Capital One buys Discover - now what? (Part 3)
The grand finale (or is it?) focusing on - what else? - regulatory implications.
Before we get started with this final(?) edition of our Capital One/Discover deep dive, for those who didn’t get a chance to join us, I wanted to share a video clip of a LinkedIn Live I was on from this past Friday with
of Tennis Finance, who graciously hosted me on his recently launched series “Fridays in Fintech”, on which I was lucky to be his fourth guest. We talked about my background including my experience at Discover and Google, but we also spent a bit of time (near the end) summarizing my thoughts on the deal. You can check it out below:Anyway - welcome back for (what could be?) the final edition of this impromptu series. To recap to this point, in part 1 we analyzed the view from the perspective of shareholders, customers, employees, and technology. Then in part 2 we looked at the branding implications, the future of Discover’s product lines, and possible location strategies for a combined company. In this part, we’ll dive into the regulatory compliance issues Discover has outstanding, the Durbin Amendment and CCCA and how they might factor into the deal, and how all of this will play into the regulatory scrutiny and approval of the deal. Let’s move into it.
Regulatory Issues on the Table
During the call last Tuesday with investors, the very first question for Cap One CEO Fairbank was on regulations:
Fairbank’s response is interesting in that he more or less avoids the question about getting comfortable with Discover’s compliance issues. This may be for good reason - Discover has more or less three active major compliance matters on the table. One of them might be a subset of the other, but the point is there’s quite a bit to sort out which drives questions like the above. To recap:
CFPB student loan consent order - original order filed in 2015 and new order filed in 2020 shortly after the closure of the original.
FDIC consent order issued in 2023, focused entirely on consumer compliance and specifically the compliance management system including corporate governance and ERM (enterprise risk management). No fine.
Self-disclosed card product misclassification issue which impacted merchants and acquirers by having their pricing placed in the wrong tier; essentially the card issuing business collects interchange from merchants and will tier the merchants for pricing/interchange collection based on things like how the transaction is accepted (manual, via website, swipe) and what type of payment card is used (debit, credit, reward, etc).
I dug into the just-released (Feb 23) Discover 10-K to dig in a bit more into these issues, and there’s 3 pages on these items (Pg. 129-131). While the FDIC matter doesn’t have an associated fine, the student loan issue has a $10 million fine and the card product misclassification issue has a $375 million liability to be paid back to merchant acquirers and merchants, of which only $12 million has been paid back as of 12/31/23 (although the actual cause of the issue itself has been resolved as of November). Clearly, all of this presents some significant hurdles to clear. So although Fairbank didn’t address it, at least we can speculate on why they might have been willing to overlook these matters:
Discover’s own ability to clear regulatory issues - Discover has had several major consent areas in the last 10-15 years - protection products (CFPB), BSA/AML (FDIC/FRB), student loans (CFPB), and compliance management system (FDIC). For the first three areas, Discover was able to clear these matters between 3-5 years depending on the item. They’ve expressed confidence in clearing the second item by 2025 which would be ahead of their typical schedule but in the same timeline.
Capital One’s confidence at clearing regulatory issues - Capital One has had a few of its own in the last decade - several consent orders by the OCC including one on remote deposit capture stands out. They also had a massive 9 digit fine levied on them related to AML in 2021. Clearly, they are no winners in the regulatory compliance space themselves, but despite all that they currently have no active consent matters.
The FDIC matter anticipated to be remediated by 2025 - The fact that the most public regulatory matter (FDIC consent order) Discover has outstanding is expected to be remediated internally by 2025, a late estimate for when the deal is expected to be closed, signals that Capital One may think bringing the deal to a regulatory body shouldn’t present challenges since they feel the work will be done to remediate the governance issues or that work will be substantially completed.
Capital One’s cash-on-hand balance - Regarding the massive amount of remediation that still needs to be done, this is one of those situations where if Discover can’t make further progress on the rest of the $375 million related to the misclassification issue, they are being acquired by a company that has around 5 times the cash on hand they do (Discover at around $9 billion as of 12/31/2023 compared to Capital One at around $45 billion at the same point in time). This is one of those situations where “throwing money at the problem” could fix the issue
In summary, while the regulatory situation is and will continue to be a concern for Discover, Capital One likely assessed all of the above and felt none of those were showstoppers, for the reasons we noted and likely other considerations behind the scenes.
Fee Regulation (Durbin and CCCA) Implications
Raised on last week’s call as well as by some astute industry commenters (namely friend of the newsletter Jason Mikula), the question immediately was asked about Capital One being able to take advantage of the exemption in the Durbin Amendment. As a recap, the Durbin Amendment passed in 2010 placed a cap on how much debit card issuers could charge merchants interchange (which in and of itself is driven by network pricing) with exemptions for smaller issuers (i.e. below $10 billion). While Fairbank didn’t frame this as an advantage explicitly on the call, the Amendment was clear when it passed that it wouldn’t apply to issuers who are also the network (aka three party networks).
Suddenly, Capital One’s eager exclamation that they were moving their entire debit business over to the Discover network (which we covered last time) makes total sense, meaning they will be able to charge increased fees to merchants, despite being significantly over the asset threshold of $10 billion at which Durbin was supposed to apply. If they had continued to issue debit cards just for Visa and Mastercard, they would still have to be subject to the Durbin cap. In essence, they’ve created a scenario which has found a loophole in the Durbin amendment, and are smartly taking advantage of it, which will be to the ultimate detriment of merchants and eventually consumers. Taken further, the Amendment has been ripped thoroughly since it was initially implemented, and this is almost the crown jewel of its failure.
On the CCCA (Credit Card Competition Act) front (another Durbin creation), which in theory is supposed to be the credit card version of Durbin, Capital One would have significantly less work to do compared to any other in-scope issuer as this proposed regulation, amongst many things (which I covered in an interview with Ballard Spahr late last year), would require issuers over an even larger threshold than Durbin ($100 billion in assets) to offer credit cards on more than one network, with one of the two networks being alternative to Visa and Mastercard. In my interview, I discussed how much work this might take especially as Discover and American Express (the unspoken non-Visa/MC networks referenced in the proposal) have never had to work with any other issuers other than themselves.
Capital One in essence will get to test the CCCA’s vision of the future ahead of time, as they will be Discover’s first non-Discover credit issuer. Depending on how smoothly the implementation goes, the experience at integration of a second non-Visa/MC network could be a selling point if the CCCA passes and suddenly banks like Regions, Northern Trust, HSBC and others are scrambling to comply. From that angle, American Express would lose some of the advantage it stood to gain along with an independent Discover when the CCCA was first being floated, as they won’t be able to tout the experience of dual network onboarding. On the other hand, I doubt these larger issuers are going to want to go to another large issuer - and in the post-Discover world, the largest - to ask for access to their Discover network just to comply. For example, I can’t see Chase wanting to grovel at Capital One’s feet just to be able to use Discover especially after being eclipsed in issuer size; in that scenario they will likely just go to American Express. In any case, this really doesn’t sound like what Durbin had in mind here either, where the biggest issuer ends up becoming a gatekeeper of sorts to its competition.
Ironically, the latest news from just yesterday is that Durbin himself is now skeptical that the deal would inject competition into the credit card market. Ya think!?! Cap One is basically doing an end-run around your current and future regulations, pal!
Scrutiny of the Deal
I am going to mostly cede the floor on this to Michelle Alt, cofounder of Klaros Group, former OCC counsel and assistant director, and general compliance expert who runs a fantastic weekly show “Radically Clear” with episodes on Friday. Michelle did an absolutely incredible breakdown of elements that regulators will consider when the deal comes up for consideration, having been one herself. She cites 5 of 13 considerations in the OCC Bank Merger Act guidance which will be red flags for Capital One in this deal, and put together a killer table analyzing each element.
As far as my contribution, I’ll point to the Fed’s entire section on “applications” which include bank acquisitions. They did a helpful FAQ on this topic as well, although it is about ten years old. Reading through some of this, the topic of competition comes up again. While we have brought up competition in the context of issuers, the biggest point of consideration that I would argue needs to be considered (and doesn’t appear to be something some lawmakers are giving much weight to) is the impact to Visa and Mastercard. Just the potential of breaking the duopoly of networks and creating a serious third option could indirectly lower interchange (as networks take a cut of interchange from issuers), force a race for innovation, open up possibilities for competition overseas, and much more.
My thought? I think it’ll be close, but the deal goes through.
Bonus Round
A few days ago, Discover and Capital One filed matching 10-Ks with the SEC. There’s a ton in there to digest. So ready or not, we’re going to do one more issue on this deal which will focus on some deal-related highlights as well as the previously promised merchant and rewards impact analysis.
See you again soon!