Why Capital One is buying Discover in biggest merger of 2024

Capital One recently announced $35.3 billion. acquisition from Discover financial This isn’t just about getting bigger (or “scaling up” as they say on Wall Street), it’s about trying to protect itself from the rising tide of fintech and regulatory threats.

It’s a chess move by one of the most forward-thinking thinkers in American finance, Capital One CEO Richard Fairbank. As a co-founder of the 10 largest US banks by assets, his tenure is a rarity in a banking world dominated by institutions such as JP Morgan Chase which trace their origins to shortly after the signing of the Declaration of Independence.

Fairbank, who became billionaire Having built Capital One into a credit card giant following its 1994 IPO, it is betting that buying rival card company Discover will improve the company’s position in the bleak future of global payments. The industry is a dynamic network in which players of all stripes—from traditional banks to fintech players and tech giants—are seeking to carve out a niche market that’s worth pursuing. trillions dollars, eating up the share of traditional operators amid the rapid growth of e-commerce and digital payments.

“This deal gives the company a stronger hand in competing with other banks, fintechs and big tech companies,” said Sanjay Sakhrani, a veteran retail financial analyst at KBW. “The more they can separate themselves from the pack, the more they can prepare for the future.”

If the deal is approved, Capital One could overtake JPMorgan as the largest credit card company and solidify its position as the third-largest by purchasing volume. It also increases the weight of Capital One’s banking operations with $109 billion in total deposits from Discover’s digital bank and helps the combined company reduce costs by $1.5 billion by 2027.

But it was Discover’s payment network – the “rails” that move digital dollars between consumers and merchants, collecting tolls along the way – that Fairbank repeatedly praised on Tuesday as analysts questioned him about the deal’s strategic merits. There are only four major card networks: the giants Visa And Mastercardthen American Express and finally the smallest of the Discover group.

“This network is a very, very rare asset,” Fairbank said. “We have always believed that the Holy Grail is to be an issuer with your own network so you can deal directly with merchants.”

Since founding Capital One in the late 1980s, Fairbank said he has dreamed of creating a global digital payments technology company that owns payment systems and works directly with merchants. In the decades since, Capital One has outpaced slower banks, gaining a reputation in tech circles as a forward-thinking bank. early adoption cloud computing and agile software development.

But its growth has relied on Visa and Mastercard, which accounted for the vast majority of payment volumes last year, processing nearly $10 trillion in the US.

Capital One intends to expand its Discover network, which had $550 billion in transaction volume last year, by quickly moving all of its debit transaction volume there, as well as increasing the share of credit card transactions over time.

By 2027, the bank expects to add at least $175 billion in payments and 25 million cardholders in the Discover network.

But the true potential of the Discover deal, analysts say, is what it will allow Capital One to do in the future if it owns the toll road.

By creating an end-to-end ecosystem that is more of a closed loop between buyers and sellers, it can fend off competition from rapidly mutating fintech players such as Block And PayPaland also buy now, pay later companies such as Confirm and Klarna, which have gained popularity among both traders and consumers.

Capital One is seeking to deepen its relationships with merchants by showing them how to increase sales, prevent fraud and provide analytics, Fairbank said Tuesday, all of which makes it harder to dislodge them. It could use some of the network fees to create new loyalty plans, such as debit rewards programs, or to support shopping incentives or experiences, analysts said.

“Owning the network allows us to deal directly with merchants rather than with network intermediaries,” Fairbank told analysts. “We create greater value for merchants, small businesses and consumers and realize additional economic benefits from vertical integration.”

This is an opportunity that technology or fintech companies are likely to crave. The Discover network alone would be worth up to $6 billion if it were sold Alphabet, Apple or FiservSakhrani wrote in a research note Tuesday.

The Capital One-Discovery combination could strengthen the lending company against another potential threat: Washington.

Proposed legislation Sen. Dick Durbin is seeking to cap fees charged by Visa and MasterCard, which could potentially undermine the economics of credit card rewards programs. If the proposal becomes law, the competitive position of the exempt Discover network would suddenly improve, according to Brian Grahamco-founder of a consulting firm Claros group of companies. This reflects what was in the earlier law known as Durbin Amendment made for debit cards.

“There are a lot of things that are aimed at card networks and that ecosystem in one way or another,” Graham said. “This pressure could be one of the things that creates opportunities for Capital One in the future if they gain control of this network.”

The biggest question for Capital One, its customers and investors is whether the merger will ultimately be approved by regulators. While Fairbank said it expected the deal to close in late 2024 or early 2025, industry experts said it was impossible to predict whether it would be blocked by regulators, like a string of high-profile takeovers among banks, airlines and technology companies.

On Tuesday, Democratic Sen. Elizabeth Warren called on regulators to quickly block the deal, calling it “dangerous.” Sen. Sherrod Brown, D-Ohio, chairman of the Senate Banking Committee, said he would monitor the deal to “ensure that this merger does not enrich shareholders and executives at the expense of consumers and small businesses.”

The survival of the Discover deal may depend on whether it is seen as boosting an ineffective payments network or creating greater concentration among an already dominant card lender – another reason Fairbank may have overstated the importance of the network.

“What you care about most will determine whether you think this deal is good or bad from a public policy perspective,” Graham said.