How Capital One’s Bid for Discover Could Shift Payments Competitive Balance

Capital One's proposed purchase of Discover Financial Services has a long regulatory road ahead of it. If the combo finds favor in Washington, Capital One will gain vertical payments integration as it picks up Discover's credit and debit networks, putting it into a unique league with American Express and providing an alternative to its longstanding relationships with Visa and Mastercard. If it works, Capital One's Richard Fairbank sees those ties holding for a long time to come.

Now that the smoke has cleared a bit from the initial bombshell announcement in mid-February of Capital One’s proposed acquisition of Discover, the banking and payments industries have had the opportunity to assess the deal’s impact on competition going forward. Like much in the payments business, little about that assessment will be simple. The competitive aspects change depending on which angle you examine the deal from.

How does the competitive picture change when Capital One picks up Discover’s network?

The arguable centerpiece of the deal is Discover’s network for accepting its own credit and debit cards as well as those of approximately 4,500 other depository institutions. Richard Fairbank, founder, chairman and CEO at Capital One, has noted that building a worldwide network for Discover cards took the target company about four decades. Capital One will gain that in one stroke.

This will bring rare vertical integration to one of the leading U.S. payments companies, granting it direct connections to merchants — not to mention fee income that usually goes to other parties, notably the Mastercard and Visa networks.

These fees will supplement card lending income. Discover’s network is not covered by debit interchange pricing rules set by the 2010 Durbin amendment to the Dodd-Frank Act, unlike the third-party networks run by Mastercard and Visa. The distinction lies in the merchant relationship. The latter deal with merchants on card issuers’ behalf, while Discover and American Express are both issuers and network operators and deal directly with merchants.

“Within the first few years, we will move our entire debit business and a portion of our credit card business to the Discover network,” Fairbank said. Why not shift it all? Fairbank says work needs to be done to build the brand and the perceived acceptance of the Discover network before Capital One can move its entire credit side.

Part of the reason the proposed deal has been hailed in some quarters — and a key to approval by regulators — is that putting Capital One’s muscle behind Discover’s network will create more competition for Visa and Mastercard, the two network leaders. Even so, Fairbank foresees continued partnering with the two payments giants for quite some time.

“It’s not unusual for companies to be both competitors and customers of one another in the credit card market alone,” let alone the payments business in general, said Fairbank.

In fact, the payments business has long been fraught with “coopetition,” according to Erin McCune, expert partner in payments at Bain & Co. The foundations of much of today’s payments infrastructure — the Visa and Mastercard networks, Early Warning Services and its cooperative anti-fraud measure and later Zelle, and more recently Paze, for example — depend on competitors working together for a common goal or system, according to McCune.

“They have all been means to collaborate on payments work best done on a massive scale,” McCune explains, while taking nothing away from the competitive struggles between the different brands and companies.

Read more: Are Banks Missing the Revenue Potential of Instant Payments?

What happens to the Discover brand if and when the merger gets approved?

Fairbank has said that the combined companies won’t be in a hurry to ditch the Discover brand. Certainly, among the companies using its Pulse PIN debit network, he sees the Discover name as an important carryover, rather than pushing the thousands of players under the Capital One branding.

“On the network side, this is a branded treasure,” said Fairbank. “We would absolutely keep the brand, to invest to build the scale and salience of the network.”

Even some consumer products will likely retain Discover branding, with the public eventually coming to see Discover as a sub-brand, Fairbank says. He believes there is a good deal of loyalty to the current company.

Independent research bears this out. John Cabell, managing director of payments at J.D. Power, says the body of the firm’s research in recent years indicates that Discover cardholders tend to maintain longer-term relationships than do Capital One cardholders. He says treating these acquired customers right will be a key element in making the deal work. Discover users tend to use their cards somewhat less than Capital One customers, he adds. So, this is a potential opportunity for growth if the buyer keeps them happy.

Read more: Should Banks Beware Credit Score ‘Grade Inflation’?

How big a deal is the proposed merger?

Payment consultant Richard Crone calls it “a once in an industry lifetime opportunity. This is like buying the unique corner lot that comes onto the market once every 30 years.”

“This is like buying the unique corner lot that comes onto the market once every 30 years.”
— Richard Crone, payments consultant

Crone says it is amazing that Capital One was able to pick up Discover and relatively inexpensively. He says he has performed evaluations of Discover as a potential acquisition for multiple providers, including major big techs and major retailers, none of which carried the interest through to a deal. As large as Discover is, for many of these huge players the likely purchase price would have been “a rounding error.” He’s never been able to learn why these projects didn’t lead to offers, he says.

On one level, Crone says, the acquisition would be a defensive move for Capital One.

That said, he suggests that having its own network and the size of the combined companies will give Capital One the leverage to offer big techs and big retailers attractive payments arrangements that could shift the balance in the industry.

One lucrative possibility would be becoming the banking and payments engine behind Apple‘s financial services forays, replacing Goldman Sachs, which wants out from the Apple Card relationship. He sees relationships with Google, Amazon and other tech players as possibilities once Capital One can leverage having its own network.

Capital One is already a leader in co-branded cards, which could be attractive to the big techs.

Crone also suggests that the deal could put Capital One’s troubled deal with Walmart back on track. The mega-retailer sued Capital One in May 2023 to break an arrangement with the bank ahead of schedule, citing multiple issues. Much of Walmart’s strong interest in financial services pivots on bringing down the cost of processing payments and having access to a issuer-owned network could be something of a peace offering, Crone says.

Crone also thinks combining the two companies will help grow banking relationships for Capital One — using the “payment button” as a cross-selling point for expanding consumer relationships. In investor meetings, Fairbank has spoken of the potential for the deal to boost Capital One’s effort to build a strong digital national bank for gathering deposits. Discover’s own savings bank effort would fold neatly into that, he has said.

Read more about Capital One:

How will the proposed deal fare in Washington?

The Biden administration has not favored major bank mergers and some have chuckled over Capital One’s estimate that the deal will be through the regulatory process by the first quarter of 2025 at the latest.

However, others think this deal could not only go through, but break the ice for more.

Capital One’s optimism seems to be catching. McCune points to Bain research indicating that, worldwide, the average time for major deals that undergo regulatory scrutiny to reach a conclusion is about a year. That puts Capital One’s prediction in a reasonable light.

The combination of the nation’s #10 bank (in deposits) and its #26 bank sounds dramatic, but during an investor event Fairbank highlighted some math to consider.

”We at Capital One are third in card purchase volume and after this deal, we’ll still be third in purchase volume, because there are some big players out there.” (In 2023, that came to $1.2 trillion for JPMorgan Chase, $1.1 trillion for American Express, and $606 billion for Capital One and $218 billion for Discover.) Similarly, pooling the deposits of both institutions — for an estimated total of $457 billion — would create a banking company that’s less than one-fifth the size of JPMorgan Chase.

“There will be scrutiny of this deal, and there should be. But if I had to bet, I think the desire for more competition in this space will override the concern about the magnitude of the issuer size. ”
— Erin McCune, Bain & Co.

Even looking at the Discover Network, “it’s about a third of the size of American Express, which makes it way, way smaller than the other two.”

The size issue can, and will, be spun the other way as well. “The merger emboldens the challenge to the Visa and Mastercard duopoly,” says Richard Crone. “Despite Senator [Elizabeth] Warren’s concerns about competitive impact, regulators will actually end up seeing this merger as increasing competition in the financial services sector.” Providing another card network but with greater muscle behind it will be part of that, he believes.

“There will be scrutiny of this deal, and there should be,” says Bain’s Erin McCune. “But if I had to bet, I think the desire for more competition in this space will override the concern about the magnitude of the issuer size.”

Thomas Vartanian, a veteran regulator and banking attorney based in Washington, says it’s clear that the Federal Reserve and the Office of the Comptroller of the Currency (OCC), the two agencies that must approve the deal, have known what’s going on for some time. In investor briefings Fairbank has referred to encouraging discussions with regulators and Vartanian says deals don’t get announced, typically, if the players haven’t received hopeful signals from regulators.

“The regulators have a statutory obligation,” says Vartanian. “They won’t do more and they won’t do less.”

Indeed, he says that even as politicians may rail over deals like Capital One-Discover, the regulatory responsibility stands. “Regulators have to apply the law that exists,” he says, “not the law that people want to apply.” Vartanian says it is difficult to see the merger being considered anti-competitive in terms of consumer choice.

Specific to the deal, however, are prior compliance issues at Discover which have to be addressed. In a LinkedIn post, Michele Alt, a veteran OCC attorney and co-founder and managing director at Klaros Group, suggested that this could be an issue. She also pointed out that one sticky area is student loans. Discover has already put that operation on the block and has arranged for third-party servicing of the portfolio.

In investor presentations, Fairbank himself has noted the effort that will be required, post-acquisition. “We are making the assumption that this will be a really significant amount of work,” he said. “We won’t inherit their [Discover’s] enforcement action, but we will inherit the challenge and necessity to bring them to a very different place with respect to compliance and risk management.”

Fairbank added that most of the businesses Discover conducts are lines that Capital One already knows and has systems for handling.

Read more: Credit Card Watch: Balancing ‘Growth Math’ and Lending Risk

Will Fairbank stick around after the merger gets done?

Assuming Capital One’s acquisition of Discover does make it through the regulatory process, what happens to Richard Fairbank? Will he put the completed merger on a shelf like a trophy and be done? Or will he head back into the scrum?

Crone thinks Fairbank, turning 74 in 2024, needs to stick around until he’s 80 or so, in order to guide the implementation of everything the combination is hoped to produce. He says the process will take several years, at least, and that it needs Fairbank’s aggressive drive to come to fruition. Capital One has a much more aggressive culture than does Discover and that pushing the combination through will take Fairbank’s influence.

During a recent Keefe, Bruyette & Woods conference analyst Sanjay Sakhrani asked Fairbank about his plans. Sakhrani said the leader’s near-term future was one of the most common questions he was getting from investors.

Fairbank reflected that Capital One began after a conversation he had with someone in the credit card industry. Fairbank said that he realized that many traditional issuers saw cards merely as an extension of traditional banking. Instead, he saw the potential for building an information-driven technology business and proceeded accordingly, comparing his insight to a “religious conversion.”

“I feel like this is the founding days [again],” Fairbank told KBW’s Sakhrani. “There’s so much to do and so many reasons maybe this won’t work. But I’m all in, in pursuit of this. There are no guarantees in business. But for me this is a quest that’s got some of its best days ahead of it.”

And he added, “I really look forward to being a part of that.”

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