The Journal. - The Deal That Could Change Credit Cards

Episode Date: February 22, 2024

Capital One announced plans to buy Discover Financial Services in a $35 billion deal that marries two of the largest credit-card companies in the U.S. and has the potential to shake up the credit card industry in a major way. WSJ’s AnnaMaria Andriotis explores what makes this deal such a game changer. Further Reading: - Capital One Is Buying Discover Financial for $35 Billion  Further Listening: - Inside the Capital One Hack  - The Fight Over Your Credit Card Swipe  Learn more about your ad choices. Visit megaphone.fm/adchoices

There are two giants who rule over the world of credit and debit cards, Visa and MasterCard. Almost every credit card, almost every debit card that people have in their pockets, almost certainly they are from the thousands of banks that are aligned with Visa and MasterCard. That's our colleague, Anna Maria Andriotis. She says Visa and MasterCard run the biggest payment networks in the U.S. That's the infrastructure that many card transactions depend on. Think of it as a set of rails. If those rails aren't there, the train can't move.

as a set of rails. If those rails aren't there, the train can't move. If you, the consumer, go to pay with your credit or debit card and there is no network tied to that card, no network enabled on that card, your transaction's going nowhere. You are unable to make that purchase. going nowhere. You are unable to make that purchase. Banks rely on these networks for their cards, but some have their own networks, like Discover. Discover's network is pretty small. It only accounted for 2% of the $10 trillion in U.S. credit and debit card purchases last year, according to the Nielsen Report. Discover is a competitor, or at least supposed to be a competitor. Transaction volume that went over its network rails compared to Visa and MasterCard

is kind of laughable. It was basically a rounding error. For years, Anna Maria has thought that someday, someone would try to challenge Visa and MasterCard by buying Discover. And then, on Monday... A major credit card company will soon have a new owner. Capital One will purchase Discover Financial for $35 billion, combining two of the largest credit card companies in the country. So when I heard about this, that Capital One

is buying Discover, I thought first, finally, someone's doing it. And second, I thought, okay, this is a really big deal for both Cap One and potentially the payments industry as a whole. Welcome to The Journal, our show about money, business, and power. I'm Kate Limewald. It's Thursday, February 22nd. It's Thursday, February 22nd. Coming up on the show, can Capital One change the credit card game? Need a great reason to get up in the morning? Well, what about two? Right now, get a small, organic Fairtrade coffee and a tasty bacon and egger breakfast sandwich for only $5 at A&W's in Ontario.

How did Discover get its start? The beginning of Discover really goes back to Sears stores. As weird as that sounds. Sears Roebuck? Sears, correct. Sears. For years, it was the largest retailer in America. And in the 1980s, it wanted to create a one-stop financial services

center in its stores. To do that, Sears bought a brokerage firm and later a bank. And in 1985, it announced the Discover Card. The Discover Card was innovative. It was one of the first cards to offer cashback rewards. But the venture wasn't profitable, and Sears cut its losses. It spun it off in 1993. A few years later, Morgan Stanley bought the venture. And then in 2007, it spun off Discover to be an independent company. As a standalone company, how did it go? Well, it was okay. It kind of did its own thing. It is located in the middle of the country in Riverwoods, Illinois. It was a quiet but innovative company, but not one that was looked at in the

credit card space like JPMorgan Chase and Amex. And they didn't go after all those affluent customers. Really what they focused on were people with good credit scores who were just like kind of normal people, not super rich, just kind of in the middle of that income spectrum. Discover's business was growing. It got into student loans, personal loans, and other consumer products. Most people think about Discover as the credit card lender. But behind the scenes of all that, there is something that is much more valuable to Discover. And that's the network.

Remember, the payment network is the infrastructure that helps process credit and debit card transactions. And Discover's network made it appealing to some interested buyers. And why didn't those deals come to pass? One large bank sources there told me that they were not impressed with the capabilities of Discover's network, that it was outdated. We need a lot of money to improve and get to scale. It wasn't just banks. Tech companies looking to start their own payment networks also wanted a piece of Discover. Tech companies wanted the network, but Discover was not willing to part just with the network. If you want to buy us,

you have to buy all of us. You can't just split us up, is what I was told. Why have Discover executives been reluctant to separate the network from the credit card business? The executives who had spoken with me in the past, people who previously ran Discover, said to me that they believed in the brand and the value of the brand and they associated the brand with both the network and the lending side. They didn't want it split and they had the brand all linked as one. But in the meantime, Discover started having some major struggles. So things started unraveling in a very clear and public way

last year. There was the departure of Discover's CEO, Roger Hochschild, at the time. This was in August of last year. The departure played out as a number of regulatory issues were playing out and concerns internally at Discover about compliance, oversight, and how seriously the company in general had to address the number of issues. What were some of the issues? of the issues. So last year, Discover disclosed that an internal review found that it had misclassified certain credit card accounts dating back to 2007. What that effectively means is that when merchants were accepting Discover cards, at least in some cases, they were paying higher fees than they were supposed to be. Discover set aside $365 million to compensate impacted parties, including merchants. Discover has also said that it's working with regulators to improve compliance on separate issues.

They were with an interim CEO for some time. In December, they announced their new CEO. It was a rocky period. So I remember looking at this playing out and thinking, wow, if anybody really wants Discover, this is the moment. And somebody did. That's next. Introducing TD Insurance for Business, with customized coverage options for your business. Thank you. customized coverage for your business. Contact a licensed TD insurance advisor to learn more.

With Uber Reserve, good things come to those who plan ahead. Family vacay? Reserve your ride as soon as you book your flights. To all the planners, now you can reserve your Uber ride up to 90 days in advance. See Uber app for details. Last year, Discover was in merger talks with a suitor you've probably heard of. So ask yourself, what's in your wallet? What's in your wallet? What's in your wallet? What's in your wallet? That suitor was Capital One, the ninth largest bank in the country and a major credit card issuer. Capital One is where a lot of people get their start with that first credit card, you know, out of college or people who are trying to rebuild their credit and they get these small credit line,

you know, of credit cards, $500 spending limit, et cetera. They also have built up their premium credit card program, you know, for those people who want to get the travel points. And those tend to be people who are more credit worthy, people with very high credit scores, people that have a lot of money to spend. And how did Capital One get interested in Discover? And how did Capital One get interested in Discover? So my understanding is that Capital One CEO, who's been the CEO since the company launched, and has looked at a variety of ways of expanding, transforming Capital One into more of a tech-based company, even from afar, has been interested in Discover, has been intrigued by Discover for some time. So clearly something played out where he felt this was the time to try to do this deal. And what was it about Discover that interested Capital One?

So there's three things. There's the credit cards and the customers associated with them. There's the deposit accounts. And by far, the biggest reason why Capital One wanted Discover is its network. In a call with investors on Tuesday, Capital One CEO Richard Fairbank said owning a network was his holy grail. We all kind of revel in the fact that a network is a very, very rare asset. There are very few of them. And it's just, you know, I don't think people are going to be building any of these anytime soon because it's such a shame. Its CEO, in announcing the deal, made clear that he intends to compete against the other networks.

I mean, who are the other networks? That is Visa and MasterCard as its networks for its credit cards and debit cards. So that would mean Capital One would be going toe-to-toe with Visa and MasterCard? In some spaces, yes. And why would Capital One want to do that? What power is there in owning a network? An insane amount of power. This is what a lot of people don't realize, especially consumers,

because as consumers, right, we care about our points. We care about like if I had to make a payment, I'm calling my bank, right? But the networks set very critical rules in the payments industry that ultimately impact merchants, consumers, and banks. The networks determine something called the interchange fee. The interchange fee is what the merchant pays every time we shop with our credit cards to the bank that issued the credit card. Okay, so for instance, if I had a Chase Visa, I go to the Gap, I buy a t-shirt, I put it on my credit card, and the Gap, the merchant, pays a fee to the bank? They pay a fee that gets divvied up and that fee goes to the bank. Yes.

So you have Visa and MasterCard that are setting fees that merchants are paying to thousands of banks in the U.S. of banks in the U.S. And generally, merchants, especially small ones, don't have a choice but to pay these interchange fees. There is no say if you're a mom-and-pop shop. There is no say if you're a mid-sized type of merchant. You need to be among the largest in the country, maybe even so in the world, in order to have a seat at that table. By owning the Discover Network, Capital One would be able to negotiate interchange fees for transactions over that network. Capital One says some of its credit cards will be put on the Discover Network,

but it will continue to use Visa and MasterCard for others. But all of its debit cards will move to the Discover Network. Anna Maria says that by doing that, Capital One would be able to keep a greater portion of the fees that merchants already pay, because it wouldn't be splitting the fees with a separate network. already pay because it wouldn't be splitting the fees with a separate network. How will this deal between Capital One and Discover, how is it going to affect consumers? I think changes for consumers, if they occur, would be in the long run. The way that consumers are impacted right now by the power that the current network system as it is has is merchants factor in the fees they incur from credit card and debit card payments and often embed those in the sticker prices we all see. Increasingly, merchants surcharge, right?

You're paying with a credit card, tack on another 2% to the bill or another 3% to the bill. So Capital One intends to negotiate directly with merchants on fees, on other terms. on fees, on other terms. If it's able to do that in a sizable way, could consumers see some additional benefits to shopping with Capital One cards on the Discover network? Maybe, but that's a longer-term development. The deal still needs to be approved

by shareholders and antitrust regulators. Now, there's been, you know, a lot of talk around, is this antitrust, you know, is this anti-competitive? You know, look, on the lending side, I can see why there would be a debate. You have one large credit card lender buying another large credit card lender. But how do you argue anti-competitiveness on the network side when you effectively have two networks accounting for the majority of share in payments volume and setting the interchange fees, setting the acceptance rules? If anything, Cap One could argue that it's trying to inject competition on the network side. A spokesman for the Electronic Payments Coalition, which includes Visa and MasterCard, said the card market is extremely competitive.

Quote, there are literally thousands of banks in America issuing cards and more ways than ever for consumers to pay for their purchases. It also said that this deal would create more competition. A MasterCard spokesman also pointed out that consumers have many options beyond cards, like buy-now-pay-later companies and digital currencies. Will this deal change the credit card industry? It has the potential to change the credit card industry, the debit and the credit card industry. Because this is a powerful bank in payments

that being Cap One. It has big ambitions. So the ball is in Capital One's court, again, assuming this deal is finalized and approved. If it truly intends to use Discover's network to make it more of a competitive force in payments, yeah, it has the chance to radically change the payment space.

That's all for today, Thursday, February 22nd. The Journal is a co-production of Spotify and The Wall Street Journal. Additional reporting in this episode by Lauren Thomas. Thanks for listening. See you tomorrow.