Use the Capital One-Discover deal to reshape the credit card market

Angus Mordant/Bloomberg

"Thank you for choosing American Airlines!"

Having flown between Miami and Philadelphia over 1,000 times since 1970, I hate that canned announcement, as I actually have no choice. Since their merger with U.S. Airways, which I opposed in 2013, American Airlines is the only major carrier on this route.

Like any good monopolist, they raised prices and reduced flights and service on this route, making sure every flight is at capacity or overbooked ("We are looking for volunteers!"). Their "first class" is really "big seat class," as only some foreign carriers offer real first class.

The proposed Capital One-Discover merger, which would create the country's largest credit card issuer with its own payment network, will have the same bad result according to anti-merger congresspeople and community groups. To them, big is bad, not better.

My analysis, however, concludes that this merger can be approved with two conditions: a pro-competitive 1% interchange fee to increase competition by challenging the dominating Visa, and a pro-community 5% deposit reinvestment requirement to eliminate "weblining" by Capital One and Discover.

Antitrust economics can be complicated, so I prefer my simple "rule of three:" As long as there are at least three effective competitors in a given market for a given product, the public's conveniences and needs are likely being met.

The CEOs of two duopolists can get together on the golf course, but it's much harder for three players to collude, never knowing who can be trusted.

Merger decisions should focus on the relative market structure of the top three participants to identify and prevent a dominant No. 1 player.

There will always be a No. 1 firm for a given product in any market, but good public policy attempts to prevent or at least limit their market domination.

Competition is more about the quality rather than just the quantity of competitors. Even with several competitors, if No. 1 dominates all others, then it effectively acts as a monopoly. In fact, market dominators love weakling competitors and irrelevant internet participants because they give the appearance of many competitors but have no real competitive impact.

In my opinion, competition can best be preserved by examining the market power of No. 1 relative to Nos. 2 and 3, using the "market domination index," or MDI, I created 25 years ago.

The primary MDI, or PMDI, is the ratio of market share of No. 1 to No. 2, and the secondary MDI (SMDI) is the ratio of No. 1's market share to the combined market share of Nos. 2 and 3. The focus must be on the relevant product in the relevant market.

My initial application of this MDI concept to bank mergers concluded that markets likely perform best with a maximum 1.5 PMDI and 1.0 SMDI. That is, No. 1 dominates with a market share more than 50% greater than No. 2 or more than double that of Nos. 2 and 3 combined. Lower MDIs mean less dominance by No. 1 and more competition.

The Capital One-Discover merger requires the analysis of numerous markets and products. For example, looking at national market share, Capital One's No. 9 plus Discover's No. 27 positions results in a No. 6 bank with $625 billion in assets but still a distance from the four league of trillionaires.  

Without overlapping retail offices, there is no local anti-competitive concern, although they both have "wholesale" credit card offices in Delaware with a combined $325 billion of nationwide deposits.

The merger would result in the largest credit card issuer in terms of outstanding debt, combining No. 4 Capital One and No. 6 Discover. Competition would be enhanced with a lower PMDI (1.1 from 1.3) and SMDI (0.6 from 0.7). Despite being displaced as No. 1, Chase, the nation's largest bank, would maintain its No. 1 deposit market share in six of the nation's ten largest metropolitan statistical areas, or MSAs.

M&A

Will the Capital One-Discover merger be approved? A guide to the issues

Banking regulators and the Department of Justice must decide whether the blockbuster deal raises antitrust concerns. Looming over their analyses are questions about how broadly or narrowly to define the relevant markets.

By Polo Rocha

April 2

This merger's real pro-competitive impact would be reducing Visa's overwhelming dominance of the card network. Visa controls a stunning 61% of 2023 purchase volume. So-called competitors Mastercard and American Express follow the leader at 26% and 11%, respectively, with No. 4 Discover at just 2%. This results in a totally unacceptable 2.4 PMDI and 1.7 SMDI.  

Counting MasterCard, Visa is technically a "duopolist," but it is really a quasi-monopolist. The recent Department of Justice complaint preventing Visa's purchase of a debit card competitor, Plaid used the term "monopoly" nearly 40 times.

It is not surprising that Visa and Mastercard, two of the world's most profitable companies, charge merchants identical interchange fees averaging 2%, often passed on to consumers (versus 3% for Amex). Discover obediently follows at 2%.

Discover's purchase by the larger, aggressive and hi-tech Capital One will increase share, especially as the only bank owning a global merchant network with direct connections to them.

But, there is no motivation for Capital One to challenge the duopoly on price.

This is where smart public policy can make a difference.

If a bank merger raises antitrust concerns in specific markets, DOJ may approve it after requiring branch, deposit or other business divestitures. DOJ, however, rarely imposes pricing conditions, which should be determined in a competitive marketplace.

A pro-competitive pricing condition, however, may be necessary when quasi-monopolists like Visa have permanently distorted competition.

DOJ should therefore require the merged Capital One-Discover to charge an average 1% interchange fee to help break the duopoly's 2% fee until network fees are in the 1% range and the PMDI and SMDI are at acceptable levels. Even at 1%, fees would still be higher than the duopolists' 0.3-0.4% fees in Europe

Despite likely challenges of this pro-competitive fee condition from Visa, Mastercard and Capital One, this may be the only opportunity to rein in Visa's domination and have network competition.

Instead of hoping for a legislative fix or for DOJ to file an Apple-type antitrust suit against Visa, this 1% solution would have Capital One doing the government's trustbusting work.

Additionally, any Federal Reserve approval should require an anti-weblining "convenience and needs" condition regarding their $325 billion combined wholesale deposits, excluding deposits in Capital One's retail offices.

The estimated $6.5 billion of Community Reinvestment Act benefits from those "branchless" deposits, now mainly benefiting Delaware, are not being reinvested in the large cities sourcing those deposits.

The Fed should use the 5% Deposit Reinvestment Rule to require a proportional reinvestment in the low- and moderate-income areas of any MSA sourcing 5% or more of deposits. This 5% solution is consistent with recent regulatory proposals encouraging "healthy" mergers benefiting communities.

The next time you hear "What's in your wallet?" the answer should be "much less costly and more community impactful credit cards," if this merger is approved with the 1% pro-competitive pricing and 5% anti-weblining conditions.