Capital One's real prize in Discover: the network

Capital One has offered $35.3 billion in stock for Discover Financial, one of the boldest bank deals since the 2008 financial crisis. Most commentary dwelt on the merged group becoming America's largest credit card lender by loans. The bigger prize is Discover's own global payment network.

Discover came to the table weakened. Last summer it admitted that it had placed some card accounts in the wrong pricing tier for years, overcharging merchants, and its chief executive stepped down in August. In September the FDIC put the bank under a consent order over its compliance management. Those troubles dragged on its share price and made an approach easier to pitch.

How card payments are split

Every card purchase involves several parties. The shopper's bank, the issuer, collects an interchange fee from the merchant's side of the transaction, and the network that carries the payment, usually Visa or Mastercard, charges its own fees to both banks for the use of its rails. In an open network the issuer and the network are separate companies. In a closed loop, as at American Express and Discover, one company issues the card, runs the network and deals with merchants directly, keeping every slice of the fee and every piece of data about the transaction.

A third set of rails

Owning that network would let Capital One move its large debit and credit card volume on to its own rails and keep interchange fees that now go to Visa and Mastercard. A lender that issues the cards and also runs the closed-loop network gains pricing power and control of customer data. Antitrust reviewers in Washington will not make the deal easy.

What the network is worth

Discover owns three sets of rails: the Discover network for its own cards, the Pulse debit network and Diners Club International. It is one of only two card networks in America, alongside American Express, that both issue cards and process them. Capital One has said it plans to move its debit business on to Discover's network and, over time, some of its credit cards. Each transaction shifted keeps the network fees inside the group instead of paying them to Visa or Mastercard.

Scale is what the network lacks. Merchants accept Discover widely at home but much less abroad, and card issuers have had little reason to put volume on a network owned by a rival lender. Pouring Capital One's accounts on to it changes that arithmetic. More volume gives Discover more bargaining power with merchants and more reason for them to accept its cards, which in turn makes the network more useful to Capital One's customers.

The data may matter as much as the fees. A lender that sees every transaction its customers make, from the merchant to the time and place of purchase, can price credit more precisely, spot fraud faster and market new products more effectively. Capital One built its business in the 1990s on using data to price credit-card risk, and owning a network gives it a much richer stream to work with than an issuer on someone else's rails receives.

Winners and losers

Visa and Mastercard stand to lose the most, even if the volume at stake is small against their global business. Capital One is among their largest issuing clients, and a precedent of a big lender taking its cards in-house could embolden others. Discover's shareholders received an offer above the market price, and Discover gains a partner with the balance sheet to invest in its network. Merchants gain little directly, since interchange rates are set by networks and do not fall just because an issuer owns the rails.

Card borrowers may notice more. A single lender with the largest credit-card loan book in the country would have more weight in setting terms for borrowers across the credit spectrum. Consumer-protection regulators are already pressing on card fees, and the Consumer Financial Protection Bureau has proposed capping most late fees at $8.

The case for approval, and against

The strongest argument for letting the deal proceed is that it adds competition at the network level, where Visa and Mastercard dominate. A stronger third network could restrain the fees that the duopoly charges merchants. Critics answer that the combination also creates the biggest card lender in America at a time when Washington has grown sceptical of big mergers, and some Democratic lawmakers have already come out against it.

Recent history offers some comfort to the buyers. The merger of BB&T and SunTrust, announced in February 2019 to form Truist, was the largest American bank deal since the financial crisis and won approval within the year. The climate has changed since then. The current administration has pressed regulators to scrutinise bank mergers more closely, and the Office of the Comptroller of the Currency proposed tighter rules for reviewing them in January. A deal that creates the largest card lender will be a test case for that stance.

Politics in Congress adds another layer. Senators from both parties have backed a bill that would require large card issuers to offer merchants a choice of at least one network other than Visa or Mastercard for routing credit-card payments. If it ever passed, a bank that owned a third network would be well placed to capture the traffic. The bill has not advanced, but its existence shows how much political interest there is in weakening the two dominant networks, which could work in Capital One's favour during the review.

The deal needs approval from the Federal Reserve and the Office of the Comptroller of the Currency, with the Justice Department reviewing competition. Signals to watch are the timetable the regulators set for public comment, any conditions attached to approval, and whether Capital One commits to specific volume shifts on to the Discover network.

Capital One is buying a route around Visa and Mastercard as much as a card book. If regulators let it through, probably after a long review, the two networks will lose some of their most lucrative volume, starting with Capital One's debit cards within a year or two of closing.