March 31, 2020 given its risk profile and underlying earnings generation ability. The Company elected to defer recognition of the estimated impact of CECL on regulatory capital for two years and it will be phased in over a three year period starting in 2022, in accordance with the interim final rule adopted by the Fed in March’20. Capital One suspended its share repurchase program in March’20 to fortify its capital base in response to the coronavirus pandemic but it expects to maintain its quarterly dividend of $0.40 per share.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

The Grid Summary Grades for Capital One Financial Corporation are as follows: Franchise Strength – Strong/Good; Earnings Power – Strong/Good; Risk Profile – Good; Funding & Liquidity – Strong; Capitalisation – Strong/Good.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 11, 2019), which can be found on our website under methodologies and criteria: https://www.dbrsmorningstar.com/research/346375/global-methodology-for-rating-banks-and-banking-organisations.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The primary sources of information used for this rating include Company Documents and S&P Global Market Intelligence. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did not participate in the rating process for this rating action. DBRS Morningstar did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

This is an unsolicited credit rating.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com

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