The Capital One-Discover Merger Application

Competition, financial stability, and consent orders. Also, Delaware

Last Wednesday Capital One filed a Bank Merger Act application¹ with the Office of the Comptroller of the Currency seeking approval for its proposed acquisition of Discover. The application gives a more detailed public look at the arguments being made by Capital One as to why the transaction is consistent with approval from a bank regulatory perspective under the relevant governing statutes.²

This post briefly highlights three of the most important arguments in the application, as well as one less important thing that I just thought was interesting.

Competition

Capital One addresses the competitive effects of the proposed transaction both in the main Bank Merger Act application itself³ and in a separate memorandum.⁴ The company’s analysis focuses on (i) banking markets, (ii) credit card issuance and (iii) credit card and debit card networks. The argument about banking markets is least controversial, so we’ll skip over it here and focus on the latter two.

Credit Card Issuance

Citing to prior Board and OCC orders, Capital One argues that the banking regulators have previously characterized the market for credit card issuance as “national in scope, intensely competitive, and not concentrated.” Capital One also gets in an early mention of the “the DOJ’s lawsuit against Visa and Mastercard, which began in 1998 and ended in 2003,” noting that the “DOJ acknowledged in that litigation that ‘[n]o one disputes that the issuer market is unconcentrated.’”

Capital One believes these prior statements still accurately depict the market today, saying that market concentration is “persistently low and decreasing” and that the market for credit card issuance “reflects dynamism, innovation, and competition in the industry.” Capital One also argues that consumers are able to “easily switch credit card products and can switch to other transaction or lending products that compete for credit card spend.”

This all leads up to the crux of the argument, in which Capital One contends that an HHI analysis of the credit card issuance market demonstrates that post-merger concentration levels would be “well below relevant safe harbor thresholds.”⁵ This is the case, Capital One asserts, whether you measure the relevant market based on purchase volume or based on outstanding balances.⁶

Capital One acknowledges that the combined company will be a leading credit card issuer, but argues that it will continue to face competition from “many significant competitors” (which it goes on to name and profile in detail) as well as “[n]umerous other banks and financial institutions.” Some of these competitors, Capital One argues, have “significantly greater resources than [Capital One] to invest in and develop new or existing products and services in competition with [Capital One].”

Capital One also argues that the proposed transaction “will likely increase access to credit,” as the company’s “distinct underwriting capabilities—which facilitate expanded access to credit for all consumers—will enable card offers to some consumers who do not satisfy Discover’s credit requirements today.”

Overall, the argument in this section is generally what one would expect. As Capital One is quick to point out, there are several precedent orders describing how the banking regulators view the credit card issuance market that, if applied here, are pretty helpful to the bank’s argument. A key point of debate may be whether those orders still accurately characterize the credit card issuance market. For example, is the right frame for any HHI analysis the credit card issuance market as a whole, or should the transaction also or instead be viewed in terms of its effects on submarkets?⁷

Payments Networks

Capital One observes that the payments networks currently owned by its proposed merger partner Discover have “reduced and declining share,” “have been in long-term decline,” and thus have “limited current competitive significance.”

Capital One says it intends to “reverse those trends” of decline in Discover’s networks. It plans to “add[] immediate scale to the networks” and to “significantly invest[] in them.” The company believes it “has the resources to make these investments, but Discover does not.”

The result of this, Capital One argues, will be the creation of a “much-needed competitive alternative to Visa, Mastercard, and Amex.” In fact, Capital One states that its acquisition of Discover and the banking regulators related evaluation of this merger application “present the most viable chance to sustain and grow the Discover payments networks and to deconcentrate and increase competition among payments networks in the United States.”

As with the above argument concerning the credit card issuance market, the argument here is about what one would have expected based on what has already been said by the parties about the proposed transaction. Note, though, that Capital One’s argument here, at least as written, is not that the potential for increased competition in payment networks offsets any negative competitive effects otherwise resulting from the transaction. Rather, the argument is that all aspects of the transaction are procompetitive.

Financial Stability

The financial stability arguments in the application⁸ generally follow the standard approach taken in other recent large bank merger applications, and in the Board and OCC public orders approving those applications. That is, Capital One argues that although the transaction would increase certain risk based indicators (e.g., size, interconnectedness), the increases in question are modest, the post-merger shares of certain indicators would remain fractions of those total reported by even larger banks, and based on GSIB score the post-merger company would be far from becoming a global systemically important banking organization.

A little newer as an argument, but understandable given recent areas of focus by the agencies, is this observation about the deposit base of the post-merger bank:

[Capital One, National Association’s] insured deposits would be approximately 79% of its total deposits, which is expected to be the highest insured deposit percentage amongst the 10 largest U.S. banks.

Also worth mentioning, given the discussion of this argument on this blog earlier in the week,⁹ is this paragraph and accompanying footnote:

In addition, COFC is a Category III organization, while Discover is currently not. As a result of the Proposed Transaction, the assets and liabilities of these companies, including the assets and liabilities of Discover acquired in the Proposed Transaction, would become subject to the Supplementary Leverage Ratio and the Countercyclical Capital Buffer requirements of the banking agencies’ regulatory capital rules, as well as the LCR and NSFR requirements that apply to COFC as a Category III firm.[36]

[36] The Federal Reserve has previously noted that the expansion of more stringent prudential standards to the assets and liabilities acquired as part of a Proposed Transaction is a favorable consideration under the financial stability factor. See Morgan Stanley/E*Trade Order, FR Order 2020-05 at p. 23 (Sept. 30, 2020).

In sum, Capital One orients its financial stability analysis very much in line with recent Board and OCC analyses. I tend to agree that, if the Board and OCC follow their previously articulated approaches, it is tough to argue this transaction is inconsistent with approval under the financial stability factor.¹⁰ But of course a key point of debate is whether the Board and OCC should in fact continue with their previous approach.

Discover’s Consent Orders

Discover has been subject to a succession of escalating enforcement actions, including a public consent order entered into with the FDIC last year. In its most recent 10-K and in other regulatory filings, the company has signaled that additional enforcement actions may be forthcoming in relation to a card product misclassification issue.

This could be framed as an argument either for or against the merger. If you are concerned about the transaction, you might worry that the merger would result in Discover’s problems simply being ported over to Capital One, potentially spreading deficient practices to a larger organization. On the other hand, you could also reasonably argue that the merger could be beneficial as Capital One could impose upon Discover Capital One’s more mature compliance and risk management frameworks. This is an argument that the OCC has recognized in recent orders.¹¹

Capital One in its application acknowledges that Discover’s outstanding enforcement actions mean that integration of Discover into Capital One’s risk management framework “will require sustained focus, investment and effort.”

In particular, Capital One believes it will need to materially strengthen and enhance Discover’s existing risk management functions, and in particular compliance, to comply with both Capital One’s internal standards and those of its regulators. Capital One anticipates that this improvement will include extensive work to address outstanding remediation under the two orders and possible future supervisory findings.

Delaware Deposits

Finally, the application raises a weird wrinkle about the geographic location of deposits that are solicited online. This should not ultimately be an obstacle to approval (assuming the agencies are satisfied on every other point), but it highlights some of the clunkiness of the current approach for evaluating where a bank’s deposits are located.

The issue comes up because one of the factors that the Board and OCC must evaluate is whether the proposed transaction complies with statewide deposit concentration limits. These limits, subject to certain exceptions, prohibit an acquiring bank that controls a bank or a branch in the target bank’s home state from controlling 30% or more of the deposits in that state following the acquisition.

For purposes of this transaction, Discover’s home state is Delaware, as that is the state in which Discover Bank holds a charter.

Capital One believes these statutory provisions are not applicable here because (i) for the OCC’s purposes, at the time of the bank merger Capital One and Discover will be affiliates¹² and (ii) Capital One does not currently have a branch in Delaware, making this an initial entry to which the statewide concentration limit does not apply.¹³

If the statue does apply, though, the analysis gets more complicated.

First, because Discover has no branches and operates a digital bank that accepts deposits nationwide, the entirety of Discover’s deposits are in some sense Delaware deposits.

Second, although Capital One is based in Virginia and does not have any branch offices in Delaware, it does accept deposits on its website from customers nationwide. And the “operational facility that accepts and reports” many or all of these “internet-based deposits” is located in Delaware.

Thus if you “conservatively assume[] that an operational facility that accepts deposits is deemed to be a branch solely for the purposes” of the statewide concentration analysis, you get a bank that looks like a Delaware behemoth.

As of June 30, 2023, CONA and Discover Bank had deposits totaling $224.2 billion and $101.2 billion, respectively, booked in these Delaware locations. Thus, reflecting that both CONA and Discover Bank book deposits from customers nationwide at locations in Delaware, on a combined basis, CONA would hold approximately $325.4 billion or 64.9% of the $501.4 billion total amount of the reported deposits of insured depository institutions in Delaware.

As Capital One explains in a footnote, the actual number of Delaware-based depositors of Capital One and Discover is likely a tiny fraction of the above number,¹⁴ but if that 64.9% figure is the figure the agencies must use for purposes of the statewide deposit cap analysis (assuming the concentration limit applies at all), then the resulting bank is well in excess of the 30% cap.

The analysis does not end there, however. The relevant statutes include exceptions for cases where (a) a bank is permitted by state statute, regulation or order to control more than 30% of deposits in the state or (b) the transaction is approved by the appropriate state banking regulator and the standard on which the approval is based does not discriminate against out-of-state organizations.

These exceptions mean that even if the statewide concentration limit is applicable to this transaction in the first place, and even if Capital One and Discover are regarded as having Delaware deposits in excess of the 30% limit, approval from the Delaware State Bank Commissioner for the transaction would mean that the proposed transaction complies with the relevant provisions of federal law that reference statewide concentration limits.

On this narrow issue, that seems like the right result. Even if you have reasonable concerns about the competitive effects of transaction as a whole, I am not sure there is a coherent argument that the competitiveness of the Delaware banking market is an important issue raised by the proposal. This does highlight, though, an aspect of the approach to bank merger analysis that is ripe for updating.¹⁵

Thanks for reading! Thoughts on this post are welcome at bankregblog@gmail.com

1. If you cannot access it at the link in the text, this document is publicly available in the OCC’s FOIA reading room.

2. In addition to approval from the OCC under the Bank Merger Act, bank regulatory approval for the merger is also required from the Federal Reserve Board under the Bank Holding Company Act and from the Delaware State Bank Commissioner under Delaware law (because Discover is a Delaware-chartered nonmember bank). Applications submitted to those regulators are not yet public, but there is typically substantial overlap between applications filed with the Board, the OCC and state regulators (if applicable), so the application that the OCC has now publicly posted gives a reasonable idea of the arguments being made in the other applications as well.

Of course here, and unlike in some bank merger transactions, the DOJ is also expected to examine this transaction in detail, but given that the focus of this post is the application filed with the OCC, the post generally focuses only on the bank regulatory analysis.

3. This is at Section IV of the BMA application, starting on page 524 of the PDF.

4. This is public exhibit 21, starting on page 388 of the PDF.

5. Capital One stresses that the transaction is inside the relevant thresholds regardless of whether one looks to the 1995 bank merger guidelines (which CFPB Director Chopra last week called “infamously outdated”) or the 2023 update from the DOJ and FTC to their joint merger guidelines (which were silent as to their effect on the 1995 bank merger guidelines). See footnote 4 on page 389 of the PDF.

6. This chart comes from page 404 of the PDF.

7. See for example the arguments about the subprime credit card lending market made on page 16 of this report from the American Economic Liberties Project. See also, though, this post on X from Herbert Hovenkamp.

8. This is Section V of the BMA application, starting on page 526 of the PDF.

9. See point #8 in this post on the FDIC’s proposed statement of policy on bank mergers.

10. One slight counterpoint on this point though is the Board’s 2012 order on Capital One’s acquisition of ING — the first post-Dodd Frank order in which the Board analyzed in detail the financial stability factor. In that order, the Board based its financial stability analysis in part on the following:

Capital One is currently the fifth largest provider of credit cards in the United States. Assuming the acquisition of the HSBC credit card assets (a transaction subject to review by the OCC in a separate proceeding), Capital One would increase its share of outstanding credit card balances in the United States from 7.7 percent to 11.8 percent and thereby become the fourth largest provider of credit cards in the United States. In considering the potential effect on financial stability in this case, the Board also has considered that three competing credit card lenders would each have outstanding credit card balances that are between one-third and two-thirds larger than those of Capital One, and two other lenders would each have balances approximately half the size of the outstanding credit card balances of Capital One. In addition, there are numerous other credit card lenders that operate on a national or regional basis. Capital One’s share of credit card loans does not appear to be substantial enough to cause significant disruptions in the supply of credit card loans if Capital One were to experience distress, due to the availability of substitute providers that could assume Capital One’s business.

This was only one aspect of the Board’s multi-faceted financial stability analysis and I do not think that the entire thing falls down if it is no longer true. Still, that middle sentence in the quote above about the size of Capital One’s credit card lending compared to its competitors is interesting to look at in the context of this deal.

11. See for instance the OCC’s order approving U.S. Bank’s acquisition of MUFG Union Bank, which said that “upon consummation of the Bank Merger, U.S. Bank’s stronger technology systems will apply to the Resulting Bank, which should correct many of the underlying concerns that resulted in” a 2021 consent order between the OCC and MUFG Union Bank.

12. This is because the bank merger will occur only after the holding company merger, such that at the time of the bank merger Capital One, National Association and Discover Bank will be affiliates under the same holding company. See 12 USC 1831u(b)(2)(E). Note that this argument works only for the OCC analysis, not for the similar provision in Section 3(d) of the BHC Act.

13. The quoted text throughout this section comes from pages 10-12 of Capital One’s BMA application, found on pages 496-498 of the PDF.

14. See footnote 17 in the application:

Importantly, (a) less than 1% of CONA’s deposits that are booked in Delaware and (b) slightly over 1% of the Discover Bank deposits that are booked in Delaware are owned by depositors who provide CONA and Discover Bank, respectively, with a primary address in the State of Delaware. Counting only these Delaware-based depositors, CONA would hold slightly over $3 billion in deposits, representing less than 2% of Delaware deposits on an adjusted basis (i.e., deducting CONA’s and Discover Bank’s non-Delaware-based depositors from the denominator as well).

15. In the preamble to its proposed policy statement released last week, the FDIC observed:

Several RFI commenters requested changes to how the FDIC compiles [Summary of Deposits] data, such as assigning online accounts to the account owner’s residence, rather than the main office of the entity receiving the deposit. Additionally, RFI commenters requested that the FDIC amend both the methods and reporting standards for SOD data, and provide more guidance and instruction regarding how a reporting entity attributes deposits to branches to enhance geographic specificity.

The agency’s response was a little noncommittal:

The Proposed SOP indicates that, as applicable, the FDIC will take into account any additional data sources, appropriate analytical approaches, or additional products beyond deposits to fully assess the competitive effects of the transaction. Further, to the extent that amendments or revisions to the SOD’s reporting requirements, standards, and methods are considered, they will be published in a separate request for industry comment and feedback.