Room for Another?

  Kenneth Lewis contends he simply was throwing out for discussion the idea of Bank of America launching its own card-processing network to compete with Visa and MasterCard. But Lewis, the Charlotte, N.C.-based bank's chairman and CEO, did not just discuss it with his staff behind closed doors.
  Instead, he fed the proposal to The Wall Street Journal and a Morgan Stanley analyst.
  The timing for Lewis to bring up the possibility of BofA starting its own network is not unexpected. These are turbulent times in which significant industry change is occurring. Merchant lawsuits over interchange, for example, have led Visa USA and MasterCard International to revamp their boards, thus reducing the decision-making power of their issuing members, particularly large ones such as BofA (see story page 10).
  BofA is a member of both card associations, and merchants have charged Visa and MasterCard with colluding with their member issuers in setting interchange, the fee merchant banks pay card issuers for debit and credit card purchases. MasterCard, which in late May was expected to complete its initial public offering, acknowledged in a recent U.S. Securities and Exchange Commission filing the significance of the lawsuits.
  "If we are found liable in any of these lawsuits, we may, among other things, be forced to pay damages and/or change our business practices and pricing structure, which could affect our revenue and profitability...," MasterCard said.
  If BofA builds its own network, the bank could escape the interchange war with merchants, and its actions could cause a ripple effect throughout the industry. "[Building a card-processing network] would be what every issuer wants to do," contends Tom Dailey, a Chicago-based industry consultant. "The associations are highly inflexible, and there's tension between them and issuers."
  The present arrangement between the associations and their members hinders development of creative products, Dailey explains. "There are a lot of cards out there, but they are all different shades of vanilla," he says, noting many cardholders believe MasterCard and Visa cards are alike, that they are the same product.
  Morgan Stanley analyst Betsy L. Graseck agrees that Lewis' network idea may prompt a change. "At least [BofA's] efforts should help drive new products for its payments' clients...," Graseck wrote in her recent report "Bank of America: Raising EPS on Higher Buybacks & Wealth/Advisory."
  Indeed, creation of a private card-processing network could lead to a more merchant-friendly network, says Gwenn B?zard, research director for Aite Group. B?zard believes if BofA starts its own general-purpose card-processing network, it would cut merchants' interchange.
  The idea of issuers creating their own card-processing networks is not a new. The models are there, and the failure rate is high. Examples include JCB International Co. Ltd., the Japanese card issuer and merchant acquirer; Citibank; Sears, Roebuck and Co.; and Diners Club.
  JCB set up a card-processing network in the early 1990s in and around U.S. airports and in U.S.-based Japanese grocery stores. JCB targeted Japanese business travelers, tourists and expatriates. The network failed when the Japanese yen declined in value.
  Citibank launched the Choice Network in the 1980s, but the network quietly closed after three or four years.
  Sears started it own private-label, card-processing network, but it was unable to get the critical mass of merchants needed to make it successful. Sears had 60 million cardholders, at the time the largest of any U.S. issuer. Though it did not fail outright, its successor, the Discover Network, has had difficulty gaining market momentum. Some experts believe BofA may have its eye on the network in a potential buyout.
  Diners Club North America, which serves the U.S. and Canada and is owned by Citigroup Inc., is the latest network casualty. In May 2005, Diners Club joined the MasterCard network, scuttling its own network.
  With a high failure rate of card-processing networks, is Lewis' notion of starting a new brand similar to whistling while walking past the graveyard? The bank, one of the nation's largest card issuers with 40 million active U.S. credit card accounts and nearly $140 billion in receivables, has the money. But does it have the patience?
  Dailey, who helped build the Discover network, says BofA would have to spend $1 billion over 10 years to grow a network from scratch. "It will take a large effort to overcome a high hurdle," says Dailey, who was senior vice president of the Discover Network from 1983 to 2003. He headed the network for five years.
  EXPENSIVE PROPOSITION
  Dailey bases his estimate on the time and money it took to build the Discover Network. Discover, which serves about 4 million U.S. merchants, spent $1 billion over 15 to 20 years.
  Lewis says the idea of building a card-processing network is something he is open to, but it is not a top priority. "The processing [network] is something that I threw out as an idea that we have the capability to pursue at some point, but nothing is on the immediate horizon," he told analysts during a Prudential Equity Group analyst conference call.
  Building a network involves a number of mundane yet important factors. It includes establishing a network-routing number to ensure merchants route card transactions over the correct network. The bank also would have to sign agreements with acquirers nationwide to secure sufficient card acceptance. And it would need to help train clerks to recognize its brand when someone presents its card at the point of sale.
  Instead of building a general-purpose network from scratch, BofA has alternatives. Dailey suggests BofA consider piggybacking on either the AmEx or Discover networks. This would involve routing BofA card transactions over those networks.
  Bank of America has an agreement to issue a cobranded AmEx card over AmEx's network. The bank inherited the agreement when it purchased MBNA Corp. on Jan. 1. MBNA was the first MasterCard and Visa issuer to sign a cobranding agreement with AmEx after the U.S. Supreme Court refused to overturn lower court decisions tossing out Visa and MasterCard rules that did not allow their members to issue AmEx or Discover cards.
  Marc Sacher, director of Auriemma Consulting Group Inc., also believes it would be a good idea for BofA to buy Discover if BofA wants to own a network. Morgan Stanley, Discover's owner, explored selling the network last year but decided to keep it.
  Sacher and Michael Auriemma, the company's president, believe that for the right price the Discover network could become available. "[Morgan Stanley] didn't get the price it wanted," Auriemma says.
  During the Prudential conference call, moderator Mike Mayo asked Lewis if BofA would buy a network. "It's not in any top-of-mind awareness with me or in my consciousness at the moment," Lewis answered. "You never say never. But we have a lot of other things that we're working on that to me would pay bigger dividends and do more for shareholders than to focus on any of that."
  In an interview before the Prudential conference, Lewis told Morgan Stanley's Graseck large acquisitions were not on BofA's agenda.
  But an industry expert says buying a network would solve the proverbial problem of the chicken and the egg. An established network would give BofA the critical mass of merchants it would need to make its private card-processing network successful.
  So why is Lewis throwing out this idea of BofA building its own card-processing network?
  Lewis told The Wall Street Journal that he is not happy with the fact that BofA helped build the Visa brand when it could have been spending the money to build the bank's own brand. Bank of America in 1958 began issuing the blue, white and gold BankAmericard in California. In 1976, BankAmericard changed its name to Visa.
  Analyst Moshe Orenbuch believes Lewis' statement is disingenuous. "He says he doesn't want to spend money building up Visa's network, but he's building up American Express's network, which is a competitor," says Orenbuch, managing director Equity Research at Credit Suisse First Boston.
  Lewis also wants to send Visa a message. "[Starting a card-processing network] is something that always will be on the table if we don't like what we're getting from Visa," he said during the Prudential conference call.
  VISA RESPONSE
  Philip Coghlan, Visa's president and CEO, said the card association's relationship with BofA has been "long and strong."
  Recently, however, BofA gave up its seat on Visa's board of directors. The bank remains a Visa partner, and it has committed the majority of its credit card volume to Visa. BofA accounts for about 20% of Visa's annual card volume.
  If it decides not to buy, BofA also may benefit from building its own network. "BofA can dodge the interchange bullet by creating its own network and dealing with merchants one on one," says Aite's B?zard. It can offer merchants discounts on interchange if they agree to promote BofA-issued cards to their customers, he says.
  B?zard believes BofA's proposal is part of an industry cycle, and the pendulum may be swinging back. "During the 1960s, banks owned their card-processing networks," he says. "Later, they got out, but they are returning to [wanting] their own networks as the industry consolidates."
  Despite Lewis' public comments, opinions are mixed about his seriousness. Orenbuch, for example, is a doubter. "It all sounds real good, but it just isn't there," he says.
  On the other hand, Auriemma believes BofA already is building a card-processing network. And the pieces seem to be in place. BofA owns a major merchant processor. In July 2004, the bank purchased National Processing Inc. for $1.4 billion from National City Corp. BofA combined National Processing with the bank's Merchant Services unit, creating the nation's second-largest merchant processor with $250 billion in annual volume.
  The bank also has been building its credit card portfolio. In October 2003 it purchased FleetBoston Financial Corp. and its $16.2 billion in credit card receivables. And in January, BofA acquired MBNA.
  TRIAL BALLOON
  Auriemma says Lewis disclosed his network plans to gauge Wall Street's reaction. What has been analysts' response? "It's too early to say," Auriemma says.
  In some cases, analysts and BofA's shareholders' response to the idea has been muted.
  Lewis answered questions for an hour during Prudential's conference call. It was not until moderator Mayo was about to end the call when he received two questions in an e-mail asking about Lewis' card-processing network comments.
  And on the day The Wall Street Journal article appeared, Lewis spoke to shareholders at the company's annual meeting. He did not mention the network proposal, and shareholders did not ask about it.
  Bank of America has the money to build a network. What remains unknown is whether it wants to do so or is simply doing what it can to leverage preferred treatment from Visa.
  KEY BofA NETWORK-BUILDING BUYS
  * October 2003: BofA buys FleetBoston Financial Corp. and its $16.2 billion in credit card receivables.
  * July 2004: BofA buys National Processing Inc. for $1.4 billion from National City Corp. It combines National Processing with the bank's Merchant Services unit, creating the nation's second-largest merchant processor with $250 billion in annual volume.
  * January 2006, BofA buys issuer MBNA Corp. for about $35 billion. The deal makes BofA one of the nation's largest credit card issuers.
  SOURCE: Cards&Payments.
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