What Does the Capital One & Discover Deal Mean for the Card Industry?
Last week, Capital One announced that they were planning to purchase Discover in a $35 billion deal. It’s already become a hot topic - some are heralding the return of “mega-deals” , others are framing the deal as a test for new anti-trust frameworks . Politicians from both sides of the aisle are calling for the deal to be blocked.
This week, I spent my time Nerding Out on the deal, the anti-trust concerns, and the impacts on the overall credit card industry.
The Businesses Today
Although Discover and Capital One are both credit card companies, they do have some notable differences. Discover operates both as a card network and a card issuer while Capital One solely acts as a card issuer (I previously wrote about credit card transactions for background on networks and issuers ). That means that Discover offers opportunities for both horizontal and vertical integration for Capital One (not to mention a few other complimentary business lines). It also means that it’s worthwhile to look at the deal and it’s impacts on both the Card Network industry and Card Issuer industry.
Capital One
As a bank, Capital One makes money through 4 different segments: Credit Cards, Consumer Banking, Commercial Banking, and Other:
Clearly, credit cards make up the majority of where Capital One makes it’s revenue and profit. Even though it is a lower margin business than their other segments, the volume of business in cards makes it a cash cow for Capital One.
But interestingly, net income from the Credit Card business has been declining in recent years, primarily due to the increase in Capital One’s assumptions on what will turn into delinquent accounts. Capital One does note that this is largely a return to the pre-pandemic normal. Credit quality had increased during the pandemic likely due to government stimulus checks and pauses on student loans leading people to pay off outstanding credit balances.
Discover
Discover breaks their business into two segments: Digital Banking (comprised entirely of their lending activities across Credit Cards, Student Loans, Personal Loans, and “other”) and their Card Network business called Payment Services.
Similar to Capital One, Discover drives the majority of it’s business (both revenue and net income) from issuing credit cards. It’s notable though, that their payment network operates at a much higher margin.
Worth noting that Discover is seeing a similar decline in profits due again to assumptions on delinquent accounts.
Additionally, the stock has lagged the broader financial sector. Prior to the deal announcement, it was up only 2.25% over the last year. Largely due to the impact of mis-classifying certain credit cards that increased expenses for merchants.
Combined Business
In terms of financial return, it should be clear that this is largely the combination of two card issuers. Card issuing is where both Capital One and Discover generate the bulk of their revenues and profits. Though, both also have interesting, higher-margin components that add a lot of interest to the deal.
The combined business would have a portfolio of cards totaling 168 million cards in circulation, generating $837.9 billion dollars of transactions annually, on total outstanding balances of approximately $256.7 billion.
And that’s just card issuing. Capital One would also be able to leverage Discover’s card network. Though a small revenue opportunity, it provides vertical integration for Capital One and grants some market power against Visa and Mastercard who make up the duopoly of open card networks. Richard Fairbank, Chairman and CEO of Capital One has been quoted as saying , “We have always had a belief that the Holy Grail is to be able to be an issuer with one’s own network.” emphasizing the importance of acquiring the network intellectual property. Their plans currently involve moving $175 billion in payment volume to Discover’s network, mostly on their debit cards.
In addition, the combination gives Capital One capabilities in traditional banking. Discover brings new consumer checking and savings customers to Capital One, as well as additional capabilities in lending. Capital One currently offers Auto Loans, and Business/Commercial Loans. Discover brings Personal Loans, Student Loans1 and Home Loans (HELOCs and ReFis).
Industry Impacts
Given the vertical and horizontal integration at play with the deal, it’s worth looking at the impact on both the Card Network industry and Card Issuer industry. But, let’s first take a brief look at what the government cares about when evaluating anti-trust.
FTC/DOJ Tests
The FTC and DOJ look at a number of factors when considering anti-trust issues. They split mergers into horizontal and vertical flavors and have different guidelines for each type (Horizontal , Vertical ). Horizontal mergers typically get more scrutiny than vertical mergers with focus on the impacts of pricing, competitiveness, and market share. Vertical mergers tend to raise concerns when they impact other service providers in the market (e.g. Amazon buys Apple with the intent of being the exclusive seller of iPhones, locking everyone else out of the market). Otherwise vertical mergers are typically perceived to help reduce costs by removing middlemen.
Given the wide ranging concerns in anti-trust, there isn’t any one litmus test, but one of the key focus areas is industry concentration. To evaluate concentration, regulators use a measure called the Herfindahl-Hirschman Index (HHI). HHI is calculated by summing the squares of the percentage market share of each company.
Ok, ok, that was nerdy even for me. All that we really need to know is that the DOJ and FTC use HHI to evaluate concentration in the industry. Their first step is to look at post-merger HHI, splitting industries into three bands
Once the band is determined, they then evaluate the increase in concentration pre-merger to post-merger. From the DOJ guidelines :
As we look at the impacts on the industry, we’ll keep this in mind. Worth a couple of footnotes though:
Card Networks
Discover is 1 of 4 card networks based in the US. The others include Visa, Mastercard, and American Express. Visa and Mastercard operate open networks, meaning that other banks can issue cards that use their network. Discover and American Express operate closed networks, meaning that only cards issued by Discover and American Express can use those networks.
Probably not surprisingly, Visa and Mastercard, with their open networks, hold about 90% of the market share as measured by transaction volume (more cards and issuers accessing the network produces more volume). Discover is the smallest network, processing just 2.5% of transactions. That makes them about 1/3 of the size of the next largest player, American Express.
As noted previously, Capital One plans to shift $175 billion in volume from the open networks (Visa and Mastercard) to Discover or 0.74% of total transactions. Moving this volume doesn’t have a huge impact on market share. Capital One has stated that their plan is to focus on shifting debit cards to the Discover Network. Anecdotally, Capital One uses Mastercard more for debit cards so the plan likely impacts Mastercard more than Visa. Even in the scenario where the entire $175 billion comes from Mastercard, Mastercard would still sit at 37.3% market share.
You’ll note that Card Network HHI drops in each of the scenarios above.
What if Capital One acted more aggressively and moved all of their volume to Discover? Capital One currently processes $620 billion in volume across their cards, about 2.6% of total payments. That change would be sizable, and definitely impacts market share but no one company is displaced by the move.
Needless to say, this scenario is unlikely to happen for two reasons:
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In all, post-deal, 4 card networks still exist. 2 remain open and 2 remain closed. Because Discover is already a closed network, there is no detrimental impact to other issuers by acquiring Discover’s network. Capital One can’t limit their competitors access to the network any more than it already is. Although this is a highly concentrated market, there is limited impact to market share. In fact HHI decreases in every scenario because the smallest network gets the backing of a larger entity, increasing competition.
Card Issuers
Let’s talk about banks; the typical card issuers. There’s three ways that credit cards make money for banks:
How do these three revenue streams apply to Capital One?
With so much revenue attributable to interest, is it any surprise that market share for card issuers is typically measured by outstanding credit balance? Higher outstanding balances means more interest income.
By outstanding balance, J.P. Morgan is currently holds the #1 spot with $211.1 billion in outstanding balances. Capital One sits at #2 at $154.4 billion and Discover sits at #5 with $102.3 billion. The combined entity would easily take the #1 spot with $256.7 billion in outstanding loans, making up 21.9% market share.
Based on the revenue drivers that I outlined previously, here are a few other metrics by which we can evaluate market share.
For sources see footnote 2
As for the FTC/DOJ test of concentration:
By the industry standard (and largest revenue driver), the deal would fall in the unconcentrated category and would likely not result in a lot of scrutiny. However, when looking at other measures, Cards in Circulation indicates that the deal should have a lot of focus from regulators while Transaction Volume suggests again, this is likely not that impactful to industry concentration.
My Take
I think that because the transaction is taking place in the financial services industry, it will get additional scrutiny from regulators. The scrutiny is likely to result in some level of divestment to get approval. But ultimately, I do think the deal will be approved and go through. I think Capital One and Discover have a lot of other benefits working in their favor: increased competition in the Card Network arena, additional statistics on the broader banking industry that make them appear smaller (total deposits, total loan volume), and stats about Discover and Capital One’s customer make-up (tend to be catered to mass market consumers; scale could help lower prices).
As others have said , Capital One, being based in Virginia has likely already had discussions with regulators to float the idea of the deal prior to announcing it publicly, giving them some degree of confidence that it’s likely to be approved.
The Bottom Line
The deal is likely to get scrutiny due to the impact within the card issuing industry but how the regulators define the market is going to matter.
If regulators just look at card issuance, evaluating the industry based on revenue generated could have a different result from my analysis above. Why? Because the Outstanding Credit Balance only gives us the volume of activity. We’re missing the price (effectively, the interest rates charged). There’s likely big differences between issuers on their interest rates based on the demographics of their ideal customer. That, in turn, has an impact on how concentrated the industry actually is. Issuers with smaller outstanding loans could be charging higher rates in effect equalizing revenue across players. The exact opposite could also be true and the industry could be more concentrated than it seems. Looking at revenue also provides a complete picture by incorporating Annual Fees, Interchange Fees and Interest Income into one number. Similar to how different players offer different interest rates, issuers can also target different Annual Fees or offer lower interchange fees for less benefits. All of these factors would show up in revenue.
Capital One could also convince regulators to look beyond cards to broader banking activities. By taking into account deposits and other lending activities, the merged Capital One and Discover could appear much smaller. Broadening the scope would also add additional competitors like Goldman Sachs, PNC, Truist, and Morgan Stanley to the analysis, theoretically further reducing concentration.
Although there’s a lot to like for Capital One shareholders, Discover’s biggest differentiator over other acquisition targets is it’s network. It will be telling to see what concessions Capital One will be willing to make (e.g. what divestments they make), in order to get a hold of it.
Assuming the deal does go through, the issuer landscape starts to look like this:
In summary: Capital One would be a credit card giant.
Opportunities for Capital One
One thing that stood out in Capital One’s announcement, presentations, and calls was that they called out synergies around revenue but hadn’t identified or modeled any specific opportunities. I’m happy to theorize about what they might be considering.
One of the most concrete is looking at fees and consequently rewards for debit cards. Matt Stoller wrote an incredibly detailed piece on this that I recommend you read for a fuller analysis. But essentially there’s a loophole in current regulations that allow debit issuers operating their own network to have higher fees. Currently this loophole only benefits American Express and Discover as the two closed networks. Capital One by buying Discover and moving their debit volume to the Discover network can now benefit as well.
There’s also the additional volume of data that Capital One can now capitalize on. By virtue of having a network, Capital One can get greater insights on merchants and actually develop direct relationships with them, something that’s typically left to the card network in traditional issuer-network relationships. American Banker had an excellent piece detailing some of the data and relationships that could start to develop including exchange of SKU sale data, merchant banking information, and interchange fee and rewards negotiations.
A bit more lofty, but there’s also the opportunity to open the network. Visa and Mastercard, the two open networks, don’t issue cards. Discover and American Express, which do issue cards, are closed networks. There isn’t currently a card issuer that also offers an open network so it remains to be seen whether Capital One could convince other banks to use their network. As mentioned previously, they would also need to scale the network to ensure it can handle increased load. This also would negate the regulatory loophole around debit card fees mentioned above, so they can’t do both. There’s no shortage of headwinds to this option, but perhaps Capital One can do some convincing of other banks to issue on their network, either through fees or sharing data and analytics (an area where Capital One excels). This is essentially the AWS play: Amazon created a great asset (their server capacity) and monetized by offering it to other consumers. Could Capital One do something similar with the Discover network?
Further Industry Consolidation?
With all the commentary on the significance of mega-deals returning, one of the last lingering questions I had was whether this deal would lead to additional deals down the line: would JP Morgan buy Visa? Would Apple pick up Mastercard (one of my more lofty thoughts)? In short, I think the answer to this is no.
For Visa and Mastercard, it’s a pretty hard sell with regulators to approve any acquisition. If the two were to merge, they would hold 90% market share. If a card issuer were to acquire them, regulators would likely be very concerned about impacts to other card issuers and block the deal.
That leaves American Express. They have cultivated a premium designation and prior statements indicate that they can be very discerning to ensure that premium feel remains in tact. Financially, they’re also one of the larger lenders which limits the possible companies that could actually acquire them and also means any potential acquisition likely comes with a lot of regulatory scrutiny. Additionally, their stock is up 25% over last year. For comparison, Visa is up just shy of 29% and Mastercard is up 33.5%. Prior to the deal announcement, Discover’s stock was flat year over year. In short, I don’t think American Express is clamoring for a buyer.
That leaves Card Issuer mergers. First, there aren’t many pure-play card opportunities. Most card offerings are tied into broader bank operations which complicates any acquisition from a regulatory standpoint. Though, one of the more interesting companies to take a look at is Synchrony. Their go-to-market approach largely relies on co-branding their cards (e.g. Verizon’s Visa card is issued by Synchrony). Those agreements potentially have some data sharing clauses to them that could add to the assets that Synchrony has to offer. Otherwise, unless one of the card issuers becomes distressed and can be snapped up for a deal, it’s probably an uphill battle on any other deals.
Thank you so much for reading this week. This deal is certainly an interesting one to dive into and I’m keen to watch it play out. If you enjoyed, please subscribe or share with a friend.
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1. Discover previously announced that they are looking to divest the student loan business and are no longer accepting new student loan customer applications .
2. Sources for the Card Issuer Market Share table include WalletHub/Nilson Report for Card Circulation data, Company SEC Filings for Transaction Volume (see Source column), and Investopedia for outstanding credit balances.