“This merger is bad for consumers…. In addition to harming consumers and small businesses, bank consolidation poses increased systemic risk in the financial system.”  – Elizabeth Warren

“Sounds like the credit card companies are finding another way to screw the American people. This merger should be blocked.” - Josh Hawley

Is this merger bad for consumers and competition, as many politicians and regulators claim?

Capital One aims to reshape the financial services landscape, offering a unique opportunity to challenge the dominance of payment network giants like Visa and Mastercard. This article argues against potential intervention to block the merger, emphasizing the merger's benefits to promote market competition, consumer welfare, and the health of the financial ecosystem at large.

Visa and Mastercard dominate the payment network - JP Morgan and others dominate financial services 

In February 2024, Capital One announced its intention to buy Discover Financial Services in an all-stock transaction valued at $35.3 billion. Understanding this merger's impact requires familiarity with the distinct functions of a credit card issuer and a payment network. A credit card issuer, often a bank or credit union, functions as the lender to the consumer. This issuer extends credit, pays the merchant at the point of sale, collects consumer payments, and offers customer service for account management. The largest credit card issuers measured by purchase volume and outstanding credit are JPMorgan Chase, American Express, and Citibank. On the other hand, a payment network plays a crucial role in ensuring the security of transactions between merchants and card issuers and in confirming the issuer's acceptance of the transaction. In the U.S., there are four primary payment networks: Visa, Mastercard, American Express, and Discover.

It’s true that Capital One and Discover are both significant players in the financial services industry. Capital One is a prominent credit card issuer and Discover issues credit/debit cards and runs a payment network. By combining their organizations, this new entity could augment current scale by promoting efficiencies between credit, debit, and payment offerings. The merger will make Capital One the largest credit card issuer measured by cards offered, but would still lag it’s primary competitors in credit extended and purchase volume.

On its face, the deal might sound like large industry leaders getting larger and more powerful. However, both companies are far from the apex of financial service providers in terms of size, and both provide only a few specific services in the array of what other bulge-bracket banks can offer. Figure 1 highlights the relative scale of Capital One and Discover vs. the other major companies in the Financial Services ecosystem. 

Figure 1

While Capital One is a much larger organization with a 2.06% market share by Assets Under Management (AUM), Discover falls below the top 30, with an AUM of just 0.63%. The new combined entity would account for 2.69% AUM, ranking it the 8th largest banking institution in the United States with the largest focus on credit card services. The merger has provoked a public response surrounding the need for regulatory intervention under the theory that the combined entity would become another megabank and would harm consumers and small businesses; a sentiment expressed by members of the US House of Representatives to the DOJ, Federal Reserve, Comptroller and FDIC [1].  In our view, the facts tell a different story. 

Together, Capital One and Discover will increase competition with entrenched industry leaders

One of the primary concerns surrounding mergers in the financial sector is the potential for reduced competition and concentration of capital risk. However, the union of Capital One and Discover could buck this trend by creating an entity capable of competing with Visa and Mastercard but not so large as to dominate the sector or reduce consumer choices. This increased competition is beneficial for the market and essential for breaking the near-duopoly held by these giants and their payment networks. 

Contrary to some concerns, this merger could inject much-needed vitality into the market, fostering innovation and competitive pricing, benefiting all stakeholders.

A staggering 76% (Nilson) of all domestic credit card purchase volume—excluding American Express, which accounts for approximately 19%—is processed through Visa and Mastercard payment processing networks. Just 4% is processed through the Discover network. Without a processing network of its own, Capital One could leverage Discover’s network to compete against Visa and Mastercard, serving as a necessary counterbalance in the market, invigorating competition, and offering consumers more robust alternatives to the dominant players.

This counterbalance appears to be precisely Capital One’s intention. “Our acquisition of Discover is a singular opportunity to bring together two very successful companies with complementary capabilities and franchises and to build a payments network that can compete with the largest payments networks and payments companies," said Richard Fairbank, founder, Chairman, and Chief Executive in the Discover acquisition announcement. In the graphic below, we classify key merger characteristics into positive/neutral/negative impacts to consumers.

Figure 2

Capital One and Discover are relatively small players in the banking industry compared to the largest banks, holding only a minor percentage of the market by total assets. As of the latest data [2], the combined assets of Capital One and Discover amount to a fraction of those held by the industry's leaders. As of the third quarter of 2023, Capital One's and Discover's asset holdings account for 2.06% and 0.63%, respectively. Merging their assets, they would still account for less than 3%, compared to the largest five banks, each with between 6.69% and 17.02% of market AUM individually, with names such as Goldman Sachs and J.P. Morgan Chase. 

Should Capital One and Discover merge, their consolidated market share will not reduce competition or restrict consumer choice - the FTC's primary drivers for blocking proposed mergers.

In this industry, there are fundamentally two types of customers: merchants who sell products and accept payments through the payment network and end consumers who purchase these products using their cards. This acquisition benefits both types of customers.

Merchant Benefits

Stronger merchant relationships: By combining their forces, Capital One looks to build closer ties with businesses. These close ties are driven by offering economic incentives for accepting their cards, improved fraud detection systems, and other valuable services that can boost sales.

More competitive network fees: Currently, Visa and Mastercard dominate the payment processing scene. The merger would result in a more capable competitor, creating pressure for lower merchants' fees for each transaction. According to Forbes [3] average merchant fees are 2.5% of each transaction.  Discover charges 1% of the transaction value to use its payment network. Critics of the deal maintain that larger financial institutions charge higher fees. It stands to reason that Capital One might raise Discover transaction fees (highly doubtful they would approach 2%), given Discover’s small footprint pushing more volume through the Discover network would result in lower fees overall.     

Leveraging data for better deals: Capital One aims to use the combined customer base and data to tailor deals and promotions that benefit consumers and merchants.

Consumer Benefits

Enhanced rewards programs: The merger could create opportunities for more lucrative rewards programs. By having its own payment network (Discover), Capital One will likely save on fees currently paid to other networks, potentially allowing it to offer better rewards to cardholders.

Increased competition:  A stronger Capital One could become a more significant competitor to Visa and Mastercard. This increased competition would, in theory, push these giants to offer better deals to consumers, including lower fees and potentially more rewarding programs.

Wider acceptance of Discover cards: Capital One might leverage its resources to expand Discover card acceptance at more merchants. This would benefit Discover cardholders by giving them greater flexibility in using their cards.

Despite the potential positive disruption that will come from increased competition in the payment network, numerous politicians and consumer advocacy groups have strongly criticized the proposed merger, citing the following points:

Lost Jobs: Among the reasons suggested for potentially blocking this merger, the most likely—albeit less frequently mentioned—is eliminating overlapping jobs across both companies. Economies of scale and enhanced efficiency are crucial aspects of nearly all mergers, inevitably leading to some impact on the workforce. This outcome is an unfortunate aspect of capitalism, yet it shouldn't impede the deal, considering the additional benefits it promises.

Higher Fees:  The merger will result in higher fees for credit card customers and merchants.  Evidence suggests that larger banks typically can charge higher fees [4].  In this case, however, the aggregate benefit will be greater.  Discover charges 1% to use the network vs. 2% for Visa/Mastercard vs. 2.5% for American Express.  Boosting volume for use of the Discover network, even if the merchant fees go up, would likely result in a reduction of fees overall. 

Notorious Bad Actors: Capital One and Discover have both been fined hundreds of millions of dollars within the last 10 years. Capital One for failure to prevent money laundering and accusations of predatory banking practices for low-income customers. Discover has been fined for, among other offenses, illegal loan servicing and deceptive marketing. The remedy for these illegal practices is continued fines, not blocking a proposed merger. 

FinTech Offerings: With the large profit margins that Visa, MasterCard, and American Express currently achieve, the credit processing business is ripe for disintermediation. PayPal/Venmo, Square, and Stripe are already disrupting the payment processing space, offering similar services to large payment networks at a fraction of the cost to the merchant or customer. These alternatives become even more compelling as a greater percentage of transactions are electronic or mobile.     

The Federal Trade Commission (FTC) should approve the deal

The FTC and DOJ state they will “review proposed transactions that affect commerce in the United States and are over a certain size, and either agency can take legal action to block deals that it believes would substantially lessen competition [5].” 

Given the benefits and the strategic importance of fostering competition within the financial services industry, we urge approval of this merger.  Although the financial services industry can be nuanced and difficult to interpret with the number of services offered (banking, investing, credit, savings, car/housing loans, etc), this deal poses little risk in decreasing competition across either credit or payment systems. 

When the leaders are as big as they are in the consumer credit market, others in the space need sufficient scale to compete.  

The credit card industry is growing exponentially, and with that growth, fintech solutions and other independent providers are creating additional competition. This deal would improve the competitive ecosystem for payment systems against the current duopoly of Visa and Mastercard by facilitating more transactions through a lower-rate payment processing network. Focusing solely on the AUM benchmarks overlooks the genuine collaborative potential of this deal; the integration of credit, payments, and consumer banking can deliver combined products and services to both merchants and consumers, creating opportunities for enhanced efficiency. Ultimately, the merger holds the promise of creating a more dynamic, competitive, and consumer-friendly financial services market.

About us: mXa, on the 20+ year foundation of Method360, was founded to intentionally serve fast-growth companies and the unique challenges they face. We understand that inorganic and organic growth provokes change, ambiguity, and uncertainty that can deeply burden the organizations involved. By seeking to understand the human element in M&A and fast growth environments, mXa embraces a unique, contrarian approach in advising clients that seeks to realize maximum value for them in alignment with business objectives.

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Sources:

[1] US House of Representatives - House Letter to DOJ, Federal Reserve, Comptroller and FDIC

[2] S&P Global - 50 Largest US Banks by total assets - Q3 2023

[3] Forbes - Credit Card Processing Fees (2024 Guide)

[4] American Action Forum - Capital One’s Acquisition of Discover Could Inject Competition Into Payments Market

[5] Federal Trade Commission - FTC Merger Review