Discover Financial Services : 3Q 2020 Basel III Disclosures

DISCOVER FINANCIAL SERVICES

Basel III Regulatory Capital Disclosures

For the Quarterly Period Ended September 30, 2020

DISCOVER FINANCIAL SERVICES
Basel III Regulatory Capital Disclosures for the Quarterly Period Ended September 30, 2020
TABLE OF CONTENTS
Disclosure Road Map...................................................................................................................................	1
Overview....................................................................................................................................................	2
Scope of Application....................................................................................................................................	3
Capital Structure..........................................................................................................................................	4
Capital Adequacy........................................................................................................................................	5
Capital Conservation Buffer..........................................................................................................................	6
Credit Risk: General Disclosures....................................................................................................................	7
Counterparty Credit Risk-RelatedExposures: General Disclosures....................................................................	9
Credit Risk Mitigation...................................................................................................................................	10
Securitization..............................................................................................................................................	10
Equities Not Subject to Market Risk Rule........................................................................................................	11
Interest Rate Risk for Non-TradingActivities...................................................................................................	11

Except as otherwise indicated or unless the context otherwise requires, "Discover Financial Services," "Discover," "DFS," "we," "us," "our," and "the Company" refer to Discover Financial Services and its subsidiaries.

Disclosure Road Map

The following table provides page references for disclosures that can be found in the Company's Quarterly Report on Form 10-Q and Annual Report on Form 10-K relating to topics addressed in this Basel III disclosure report:

		Basel III		3rd Quarter	2019
		2020			Annual
		Report		Form 10-Q			Report
Topic	Subtopic		Page Reference(s)
Overview	Introduction........................................................	2
	Basel III and Regulatory Capital Disclosure Report..	2	30-31			119-120
Scope of Application	Basis of Consolidation.........................................	3					80
	Capital in Subsidiaries.........................................	3
	Restrictions on Capital.........................................	3					18-19
Capital Structure	Regulatory Capital Instruments.............................	4					113
	Regulatory Capital Ratios.....................................	4	31			120
Capital Adequacy	Capital Planning and Management.......................	5	30-31			119-120
	Standardized Approach Risk-Weighted Assets......	6
	Risk-BasedCapital Ratios.....................................	6	31			120
Capital Conservation Buffer		6	75-77			66-68
Credit Risk: General Disclosures	Credit Risk Management Objectives and Policies...	7					5-6,10-16
	Past Due and Impaired Loans...............................						82-83,
		7	12-20			86-87,
				93-100
	Allowance for Credit Losses..................................	7	21-22
	Credit Risk Exposures..........................................	7	11-22			92-100
Counterparty Credit Risk-Related Exposures:	Counterparty Credit Risk Exposures......................	9	39-43			129-133
General Disclosures	Methodology Used to Assign Derivative Credit
	9
	Limits..................................................................
	Policies for Securing, Valuing and Managing
	Collateral for Derivatives and Establishing Credit	9
	Reserves.............................................................
	Primary Types of Collateral for Derivatives	10
	Exposures...........................................................
	Impact of Downgrade in Creditworthiness on	10
	Derivatives Collateral...........................................
Credit Risk Mitigation		10
Securitization	Securitization Activities........................................	10	22-24			101-102
Equities Not Subject to Market Risk Rule	Overview............................................................	11
	Risk Weighting....................................................	11
Interest Rate Risk for Non-Trading Activities		11	78-79			69-70

1

Overview

Introduction

Discover Financial Services ("DFS" or the "Company") is a direct banking and payment services company. We were incorporated in Delaware in 1960. We are a bank holding company ("BHC") under the Bank Holding Company Act of 1956 as well as a financial holding company under the Gramm-Leach-Bliley Act and therefore are subject to oversight, regulation and examination by the Board of Governors of the Federal Reserve System (the "Federal Reserve"). We provide direct banking products and services and payment services through our subsidiaries. We offer our customers credit card loans, private student loans, personal loans, home equity loans and deposit products. We operate the Discover Network, the PULSE network ("PULSE"), and Diners Club International ("Diners Club"). The Discover Network processes transactions for Discover-branded credit and debit cards and provides payment transaction processing and settlement services. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE network with access to ATMs domestically and internationally, as well as merchant acceptance throughout the U.S. for debit card transactions. Diners Club is a global payments network of licensees, which are generally financial institutions, that issue Diners Club branded charge cards and/or provide card acceptance services.

Our main banking subsidiary, Discover Bank, offers credit card loans, student loans, personal loans and home equity loans as well as certificates of deposit, savings and checking accounts and other types of deposit accounts. Discover Bank is chartered and regulated by the Office of the Delaware State Bank Commissioner, and is also regulated by the Federal Deposit Insurance Corporation (the "FDIC"), which insures its deposits up to applicable limits and serves as the bank's primary federal banking regulator.

Basel III and Regulatory Capital Disclosure Report

The Company and Discover Bank are subject to regulatory capital rules issued by the Federal Reserve and FDIC, respectively, under the Basel Committee's December 2010 framework ("Basel III rules"). The Basel III rules, which became effective for the Company January 2015, were subject to phase-in periods through the end of 2018 based on the Company being classified as a "Standardized Approach" entity. On March 27, 2020, federal bank regulatory agencies announced an interim final rule, which has since been adopted as a final rule, that allows banks that have implemented the current expected credit losses ("CECL") standard the option to delay for two years the estimated impact of CECL on regulatory capital, followed by a three-year transition period. For purposes of calculating regulatory capital, the Company has elected to defer recognition of the estimated impact of CECL on regulatory capital for two years in accordance with the federal bank regulatory agencies final rule published on September 30, 2020. Pursuant to the final rule, the estimated impact of CECL on regulatory capital will be phased in over a three-year period beginning in 2022. See Note 12: Capital Adequacy of the Company's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2020 ("3Q20 Form 10-Q") for a detailed discussion of Basel III requirements.

The Basel III rules are designed to establish a more risk-sensitive approach to capital management and require the Company to publicly disclose certain qualitative and quantitative information regarding its capital structure and adequacy, credit risk and related mitigation policies, securitizations, equity exposures, operational risk, and other matters. The qualitative and quantitative information included are commonly referred to as the "Pillar 3 Disclosures." The U.S. regulators have required the Pillar 3 Disclosures, with an expressed objective of improving market discipline and encouraging sound risk management practices. This report provides the required disclosures or references to other publicly-available documents where they are located and includes information on the methodologies used to calculate risk-weighted assets ("RWA").

This report should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2019 ("2019 Form 10-K"), 3Q20 Form 10-Q and Federal Reserve FR Y-9C form for the year-to-date period ended September 30, 2020, as well as Discover Bank's Call Report ("Call Report") for the year-to-date period ended September 30, 2020, which include important information on risk management policies and practices and regulatory capital ratios. A disclosure road map is contained herein.

2

Scope of Application

Basis of Consolidation

The basis of consolidation used for regulatory reporting is the same as that used under U.S. Generally Accepted Accounting Principles ("GAAP"). See Note 1: Background and Basis of Presentation in the 2019 Form 10-K for details on the Company's principles of consolidation.

Capital in Subsidiaries

At September 30, 2020, the Company did not have any subsidiaries whose regulatory capital was less than the minimum required regulatory capital amount. The Company does not have any insurance subsidiaries subject to the Basel III rules.

Restrictions on Capital

The Federal Reserve requires a BHC to inform and consult with the Federal Reserve before declaring and paying any dividends that would cause an institution to be inadequately capitalized. The declaration and payment of future dividends are subject to the discretion of our board of directors and the Federal Reserve's non-objection to our capital plan. The amount and size of any future dividends and share repurchases will depend upon our results of operations, financial condition, capital levels, cash requirements, future prospects, regulatory review and other factors as further described in "Business - Supervision and Regulation - Capital, Dividends and Share Repurchases" in the 2019 Form 10-K. Holders of our shares of common stock are subject to the prior dividend rights of holders of our preferred stock or the depositary shares representing such preferred stock outstanding, and if full dividends have not been declared and paid on all outstanding shares of our preferred stock in any dividend period, no dividend may be declared or paid on or set aside for payment on our common stock. Pending the resubmission of our capital plan, the Federal Reserve has capped our capital distributions based on a formula that restricts most share repurchases and limits dividends based on average net income during the past four quarters. Banking laws and regulations and our banking regulators may limit or prohibit our payment of dividends on or our repurchase of our stock at any time. There can be no assurance that we will declare and pay any dividends on or repurchase our stock in the future. At September 30, 2020, the Company was "well-capitalized" as defined in Regulation Y.

Discover Financial Services, our parent holding company, depends on dividends, distributions and other payments from its subsidiaries, particularly Discover Bank, to fund dividend payments, share repurchases, payments on its obligations, including debt obligations, and to provide funding and capital as needed to its operating subsidiaries. Banking laws and regulations and our banking regulators may limit or prohibit our transfer of funds freely, either to or from our subsidiaries, at any time. These laws, regulations and rules may hinder our ability to access funds that we may need to make payments on our obligations or otherwise achieve strategic objectives. For more information, see "Business

- Supervision and Regulation - Capital, Dividends and Share Repurchases" in the 2019 Form 10-K.

The Federal Deposit Insurance Act ("FDIA") imposes various requirements on insured depository institutions. For example, the FDIA requires, among other things, the federal banking agencies to take "prompt corrective action" in respect of depository institutions that do not meet minimum capital requirements. The FDIA sets forth the following five capital tiers: "well-capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." A depository institution's capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors that are established by regulation. At September 30, 2020, Discover Bank met all applicable requirements to be deemed "well-capitalized."

The FDIA also prohibits any depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be "undercapitalized." "Undercapitalized" institutions are subject to growth limitations and are required to submit a capital restoration plan. For a capital restoration plan to be acceptable, among other things, the depository institution's parent holding company must guarantee that the institution will comply with the capital restoration plan. For more information on FDIA regulations, see "Business - Supervision and Regulation - FDIA" in the 2019 Form 10-K.

3

Capital Structure

Regulatory Capital Instruments

The Company's regulatory capital instruments consist of common stock, preferred stock and subordinated debt. The following table presents components of the Company's capital structure on a transitional basis (dollars in millions):

	September 30,
		2020
Common stock............................................................................................................................................................................	$	6
Additional paid-incapital............................................................................................................................................................		4,235
Retained earnings.......................................................................................................................................................................		21,793
Accumulated other comprehensive (loss) income...........................................................................................................................		93
Treasury stock............................................................................................................................................................................		(14,430)
Common shareholder's equity..................................................................................................................................................		11,697
Less: Deductions for goodwill and intangible assets, net of deferred tax liabilities.............................................................................		335
Less: Deductions for AOCI related adjustments..............................................................................................................................		93
Common equity tier 1..............................................................................................................................................................		11,269
Perpetual non-cumulativepreferred stock......................................................................................................................................		1,056
Tier 1 capital..........................................................................................................................................................................		12,325
Qualifying subordinated debt......................................................................................................................................................		517
Other elements of tier 2 capital....................................................................................................................................................		1,204
Tier 2 capital..........................................................................................................................................................................		1,721
Total capital.......................................................................................................................................................................	$	14,046

For terms and conditions related to the Company's common and preferred stock, refer to Note 8: Preferred Stock and "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Capital" in the 3Q20 Form 10-Q and Note 12: Common and Preferred Stock in the 2019 Form 10-K.

The following table presents the terms and conditions of the Company's qualifying subordinated debt (dollars in millions):

	Issuance Date	Interest	Interest Rate	Maturity		Par
	Rate	Terms
At September 30, 2020
Discover Bank
Subordinated bank notes due 2028...............................	August 9, 2018	4.68 %	Fixed	August 9, 2028	$	500

The subordinated debt is subject to a Basel III provision that limits its amount that can be included on the BHC level. That limitation is imposed on capital instruments issued by a consolidated bank subsidiary of BHC as availability of this capital might be limited to the BHC.

Regulatory Capital Ratios

For the Company's capital ratios and related components, as of September 30, 2020, see Note 12: Capital Adequacy in the 3Q20 Form 10-Q and Schedule HC-R in the 3Q20 FR Y-9C report.

4

Capital Adequacy

Capital Planning and Management

Discover's capital planning and management framework is designed to ensure that the Company maintains sufficient capital consistent with its risk profile and all applicable regulatory standards and guidelines. The framework encompasses forecasting capital levels, establishing capital targets, monitoring capital adequacy against targets, maintaining appropriate contingency capital plans and identifying strategic options to deploy excess capital.

The regulations resulting from the Economic Growth, Regulatory Relief, and Consumer Protection Act were largely finalized in fall 2019. Under the final rules, Discover is categorized as a Category IV institution and therefore subject to the least stringent requirements for bank holding companies with at least $100 billion in assets. Among other things, Discover is subject to supervisory stress tests every other year rather than annually, is no longer subject to regulations requiring submission of company-run capital stress tests and is no longer subject to the liquidity coverage ratio. However, Discover is still required to submit annual capital plans to the Federal Reserve and remains subject to other core components of the enhanced prudential standards rules, such as risk management and risk committee requirements and liquidity risk management regulations.

Discover was notified of the requirement to submit a capital plan to the Federal Reserve and participate in its 2020 Comprehensive Capital Analysis and Review ("CCAR") stress tests. Despite not being subject to the CCAR process in 2019, Discover was still required to prepare and submit a capital plan that was approved by its Board of Directors, which contained planned capital distributions for the period from July 1, 2019 to June 30, 2020 based on a formula that was largely based on results from the Federal Reserve's 2018 CCAR stress test. On June 25, 2020, Discover received results of the Federal Reserve's supervisory stress tests and preliminary Stress Capital Buffer ("SCB") requirement. The notice indicated that Discover's capital ratios remain above all required minimums under each of the supervisory scenarios and its preliminary SCB requirement was set at 3.5%, which was announced as final in a public notice issued by the Federal Reserve on August 10, 2020. In addition to the stress test and SCB results, the Federal Reserve also notified Discover that it and all other firms that participated in the 2020 CCAR exercise would be required to submit a revised capital plan that will be assessed by the Federal Reserve later this year under newly developed scenarios incorporating economic stresses reflecting the ongoing COVID-19 pandemic. Discover's revised capital plan was submitted to the Federal Reserve on November 2, 2020, with the Federal Reserve planning to release firm-specific results via public disclosure before the end of the year. It is not yet known whether the Federal Reserve will utilize the capital plan resubmission to adjust firms' SCB or distribution limits. In the interim, for both the third and fourth quarters of 2020, the Federal Reserve has capped covered firms' capital distributions based on a formula that restricts most share repurchases and limits dividends based on average net income during the past four quarters. Consistent with regulatory expectations, our management also continues to conduct forward-looking sensitivity analysis and stress tests to assess the potential impact of economic changes resulting from the COVID-19 pandemic on capital planning and provides this information to our Board of Directors as well as our regulators. For more information, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Regulatory Environment and Developments" in the 3Q20 Form 10-Q.

5

Standardized Approach Risk-Weighted Assets

RWA are an institution's assets and off-balance-sheet exposures, weighted according to the risk categories prescribed in the Basel III rules. Percentage of RWA is used to determine minimum capital requirements.

The following table presents components of Discover's RWA in accordance with the standardized approach, subject to transitional provisions (dollars in millions):

	September 30,
		2020
On-balance sheet:
Exposure to depository institutions and foreign banks.................................................................................................................	$	315
Exposures to GSE(1) and PSE(2)..................................................................................................................................................		2,198
Credit card receivable.............................................................................................................................................................		68,697
Personal and student loans receivable.......................................................................................................................................		17,153
Residential mortgage exposure.................................................................................................................................................		1,539
Retail exposure...................................................................................................................................................................		87,389
Past due exposure(3)................................................................................................................................................................		1,310
Equity exposures.....................................................................................................................................................................		487
Other exposures(4)...................................................................................................................................................................		3,769
Off-balance sheet:
Off-balancesheet derivatives...................................................................................................................................................		-
Off-balancesheet commitments................................................................................................................................................		176
Off-balancesheet repo-styletransactions(5)................................................................................................................................		692
Allowance for credit losses excluded from RWA............................................................................................................................		(3,979)
Total standardized risk-weightedassets........................................................................................................................................	$	92,357

1. Government -sponsored entity ("GSE")
2. Public sector entity ("PSE")
3. Includes 90 days past due and non-accruing loans.
4. Includes $159 million of business card receivables classified as commercial loans under regulatory guidelines.
5. Includes amounts related to a securities lending transaction in September 2020. See Note 2: Investments in the 3Q20 Form 10-Q for additional information.

Risk-Based Capital Ratios

For CET1, tier 1 and total risk-based capital ratios as of September 30, 2020, as calculated under the Basel III Standardized Approach framework for Discover Financial Services and Discover Bank, see Note 12: Capital Adequacy in the 3Q20 Form 10-Q.

Capital Conservation Buffer

Per the Basel III rules, effective January 2016, the Company and its Bank subsidiary are subject to a capital conservation buffer. Under this requirement, a covered institution is subject to limitations on its ability to make distributions of capital or make discretionary bonus payments unless it maintains a buffer of capital, composed solely of CET1, sufficient to exceed each of the minimum regulatory capital ratios applicable to the institution by more than 2.5%. The capital conservation buffer is a complementary requirement to the Prompt Corrective Action ("PCA") framework described in Basel III rules.

On March 4, 2020, the Federal Reserve announced the SCB final rule, which will impose limitations on capital distributions if DFS does not maintain capital to meet a calculated level above stated minimum regulatory capital ratios that are based on the results of supervisory stress tests. DFS participated in the CCAR supervisory stress test this year and

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received an SCB of 3.5%, which primarily reflects the difference between the actual CET1 ratio as of the fourth quarter of 2019 and the projected minimum CET1 ratio based on the Federal Reserve's models in its nine-quarter Severely Adverse stress scenario. The SCB became effective October 1, 2020. Under this rule, DFS will be required to assess if planned capital actions are consistent with the effective capital distributions limitations that will apply on a pro-forma basis throughout the planning horizon (i.e., the stress capital buffer). For results of the Federal Reserve's supervisory stress tests and preliminary stress capital buffer, see "- Capital Adequacy - Capital Planning and Management" above. For more information, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" in the 3Q20 Form 10-Q.

The Company and its Bank subsidiary each maintained a buffer of CET1 capital sufficient to meet the capital

conservation buffer requirements as of September 30, 2020. For Discover Financial Services' capital conservation buffer, see Schedule HC-R Part I in the 3Q20 FR Y-9C report. For Discover Bank's capital conservation buffer, see Schedule RC-R Part I in the 3Q20 Call Report.

The Company's eligible retained income at September 30, 2020 was $262 million. The Company is not subject to any limitations on distributions and discretionary bonus payments resulting from the capital conservation buffer framework.

Credit Risk: General Disclosures

Credit Risk Management Objectives and Policies

Credit risk management is a critical component of our management and growth strategy. Credit risk refers to the risk of loss arising from borrower default when borrowers are unable or unwilling to meet their financial obligations to us. Our credit risk arising from consumer lending products is generally highly diversified across millions of accounts without significant individual exposures. We manage credit risk primarily based on customer segments and product types. See "Business - Credit Risk Management" and "Business - Risk Management" in the 2019 Form 10-K for more information regarding how we define and manage our credit and other risks.

Past Due and Impaired Loans

For the Company's significant accounting policies regarding past due, non-accrual and impaired loans and charge-offs of uncollectible amounts, see Note 2: Summary of Significant Accounting Policies in the 2019 Form 10-K and Note 3: Loan Receivables in the 3Q20 Form 10-Q.

Allowance for Credit Losses

For the Company's significant accounting policies regarding the allowance for credit losses, see Note 3: Loan Receivables in the 3Q20 Form 10-Q.

Credit Risk Exposures

The following table presents the major types of credit exposure relevant to the Company (dollars in millions):

	September 30,	QTD Average
		2020
Cash and cash equivalents(1).............................................................................................................................	$	1,576	$	5,701
Loans held for investment ("LHFI")(2)...................................................................................................................	$	88,660	$	88,422
Unused commitments(3).....................................................................................................................................	$	214,715	$	214,395
Debt securities(4)...............................................................................................................................................	$	28,902	$	15,289

1. Excludes cash held with the Federal Reserve.
2. Includes credit card, student, personal and other loans.
3. Primarily includes credit cards.
4. Includes amounts related to a securities lending transaction in September 2020. See Note 2: Investments in the 3Q20 Form 10-Q for additional information.

Virtually all of the Company's unused commitments are unconditionally cancellable and receive zero conversion factor for the purpose of risk-based capital calculations.

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The following table presents the geographic distribution of the loans held for investment (dollars in millions):

		(1)			Unused	(2)
		LHFI		commitments
At September 30, 2020
California..........................................................................................................................................................	$	7,970	$	20,459
Texas................................................................................................................................................................		7,205			17,029
New York..........................................................................................................................................................		6,587			14,138
Florida..............................................................................................................................................................		5,716			14,647
Illinois................................................................................................................................................................		4,811			11,862
Pennsylvania......................................................................................................................................................		4,802			11,638
Ohio.................................................................................................................................................................		3,654			9,577
New Jersey........................................................................................................................................................		3,525			7,975
Georgia............................................................................................................................................................		2,623			5,779
Michigan...........................................................................................................................................................		2,519			6,355
Other................................................................................................................................................................		39,248			95,256
Total..................................................................................................................................................................	$	88,660	$	214,715

1. Includes credit card, student, personal and other loans.
2. Primarily includes credit cards.

All debt securities held by the Company are issued by domestic parties. Cash and cash equivalents held in accounts located outside of U.S. by all Discover entities amounted to $31.2 million as of September 30, 2020.

The following table presents the counterparty type distribution of credit exposures (dollars in millions):

				Sovereign		Banks &
		Retail		(including		Brokerage		Other
			GSE)	companies(1)
At September 30, 2020
Cash and cash equivalents(1).............................................................................	$	-	$	-	$	1,576	$	-
LHFI................................................................................................................	$	88,447	$	-	$	-	$	213
Unused commitments........................................................................................	$	213,699	$	-	$	-	$	1,016
Debt securities(2)...............................................................................................	$	-	$	28,902	$	-	$	-
Loans past due 90 days and non-accruing.........................................................	$	51	$	-	$	-	$	-
Loans past due 90 days and still accruing	$	655	$	-	$	-	$	2

1. Excludes cash held with the Federal Reserve.
2. Includes amounts related to a securities lending transaction in September 2020. See Note 2: Investments in the 3Q20 Form 10-Q for additional information.

The following table presents the remaining contractual maturity delineation of the LHFI portfolio(1) (dollars in millions):

	September 30,
		2020
One year or less.........................................................................................................................................................................	$	60,237
Over one year through five years.................................................................................................................................................	$	15,308
Over five years...........................................................................................................................................................................	$	12,887

(1) Includes fixed rate credit cards in the over one year through five years classification per Call Report guidelines and excludes loans in non-accrual status.

See the following references to the Company's 3Q20 Form 10-Q for quantitative information regarding credit risk exposures, which are presented in accordance with U.S. GAAP.

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Loan Receivables

• See Note 3: Loan Receivables for information on loans outstanding, non-accrual, delinquent, and impaired loans, as well as charge-offs during the period. Discover does not identify impaired or past due loans by significant geographic area.

Allowance for Credit Losses

• See Note 3: Loan Receivables for a reconciliation of changes in the allowance for credit losses.

Counterparty Credit Risk-Related Exposures: General Disclosures

Counterparty Credit Risk Exposures

With respect to derivatives, counterparty credit risk is the risk that the counterparty to a derivative transaction could default before final settlement of the transaction's cash flows. For derivatives, the Company's counterparty credit risk arises primarily from interest rate swap transactions and foreign exchange forward transactions. For non-cleared transactions, the Company has master netting arrangements and minimum collateral posting thresholds with its derivative counterparties for these fair value and cash flow hedge interest rate swaps and foreign exchange forward contracts. For cleared transactions, the Company trades through clearing members of a central counterparty ("CCP") exchange such that all positions traded through the CCP clearing member are netted and collateralized per the rules of the exchange. Certain cash collateral amounts associated with derivative positions that are cleared through a CCP exchange are legally characterized as settlement of the derivative positions and are reflected as offsets to the associated derivatives balances recorded in other assets or in accrued expenses and other liabilities, instead of as collateral in other assets or deposits. For more information on the Company's counterparty credit risk-related exposures for derivatives, see Note 16: Derivatives and Hedging Activities in the 3Q20 Form 10-Q.

With respect to securities repurchase and reverse repurchase transactions, counterparty credit risk is the risk that the counterparty to a transaction could default before the securities and cash (plus interest) in the transaction have been returned to their original owners. For securities repurchase and reverse repurchase transactions, the Company's counterparty credit risk arises from its use of securities repurchase and reverse repurchase agreements with major broker- dealer counterparties or central banks using primarily U.S. Treasury and/or Agency securities as collateral.

Methodology Used to Assign Counterparty Credit Limits

The process for approving a counterparty's credit risk exposure limit is guided by: core credit policies, procedures and standards as well as the experience and judgment of credit risk professionals. The process applies to all investment and hedging activities conducted by the Company's Treasury group and includes the determination of maximum potential exposure to each counterparty after taking into account market volatility, netting agreements and collateral support as appropriate.

Internal ratings are assigned to each counterparty and reflect a range of factors including the financial condition of the counterparty, the strength of its management, the business profile of the counterparty and the regulatory environment facing the counterparty. These factors are taken into consideration in setting counterparty credit exposure limits, which drive internal approval levels.

Credit risk analysts conduct daily monitoring of exposures versus limits and any resulting issues are escalated per policy to risk officers and senior management as appropriate.

Policies for Securing, Valuing and Managing Collateral and Establishing Credit Reserves

The Company's policies and procedures cover management and governance of financial assets (including securing and valuing collateral) utilized for the purpose of mitigating counterparty credit risk. Specifically, the Company's Corporate Risk Management group considers standard eligibility criteria and market value haircuts for any collateral used to reduce estimated net exposures in the Company's transactions. Industry standard legal agreements combined with internal reviews for legal enforceability are employed to ensure that the Company's rights to collateral are appropriately protected.

Where collateral is used to offset estimated net exposure, the current market value of collateral is monitored on a regular basis. Margin procedures have been established by the Company's Treasury group for managing margin calls in order to maintain an appropriate level of collateral coverage in light of market value fluctuations and CCP exchange rules. Trades are reconciled on a daily basis, consistent with regulatory guidance and industry best practice, and margin

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dispute processes are in place. Counterparty credit risk arising from derivative transactions, and securities repurchase and reverse repurchase transactions is mitigated through these margining processes and the regular monitoring of exposures.

Primary Types of Collateral for Derivatives Exposures

Cleared transactions are cash settled on a daily basis, with cash and U.S. Treasury securities used to meet daily margin requirements, per CCP exchange rules. Cash collateral and U.S. Treasury securities are used to secure the net open exposure of non-cleared derivative transactions.

Impact of Downgrade in Creditworthiness on Derivatives Collateral

Some of the Company's agreements with derivatives counterparties contain provisions that require DFS or Discover Bank to post additional collateral if a specified minimum credit rating is not maintained with certain major credit rating agencies.

Discover Bank's credit rating met all specified ratings thresholds set by its derivatives counterparties at September 30, 2020. However, if Discover Bank's credit rating were reduced below investment grade, Discover Bank would be required to post additional collateral with its derivatives counterparties, which, as of September 30, 2020, would have been $9 million. DFS (Parent Company) had no outstanding derivatives as of September 30, 2020, therefore, no collateral was required.

Credit Risk Mitigation

As part of its risk management activities, Discover uses various risk mitigants to manage portions of the credit risk in its portfolios. Credit risk mitigation is important to the Company in the effective management of its credit risk exposures. A majority of the Company's assets are comprised of credit card receivables, with unfunded commitments that are unconditionally cancelable.

The sole asset category of the Company that benefits from collateral in order to reduce capital requirements are loans, secured by 1-4 family residential properties. As of September 30, 2020, RWA was reduced by $188 million as a result of collateral held against those loans, which represents only 0.20% of total RWA and has no impact on Discover's capital ratios.

As of September 30, 2020, Discover does not utilize credit derivatives as a risk mitigation tool.

Securitization

Securitization Activities

The Company engages in credit card and student loan securitization activities. The Company's securitizations are accounted for as secured borrowings and the trusts are treated as consolidated subsidiaries of the Company. The assets of the Company's consolidated variable interest entities ("VIEs") are restricted from being sold or pledged as collateral for other borrowings and the cash flows from these restricted assets may be used only to pay obligations of the trusts. The related debt issued by all securitization trusts is reported in long-term borrowings.

The Company accesses the term asset securitization market through the Discover Card Master Trust I ("DCMT") and the Discover Card Execution Note Trust ("DCENT"). Credit card loan receivables are transferred into DCMT and beneficial interests in DCMT are transferred into DCENT. Interests in DCENT are issued to investors in the form of debt securities.

Student loan trust receivables underlying third-party investors' interests are recorded in student loans. See Note 4: Credit Card and Student Loan Securitization Activities in the 3Q20 Form 10-Q for more information on the Company's credit card and student loan securitization activities.

The total outstanding principal amount of assets securitized by Discover does not meet operational criteria as defined in the Basel III rules. The underlying assets are reconsolidated in the balance sheet and accordingly risk weighted based on their balance sheet classification for Basel III purposes. In addition, Discover did not hold investments in asset- backed securities subject to Basel III securitization disclosure requirements as of September 30, 2020. As a result, Table 8 of disclosure requirements under section 217.63 is not applicable to Discover at this time.

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Equities Not Subject to Market Risk Rule

Overview

Discover makes investments in equities with objectives of: (i) generating capital gains; (ii) fostering strategic relationships; and (iii) fulfilling Community Reinvestment Act requirements. None of the Company's equity investments are publicly traded or are included in tier 1 or tier 2 capital.

The following table presents the carrying value and fair value of the Company's equity investments (dollars in millions):

		Carrying		Fair Value
		Value
At September 30, 2020
Equity investments...............................................................................................................................................	$	939	$	939

Risk Weighting

The Company utilizes different approaches in calculating RWA for equity exposures not subject to market risk capital rules. Simplified Risk-Weight Approach ("SRWA") is used to risk weight community development and non- significant equity exposures. Under SRWA, adjusted carrying value for each type of equity exposure is multiplied by the prescribed risk weight. The adjusted carrying value for an on-balance sheet exposure is the carrying value of the exposure. Equity investments are considered non-significant if the aggregate adjusted carrying value of the exposures does not exceed 10 percent of a banking organization's total capital.

Alternative Modified Look-Through Approach is used to calculate RWA amounts for equity exposures to investment funds. Using the Alternative Approach, the adjusted carrying value of an equity exposure to an investment fund is assigned on a pro-rata basis to the different risk weight categories based on the investment limits in the fund's prospectus, partnership agreement, or similar contract that defines the fund's permissible investments. It is assumed the fund invests to the maximum extent permitted under its investment limits in the exposure type with the highest applicable risk weight and continues to make investments in order of the exposure type with the next highest applicable risk weight, until the maximum total investment is reached. The assignment of the pro-rata investment limits risk weights for all exposure types within the fund will not exceed 100 percent.

The following table presents the Company's equity exposures not subject to the Basel III market risk capital rule, using the Simplified Risk-Weight Approach and the Alternative Modified Look-Through Approach (dollars in millions):

	Risk		Exposure			RWA
	Weight %
At September 30, 2020
Community development equity exposure....................................................................................	100%	$	323	$	323
Non-significantequity exposure..................................................................................................	100%		40			40
Modified look-through...............................................................................................................			576			124
Total equity exposure not subject to the Basel III market risk capital rule......................................		$	939	$	487

Interest Rate Risk for Non-Trading Activities

For information on the Company's interest rate risk related to non-trading activities, see "Quantitative and Qualitative Disclosures About Market Risk" in the 3Q20 Form 10-Q.

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