What’s in Cap One’s Wallet?

Its blockbuster bid for Discover could position Capital One to compete not only with the largest credit and debit card issuers, but also with networks like Visa, Mastercard, and AmEx.

Capital One Financial Corp.’s bombshell announcement in February that it is offering to acquire Discover Financial Services in all-stock deal valued at $35.3 billion was one of the biggest wow moments the payments industry has seen in years, if not more than a decade.

As news of the deal swept the industry, it was immediately clear the combination, if approved by regulators, could transform the payments industry in ways not seen in years.

For starters, there’s the network advantage. The acquisition not only of the Discover network but also of its big debit network, Pulse, would give Cap One a huge operating-cost advantage and revenue boost through increased economies of scale.

McLean, Va.-based Cap One plans to increase volume on the Discover network by adding more than 25 million debit and credit card holders, along with $175 billion in credit and debit volume, by 2027.

“The possibility of driving Capital One’s existing transaction volume through the Discover and Pulse networks introduces efficiencies of scale that will strengthen these networks and make them much more competitive relative to Visa and Mastercard,” says Beth Robertson, managing director, for Keynova Group, a Wilmington, Del.-based competitive-intelligence firm for the financial-services industry.

The planned increase in network volume, along with organic network growth, will not only make Riverwoods, Ill.-based Discover a more competitive network, it could vault Discover ahead of American Express Co. among the four major card networks, something Discover has not able to achieve on its own during its nearly 40 years in operation.

Adding Scale

A more competitive Discover could bring downward pressure on the network fees merchants pay, including interchange, should Capital One decide to compete on price for additional network volume. Such a scenario could force other card networks to lower fees they charge merchants.

“Discover has generally offered services at a lower price point than the other networks, so they are likely to influence downward pressure on the other networks’ interchange fees,” Robertson adds.

Visa, Mastercard, and AmEx did not respond to inquiries from Digital Transactions for this story.

Not to be overlooked is that owning its own network would give Cap One a larger cut of cardholder fees, observers point out.

“Acquiring Discover not only adds scale to Capital One, which matters for payments networks, it gives Capital One access to both sides of the network revenue stream,” says Brian Graham, cofounder and partner at Klaros Group LLC, a Beallsville, Maryland-based advisory and investment firm for financial-services providers.

Cardholder rewards is another area where the deal could shake up the payments landscape. Stacking its Capital One Shopping app—which automatically searches for online coupons, better prices, and rewards at over 30,000 retailers—on top of Discover’s cash-back rewards, could allow Cap One to create an extremely potent and cost-effective customer acquisition tool.

Cap One could use that value proposition as an entrée to selling other banking products to consumers, such as depository accounts and loans, to deepen cardholder relationships. Rewards could even be extended to Capital One and Discover debit cards, a perk that fell away from nearly all debit cards after the passage of the Durbin Amendment.

Other areas the deal could affect include Cap One’s desire to increase its global card business. Discover is a global card brand and network, and it owns Diner’s Club, which remains a viable card and network brand outside the United States. Discover acquired Diners in 2008.

Yet another implication of the deal is that it can open the door for the merged entity to become a major player in prepaid cards, which Cap One could use to reach low-to-moderate-income consumers with high-risk credit profiles.

Cap One could use prepaid cards to help consumers rehabilitate their credit score or to provide low-risk alternative to a debit card, suggests Ben Jackson, chief operating officer at the Innovative Payments Association (Jackson expands on this theme in his “Payments 3.0” column on page 12).

The Perception Gap

As with any merger or acquisition, determining the impact of the deal is tough, especially if its impact is as potentially far-reaching as that of a Capital One/Discover combination. The principals in the deal have revealed little about their vision for the new company beyond what they told analysts in February when the acquisition was announced.

Putting the deal in perspective requires focusing on its main elements: the impact on the card businesses of Cap One and Discover and on the Discover network; the impact on the principals’ respective debit businesses and on the Pulse network; and the question of whether regulators will approve or scotch the massive deal.

When it comes to Cap One’s credit card business, chairman and chief executive Richard Fairbank told analysts when the deal was announced that being a card issuer with its own network is the “holy grail.” By this, he meant it allows an issuer to deal directly with merchants and also have a comprehensive relationship with both merchants and cardholders for credit and debit acceptance.

A key benefit of that scenario is that Cap One can negotiate lower network fees with merchants, which can expand merchant acceptance for Discover. Fairbank acknowledges that the perception of lesser merchant acceptance for Discover compared to Visa and Mastercard has been a hindrance to Discover’s growth, even though Discover has achieved parity with its two rival networks in the United States when it comes to merchant acceptance.

While reality is different from perception, Fairbank acknowledges that overcoming consumer perception can be tough, which is why he said Capital One intends to invest in the Discover network’s brand and credibility with merchants to close the so-called perception gap.

“A more competitive Discover can be a counterweight to the Visa and Mastercard duopoly,” says Matthew Goodman, founder of Totavia, a Pasadena, Calif.-based fintech consultancy. “Building a payment network from scratch is costly and almost unrealistic today. In Discover, Capital One gets a readymade network it can grow.”

Challenging the Visa and Mastercard network duopoly could force both global networks to be more price-competitive when negotiating network fees with merchants. “But I don’t expect Visa and Mastercard to lose money over this,” Goodman adds.

‘The Next Frontier’

Some observers point out the deal could also prompt Visa and Mastercard to lower what they charge Cap One to issue cards on their respective networks. An estimated 59% of Cap One’s cards are issued on the Mastercard network and 41% on the Visa network, according to payments experts.

But there’s far from agreement on this point. The potential of losing a large chunk of those cards to Discover may have little or no effect in prompting Mastercard and Visa to cut fees to Cap One and dissuade it from shifting cards to Discover.

“There will be some loss of network volume from Capital One shifting cards to Discover, but Visa and Mastercard will deal with it, because they work with many players that do things they don’t like,” says Eric Grover, principal at the payments advisory Intrepid Ventures.

While Fairbank lost no time announcing the bank’s intention to move all of its debit cards to the Pulse network, Cap One has stayed silent on what portion of its credit card portfolio it plans to move to Discover. Payments experts doubt Cap One will move the bulk of its credit card portfolio, given the card issuer’s long affiliation with Mastercard and Visa.

Fairbank indicated as much when he told analysts that, while it is not unusual for companies in the payments business to be competitors and partners, “Visa and Mastercard will be important partners as they can help add value for our customers.”

Cap One had credit card purchase volume of $606 billion in 2023. The company reportedly had about 44 million cardholders in 2022. A more recent number was not immediately available.

Another way Cap One can grow volume on the Discover network is to extend its Capital One Shopping app to existing and new Discover cardholders.

While payments experts say Discover’s cash-back rebate generates fierce brand loyalty among Discover cardholders, adding another rewards program can increase spending among existing cardholders and attract new cardholders to the Discover brand, they argue.

The Capital One Shopping app, which is also available to non-Capital One cardholders, helps shoppers find the lowest price on items at more than 30,000 retail Web sites. It also searches for applicable coupon codes, and allows shoppers to earn Capital One Shopping Credits. The shopping credits can be redeemed for gift cards at such merchants as eBay or Walmart.

The app also compares shipping costs with different retailers. If the app finds a merchant charging a lower shipping fee for the same item, it will show the difference and provide a link to the lower-cost merchant. Consumers can also create a Watchlist that sends them alerts when an item they want to purchase drops in price.

“Having a rewards program like Capital One Shopping helps issuers connect with cardholders wherever they are during the shopping journey and keep their card top of wallet,” says Jordan Glazier, founder and chief executive at Wildfire Systems, a San Diego-based white-label loyalty-rewards platform provider.

“Capital One Shopping has become a centerpiece for customer acquisition and provides a strong point of differentiation,” Glazier adds. “Discover has defined its value proposition with cash back, but it lacks an online-shopping component. Capital One Shopping would be a great fit for Discover’s value proposition as value-added services are the next frontier of competition in payments.”

There would be no cost to Capital One to extend the rewards program to Discover cardholders, as merchants pay the issuer a commission when users make a purchase. As a result, Capital One’s rewards program is a profit center, as it uses the commissions from merchants to fund rewards as opposed to interchange, Glazier says.

“Every issuer and payment network we talk to lists value-added services as a top priority to hedge against revenue pressure and to help with customer acquisition,” Glazier adds. “Given Capital One’s history of innovation, it can breathe new life into Discover through value-added services.”

The ‘Unwanted Stepchild’

One other area where Capital One’s acquisition of Discover potentially benefits the card issuer is that owning Discover will put it in prime position to pick up new volume should the Credit Card Competition Act pass.

The CCCA would require financial institutions with $100 billion or more in assets to enable at least one network other than Visa or Mastercard for credit card transaction processing. While banks would choose which networks to enable, merchants would choose which network to use. Proponents of the legislation contend that, given a choice of networks, merchants will opt to route transactions over the lower-cost system.

As owner of the Discover network, it’s only natural Capital One would make Discover the alternative network on their Visa- and Mastercard-branded cards if the CCCA passes, payments experts say.

“Owning the Discover network is a great hedge for Capital One, should the CCCA pass, because they will own an alternative network that can be leverage to break up the Visa and Mastercard duopoly,” says Dave Grossman, founder at YourBestCreditCards.com, which helps consumers find suitable rewards cards.

Arguably the biggest question mark in the deal is what Cap One plans to do with Diners Club, which Discover acquired in 2008 from Citigroup for $165 million. Since acquiring Diners in the 1990s, Citi had tried to breathe new life into the travel and entertainment brand, with mixed results.

“The Diners brand could be revived, but it would require a bold move on Capital One’s part,” Grossman says. “The question is whether the payoff from such a move [would] justify the cost.”

Some payments experts have described Diners as an “unwanted stepchild,’ an asset Capital One had to take to make the deal. “There are assets that come with an acquisition that don’t necessarily make sense to keep, but are the part of the deal nonetheless. It may be better for Capital One to sunset the brand,” says Totavi’s Goodman.

‘We Will Complain’

For all the what-ifs surrounding Cap One’s credit card business in light of the potential acquisition of Discover, the potential benefits on the debit side of the business are more straightforward. The reason is simple: A provision in the Durbin Amendment exempts debit issuers that also own a network from the regulation’s interchange caps.

The exemption results from how the Federal Reserve Bank defines a payments network. In light of Durbin, the Fed defines a payments network as one that routes transactions to a third-party rather than to itself. Under that interpretation, not only Discover but also American Express do not meet the definition of a payments network.

For Cap One, the big advantage of the exemption is that interchange fees on the Pulse network, once the deal with Discover is consummated, don’t have to be capped.

Pulse serves more than 3,000 financial institutions, down from a high of more than 4,500 when Discover acquired the network in 2005. Industry consolidation is the culprit for the reduction, a Pulse spokesperson says.

Even so, Pulse’s transaction volume continues to grow. During the fourth quarter of 2023, the network saw transactions increase 19% year-over-year. Indeed, debit transaction volume grew each quarter in 2023 on a year-over-year basis. The low-water mark was a 9% increase in the first quarter.

Cap One’s debit portfolio reportedly generated $65 billion in volume in 2022, according to Intrepid Ventures’ Grover. “Capital One’s debit business is pretty small compared to the big boys, like Chase,” Grover says. “Nevertheless, Capital One should see an enormous lift from debit-interchange revenue.”

But Cap One’s exemption is sure to rankle larger debit card issuers. When asked during an interview on CNBC about whether the exemption created an unfair advantage for Cap One, JP Morgan Chase & Co. chairman and chief executive Jamie Dimon agreed it would.

“Of course I have a problem with that [exemption], why should [Capital One] be able to price debit differently than we price debit because of a law that was passed,” Dimon said. “If we think it’s unfair, we will complain [to regulators].”

While the potential new revenue stream and operating efficiencies from owning Pulse are sure to bolster Cap One’s balance sheet, they also create the opportunity to add value to the bank’s debit portfolio by helping subsidize rewards. Prior to the passage of Durbin, debit rewards were quite common. They went away after the law was passed because debit issuers claimed the caps limited the financial resources to offer rewards.

“Durbin killed off debit rewards, which has essentially made debit cards uninteresting to consumers,” says Grossman. “Why not take some of the revenues [from Pulse] and use them to fund additional benefits that increase the value proposition for cardholders?”

Regulatory Angst

One of the thorniest questions surrounding Cap One’s bid to acquire Discover is whether the deal will be approved by regulators.

Already, Sens. Elizabeth Warren (D-Mass.), who sits on the Senate Banking, Housing, and Urban Affairs committee, and Josh Hawley (R- Mo.) have called on regulators to block the deal, arguing it would be anti-competitive and harmful to consumers.

That senators from both sides of the aisle immediately raised concerns about the deal suggests it may not be a slam dunk for regulators to sign off on it, says IPA’s Jackson.

Most payments experts, however, counter the deal actually helps foster competition by making Discover a more competitive network with Visa, Mastercard, and AmEx, something it struggled to achieve on its own. After all, Discover has been a distant fourth-place network since its launch in 1985.

“This deal can bring more competition, especially among large issuers [and competing networks] that want to protect their share,” says Brian Riley, director of credit and co-head for payments at Javelin Strategy and Research. “The question for regulators will be what boundaries, if any, need to be put in place to make the deal fly.”

Still, payments experts acknowledge that anything can happen in a regulatory environment, especially during a presidential election year, when politics take center stage.

“Whether regulatory approval around this deal will be a public debate or a technical discussion will have a lot of influence on how this deal plays out from a regulatory standpoint,” Jackson says.

For now, Cap One has strengthened its hand considerably. What the big bank actually does with Discover’s assets, should the deal clear its approval hurdles, will be closely watched. And no wonder, as the impact on the payments industry from the deal will play out for years to come.