Written by Jonathan Rubin, Partner and Co-Founder of MoginRubin LLP --
When federal agencies review bank mergers, the competition issues typically relate to the number and location of physical branches and the extent of any overlap in the areas served. By contrast, the proposed $35 billion Capital One-Discover merger raises different and far more subtle competitive issues. The agencies—the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Antitrust Division of the Department of Justice—will have to assess not only the deal’s effect on the consumer banking market, but also on the credit card issuer market and the payment network market.
Consumer Banking
In consumer banking, the number of U.S. commercial banks has declined from more than 10,000 about 20 years ago to around 4,000 today. Some institutions were allowed to become so large that their failure could destabilize the banking system, becoming, in that sense, “too big to fail.” The largest of these, JPMorgan Chase, holds about $2.4 billion in deposits, or 8.6% of the U.S. deposit base, followed by Bank of America (6.4%), Wells Fargo (4.4%), and Citibank (4.2%). The remainder is shared among smaller institutions, including the 10th largest, Capital One ($348 million or 1.2%), and the 26th largest, Discover Bank ($109 million or <1%).
Nonetheless, the combined Capital One-Discover company would hold less than 3% of consumer deposits and will own fewer than 300 physical branches (and 55 Capital One Cafés), compared to around 2,300 PNC branches and 5,000 at JP Morgan Chase. Thus, the combined firm does not approach the scale of its largest rivals and is not likely to raise safety and soundness concerns on the grounds of size alone. This makes it difficult to argue that the transaction will create yet another too-big-to-fail institution.
Credit Card Issuance
Practically every financial institution issues credit and debit cards and barriers to entry into the issuer market are relatively low. Consequently, consumers have an enormous range of credit card products to choose from, including a proliferation of private-label cards. Because of these conditions, the OCC and the Federal Reserve have characterized the credit card market as “intensely competitive” and the Justice Department considers the issuer market to be “un-concentrated.”
With almost 191 million credit cards in circulation, Capital One is the largest U.S. issuer by number of cards, but it ranks third in credit card purchase volume, after JP Morgan Chase and American Express. After the merger, the combined Capital One-Discover will still be third, with about $824 bn in annual purchase volume, compared to Chase, at $1.16 trillion, and American Express, at $1.12 trillion.
In spite of increased concentration in the commercial banking market, since 2016 smaller institutions have captured a larger share of outstanding U.S. card balances. The top 10 issuers accounted for 87 percent of credit card loans in 2016 but less than 83 percent in 2022. Both of the merging banks are among the top 10 issuers, together accounting for about 22 percent of outstanding balances. The merged firm will hold the largest share of credit card loans, at about $250 billion, surpassing Chase, which currently holds the largest credit card loan portfolio, at about $211 billion. Nonetheless, measured by shares of outstanding card balances, the industry’s Herfindahl-Hirschman Index (HHI), which measures market concentration, would remain below its 2010 level after the merger.
Some commentators have observed that for balances owed by less creditworthy customers, the market share of the merged entity would approach 30 percent, a conventional benchmark for presuming that the merger would create a firm with market power. But it is not clear that segmenting the market for credit card balances into higher- and lower-creditworthy customers comports with sound antitrust analysis, which generally requires markets to be defined in accordance with certain accepted economic principles.
Payment Networks
The most interesting competitive issue arises out of the integration of Discover’s payment networks, the Discover credit network and the Pulse PIN-debit network, with such a significant card issuer. The Discover network is accessed by 70 million merchants. The Pulse debit network has connections with practically every commercial bank.
Combining downstream banking with upstream payment network services introduces a “vertical” element into the transaction. The combination is likely to alter the competitive landscape in the payment network market, with system-wide implications for all participants, banks and issuers, merchants, cardholders, and fintech innovators.
Four payment networks serve the market for U.S. transaction volume. Using 2023 data, Visa was the largest, with 59 percent of total volume, followed by Mastercard with 24.5 percent, American Express with 11.7 percent, and Discover with 4.8 percent. In recent years, Visa has processed about 100 billion credit card transactions, compared to about 3.5 billion by Discover.
Visa and Mastercard function as “open loop” or “four-party” networks, in which each transaction over the network involves a cardholder, issuer, merchant, and an acquirer, which is a financial institution that is a member of the network that connects the merchant to the network. When a merchant accepts a Visa or Mastercard card, it pays the acquirer a fee for processing the transaction, known as the merchant discount rate.
The American Express and Discover networks run on a “closed loop” or “three-party” system involving the cardholder, the merchant, and a single company that both issues the card and provides the network. Thus, American Express and Discover function as the issuer, the network, and the acquirer, and the merchant discount rate is negotiated directly with the merchant.
In the open loop Visa and Mastercard networks, the majority of the merchant discount rate is paid as “interchange” to the issuing bank, with the remainder going to the fee charged by the network. Because the marginal cost of authorizing, clearing, and settling a transaction is extremely small, the fees for network services consistently generate a net profit for the networks of close to 50 percent.
Profitability in the payment network market, therefore, can only be achieved by increasing a network’s transaction volumes. This is where the proposed Capital One-Discover merger promises to exert its most significant market impact. Capital One currently operates over the Visa and Mastercard payment networks, primarily issuing Mastercard-branded credit cards. Capital One expects to add $175 billion in transaction volume to the Discover and Pulse networks by 2027 but, more importantly, it will have the capacity to move significant numbers of credit and debit transactions now carried by Mastercard and Visa to its own network.
The implications of this shift in the balance of economic power in the payment network market are far from clear. For example, some commentators have argued that the three-party structure of Discover’s network creates the incentive and ability of the merged entity to force merchants to pay higher discount rates. However, Capital One’s CEO has committed, as he must to maintain continuity, to maintaining existing agreements with Visa and Mastercard. Thus, at least for an initial period, the merged entity will be a “hybrid” issuer of both four-party cards and three-party cards with the incentive to shift volume to the three-party network. In that scenario, it seems unlikely that merchants will be asked to pay higher interchange fees for Discover transactions. It is far more likely that Capital One-Discover will seek to disrupt the payment network space by charging merchants significantly lower interchange fees to grow volume on the Discover networks and to incentivize acquirers to route merchant transactions over Discover rather than more the costly Visa and Mastercard networks for cards enabled for both networks.
Conclusions
The payment network services industry has been dominated by the Visa-Mastercard duopoly since the early 1970s and has remained durable because of their four-party structures that sweep in virtually all demand deposit institutions, making it very difficult for players outside the commercial banking system to exert competitive pressure on the networks. In the proposed Capital One-Discover transaction, however, a powerfully large issuing bank, operating from within the banking system and the existing network environment, could be poised to mount a competitive challenge to the status quo, introducing a level of competition heretofore lacking in an industry highly resistant to change. On balance, the proposed Capital One-Discover merger makes sense.
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