Critics of Capital One–Discover Merger Are Missing the Elephants

T he phrase “missing the elephant in the room” is often trotted out when an argument or conversation overlooks a large aspect of the situation at hand. Seldom has this analogy been more apt than in describing politicians’ and activists’ statements in opposition to the recently announced merger plans of Capital One and Discover.

In this case, there are two elephants in the room: Visa and Mastercard, the two dominant networks in the credit-card market. According to the Nilson Report compilation of credit-card data (as reported by the finance-news site Upgraded Points), Discover’s current share of the credit-card market is 7.13 percent by purchase volume. By contrast, market share held by Visa and Mastercard combined comes to almost 70 percent — 41.7 percent for Visa and 27.41 percent for Mastercard.

Yet critics of the merger tiptoe around these elephants in their claims about how big and potentially dominant a combined Capital One–Discover entity would be. Senator Elizabeth Warren (D., Mass.) declared to the Guardian that the merger “threatens our financial stability, reduces competition, and would increase fees and credit costs for American families.” Expressing similar “big is bad” sentiments, Senator Josh Hawley (R., Mo.) wrote to the Justice Department: “This is destructive corporate consolidation at its starkest. If consummated, this merger will create a new juggernaut in the credit card market.”

But what Warren, Hawley, and other critics of this merger overlook is that in the case of market dominated by a few large players, often a “new juggernaut” is exactly what’s needed to bring lower prices and other benefits to consumers and entrepreneurs. While small start-ups create many innovations, it is the process of smaller players becoming larger — both through organic growth and mergers and acquisitions — that is often necessary to bring meaningful competition to the biggest players.

Take, for instance, the airline industry. Before Southwest could challenge the few airlines that had dominated U.S. air travel for decades since the 1930s, it had to grow from its position in the 1960s and ’70s as a regional carrier that offered only intrastate flights within Texas. It was helped greatly — as were airline passengers as a whole — by the bipartisan airline deregulation of 1978 that eliminated the price floors that had prevented bargains on flights between states.

But Southwest also took active steps to grow to compete. These expansion measures included raising money through investors to acquire more airplanes and personnel, but that still did not give Southwest an national and international presence. So Southwest acquired rival airlines in the ’80s and ’90s and in 2010 substantially increased its presence both in the Northeast and in Latin America (becoming an international airline) through its acquisition of AirTran. Today, Southwest is a major airline, once-dominant carriers such as Pan Am and Eastern have gone by the wayside, and airlines regularly compete on prices and perks.

Now, the credit-card market — as well as the larger markets for payments and credit — may be ripe for a similar transformation from a combined corporate entity. For decades, there have been many credit-card issuers, including hundreds of community banks and credit unions, but very few networks. Networks and issuers work together on credit-card operations, with networks having much control over payment processing.

Since the 1980s, Visa, Mastercard, American Express, and Discover have been the only four networks that handle significant volumes of American credit-card transactions. Visa and Mastercard grabbed their footholds in the days when Depression-era laws and regulations prevented banks from branching across state lines, limiting the reach of any individual bank’s credit card. Visa and Mastercard both began as cooperatives to allow member banks to issue cards with national and international reach, enabling consumers with a card from a local bank in Kansas (to take this author’s home state as an example) to be able to use their cards in New York or even Paris or Tokyo.

Today, even with the existence of interstate banks after the rightful repeal of branching restrictions in the mid ’90s, community banks and credit unions still benefit from being able to offer credit cards to their customers from the same networks as larger banks. Merchants also benefit from having the widespread use of credit cards from different financial institutions, as it reduces a myriad of risks from cash and checks including employee theft and dealing with customers’ overdrawn accounts.

But this doesn’t mean there’s not room for improvement in this market, as in any market. One of the most contentious issues is processing fees for merchants, which are largely set by networks rather than issuers. Specifically, merchants have complained that the processing charges set by Visa and Mastercard called interchange fees — derisively referred to by retailers as “swipe fees” — are too high. For about two decades, Senate Majority Whip Dick Durbin (D., Il.) has sponsored bills containing mandates to force down credit-card interchange fees — as he did with the price controls for debit card interchange fees in the Durbin Amendment of the 2010 Dodd-Frank financial overhaul.

My Competitive Enterprise Institute colleagues and I have long opposed such measures, as we oppose government coercion and price controls in particular in every sector of the economy. We and others have also pointed out that these pieces of legislation, such as Durbin’s misnamed Credit Card Competition Act, would decimate credit-card reward programs, result in higher fees or interest payments for consumers, and, ironically, lead to more concentration by making it too costly for community banks and small credit unions to issue credit cards. As I have previously written in NR, the original Durbin Amendment led to similar results as banks shed free checking and raised fees for consumers en masse while the price controls shifted the cost of processing debit cards from retailers to consumers

Yet the combined credit-card entity of Capital One and Discover may be better able to compete on pricing for retailers and still bring benefits to consumers. Business journalist James Surowiecki, author of the acclaimed book The Wisdom of Crowds, writes in Fast Company that “Capital One will almost certainly lower swipe fees as a competitive tool” once the merger is completed. And given that Discover pioneered consumer-friendly innovations such as cash-back rewards and the lack of an annual fee, it’s a good bet that the combined entity could also bring consumers more card benefits and lower costs.

There’s another lesson that can be learned from Discover’s origins. The card actually began in 1985 as part of a financial-services subsidiary of Sears, then the No. 1 retailer in the U.S. The initial backing by Sears gave Discover a boost in challenging the dominant players, and beneficial innovations for credit-card consumers were the result.

At that time, Sears was described as a “behemoth” and “colossus” that could never be toppled.  Yet this combination certainly did not make Sears an impenetrable force; the company faced a steep decline just a few years later. By 1990, Sears’s retail sales had been overtaken by Walmart. As its core sales kept shrinking, Sears spun off the subsidiary that had carried Discover in 1993. Sears filed for bankruptcy in 2018.

No one knows whether, in the long run, a combined Discover and Capital One will rule the credit-card market or will have the fate of Sears as a corporate entity. It’s also possible that in the not-too-distant future, all credit cards could lose a substantial chunk of the credit market to new options such as buy-now-pay-later and other FinTech innovations. In the meantime, if the welfare of consumers who use and merchants who accept credit cards is regulators’ primary motivation, they will allow the merger of these two firms to create a new corporate animal to challenge the dominance of the current credit-card elephants.

(Disclosure: John Berlau owns shares in Capital One.)

Mitchell Thornton, a research associate at the Competitive Enterprise Institute, contributed to this article.