Bankers might still be waiting for Discover Financial Services to mount a credible challenge to mega-networks Visa Inc. and MasterCard Inc. — but the smaller credit card company has been frying other fish in the meantime.
Since the height of the financial crisis, Discover has managed to thrive despite increased regulation, intensifying competition, consumer debt fatigue, and the rise of mobile payments and other disruptive technology. In a wide-ranging interview in mid-January, Chief Executive David Nelms weighed in on many of those issues, including the "sketchy" economics of the prepaid industry; the price of defending Discover's rewards program against JPMorgan Chase & Co. and other competitors; and why he doesn't plan to copy other credit card lenders by recruiting in Silicon Valley anytime soon.
Appropriately for an election year, the conversation began with politics. Nelms, who started out in mechanical engineering, came out of Harvard Business School at Bain & Co., with "offices around the corner from [now-presidential candidate] Mitt Romney actually," he says. "I've never thought Bain would be so much in the news — it's not something they usually like to do."
Below are more excerpts from American Banker's interview with Nelms, and please see a related story here.
What's your opinion on financial services being so much in the political news these days and the discussion over Romney's resume at Bain?
It's probably unfortunate … I don't think it gets the public a good picture of the value that private equity or consulting or financial services provide. … I think the facts couldn't be better, in terms of how successful they [at Bain] were, and some of the sizes of some of the companies that were created, but you can always have a negative spin. If the point is to have a negative spin, you can accomplish that with most anything. So it can't be positive or helping.
If Romney becomes the Republican nominee, are there any things that Discover will have to do to disassociate itself from the negative political chatter about financial services?
We generally will try to stay neutral on political things, and it's pretty far afield. I don't think that our customers are connecting Discover with private equity or anything like that. I actually don't see any impact. … To some degree, the politics most manifest themselves ultimately in regulatory stuff, and that takes a really long time to change anyway.
These days, who is the core Discover customer?
We're in 25 % of U.S. households … our customer base pretty well follows where people live. Our largest group is in California … we will tend to be a little bit stronger in the Midwest, a little bit stronger in the secondary cities, and a little bit underrepresented in New York City or Los Angeles.
If you're at a place that doesn't take Discover, what other credit card will you pull out of your wallet?
I don't have another credit card. I'll use a debit card. And that is a factor in a place like New York or LA — it's the single outlet merchants that may not take Discover or American Express. That tends to be in New York City — you go out to the suburbs and it's all about Target and Chili's, and you tend to get much more of the chains.
How would you describe the company in five words or less?
The leader in direct banking and payments. … Five years ago we launched student loans and personal loans, and started emphasizing direct deposits, which we had for quite some time, and that broadened us out quite sign as a direct bank. … If you go back to before my time, the original launch of Discover was the Sears financial services network, and credit card was supposed to be a part of a whole bunch of things. It's ironic — that was the right strategy for now, it was before its time. Now people are doing things online, the Internet's here, they have less and less loyalty to their branch bank, they have less and less need to go to the branch. … It's much like many other industries, where books and everything are being bought on Amazon, instead of by going to the store. Financial services are moving in that same direction because of the combination of consumer preferences, mobile phones, technology, and the internet.
Those two that you mentioned just moved things around — I'm not sure that you get a big change one way or another. The bigger thing is, the industry recovered with a vengeance in terms of the marketing pressure. … There's a lot more competition out there.
Speaking of marketing, I see a lot of ads these days for cash-back offers, which is something Discover is known for. How do you defend your cash-back rewards reputation?
Aggressively. We are the leader and we're going to stay the leader. Some people have copied a number of the innovations we've had in recent years, but we keep upping the ante. … It's really easy to give away money and it can get very expensive really quickly. You've seen our rewards rate go up — that is partly because we are giving more, and making sure we stay the leader as competitors come after us more. … We're focused on this — this is our Coca-Cola formula, this is our business, and other people get hot and cold in it. A few years ago, American Express was much bigger in it, and now they've really backed off. Citigroup was much bigger in it — they've backed off. Right now, you've got [JPMorgan] Chase, and to a much lower degree, Capital One — but if you get your rewards rate up much higher than we have ours, it makes it really expensive and you just can't make the profits you need. You've already seen Chase for instance, it's not even cash anymore, they changed their program to points that turn into cash. Well, why do you do that? You only do that if you're going to eventually devalue your points. It is absolutely a focus of ours — this quarter we went to $1500 on the cap for our 5% program, which is a very high level. We're not going to let Chase or anyone else up us in something.
But how do you do that and keep expenses reasonable, and avoid getting into a bidding war for customers?
Carefully, and we're very focused on continuing to evolve our program, as we have over the last number of years. You think about what's been added in the last six years: the five percent program; different categories that rotate was an innovation we came up with, and millions of our customers have registered for that every quarter … you can get more with a gift card, the online capabilities, even the effectiveness of the advertising. … There's not one silver bullet. … We just make it clear to our competitors that we're going to win this game, and make it very expensive for them. It costs us something, too, but it costs them more.
Prepaid and mobile are both buzzy topics in the payments industry these days. Which do you see being here for the duration, and which are overhyped?
I think both will continue to grow and be increasingly important, and I think there may be some twists and turns on both. Prepaid — as a network, we process a number of the biggest guys in the industry. We've done less on the actual issuing side, because frankly the economics are sketchy. The fees that you have to charge are very controversial, and the model keeps changing — it used to be breakage, but then there's regulatory pressure against getting the breakage. So far we haven't seen any regulated bank that's gotten really big in prepaid. You think about all the banking regulations that have to apply, like know your customer, anti-terrorism, money-laundering and all that — there is today an unlevel playing field. Now, some of those prepaid guys are buying banks, the Consumer Financial Protection Bureau is supposed to be looking after nonbanks too, so the playing field will probably get leveled to a greater degree. But it's still a little bit tough to see how you make money in prepaid once you do everything that we have to do as a credit card company, or as a bank holding company. So I'm on the one hand excited about it, on the other hand guarded about it … but it's here for the long term.
On mobile, I think that it's going to over time transform the industry. I do think that people eventually are going to be paying with their phones, not pulling anything out of their wallets — not even carrying a wallet. And it's likely to take longer than we think, because you've got to change both the device and the point of sale. But I don't think it'll be like the chip cards that have been in pilots since the mid-80's and still haven't taken off in this market, I think it'll be sooner. There's already a lot more places I can use my phone to buy, using Discover Zip [contactless cards] than there are to use a chip card in this country, after one had a thirty year lead over the other, so I think it's going to happen. … We've got our own Zip program, we've got acceptance with the people who have already rolled it out in terms of merchants, we've got over half a million customers who've had it in their Discover card or the stickers, or the phones with Discover Zip [embedded chips]. You can quickly get your numbers up by reissuing cards, but we did it sort of by request, because I think it's [only of interest to] the early adopters until you get enough of a critical mass of places where you can use it.
Anything next for Discover post-Isis?
We're part of the Google Wallet, we've been part of a number of efforts. You really have to partner both because you can't do it all yourself, and different partners are adding different value — there's access to the phone; there's the chip manufacturers for how do you get it in the phone; there's the terminal manufacturers for, how do you get it in the retailers; even the retailers themselves. You go to Best Buy and they won't take Visa [contactless cards] but they'll take Discover Zip. So there's the whole point of sale thing, that alone could be interesting — there are retailers that feel like they have to take Visa and MasterCard, but maybe they don't have to take it on the phone terminal, so is this going to be any kind of turning point.
We've just come through the Durbin amendment and its regulation of debit card interchange. What's your outlook about regulation affecting credit card interchange, or the outcome of the merchants' litigation over credit card fees?
[Long pause.] I think it's important to balance both the merchants and the issuers and we've successfully done that and seemed to avoid getting sued by merchants. … This is a recurrent issue. From an income-to-banks perspective, and from a lack-of-benefits-to-consumers perspective, I think people maybe were surprised by the Durbin amendment that got kind of thrown in there at the last moment … so I actually think it's less likely that we see credit card interchange legislation, because I think there's an awful lot of people that, once they figured out what this thing was, they wished they hadn't voted for it the first time. So when the next thing comes along, I don't think they're going to jump onto it. … But it seems like Visa and MasterCard keep being incredibly aggressive and they are getting the backlash, and so far that backlash keeps hitting the banks. Eventually, if I'm a bank, I'm not going to put up with that anymore.
So you see that as a potential opportunity for Discover?
When? Do you have a timeline for when you would start seeing more banks getting fed up with Visa and MasterCard?
No, not really. They are very, very strongly connected … but eventually, [the banks] keep having to pay these legal bills, and every time there's legislation aimed at Visa, that hits them. The banks are dealing with a lot of issues right now and I don't think there's an easy choice for them, but either the retailers are going to get fed up — the usual stuff's not going to fix it, they're going to find a different way — or the banks are going to say, 'I'm fed up with legal charges and controls on my pricing, that's just killing me. There's got to be a different way.'
Some think the CFPB will "level the playing field" by looking at nonbank lenders and other nonbank financial institutions — do you believe that?
That would be good, but obviously they haven't been able to do it yet, so I'll wait and see whether that is really happening. I think it's a much harder task to monitor all those people who have never been regulated before, and there's lots of them, and they tend to be small, and they tend to be state by state. … It's a lot easier to go after the six big credit card companies and the three big student loan companies, right? So I think it's a harder task, and the question is will they rise up to doing that task.
You're 50, and you've been CEO since 2004. Do you see yourself continuing to run Discover for the next 15 years, or is there anything else you want to do?
I don't think I've planned out quite that far, but I love Discover and I think that this is about as good as a grand finale to a career as I could imagine.
I've seen some musical chairs in the industry in the last couple of years —
A lot. There's a lot of companies that don't have people with credit card backgrounds running credit cards, which is interesting.
Especially American Express, which has been taking all of these people from the tech industry and Silicon Valley — do you see any value in doing that and going outside the credit card industry for outside experience?
[Long pause.] I guess I think that we've tended to go outside with partners, partnering with people who are outside the industry, and we try to get lots of ideas from outside the credit card industry. … But at the senior levels, I do think that fundamentally we are in banking, and in credit cards, and it's very specialized. … I don't think I could run Google, and I don't think the guy running Google could run Discover. So at some point I do think there's some expertise that's required, even as you have openness to change and embracing the new.