(Bloomberg) -- Capital One Financial Corp. has for decades extended credit to the kinds of borrowers that other banks deemed too risky, only to watch some of those same customers—now equipped with improved credit scores—move on to more plush, exclusive pastures.
Even Lia Dean, Capital One’s president of banking and premium products, couldn’t blame them. “What we heard from customers is, well, that’s great, but I want to go to a lounge,” she said. “I might want my breakfast included, or to go to the spa or get a late checkout. There’s other benefits that, you know, are available in the market, and we were not providing those.”
Over the past decade, Capital One has been trying, adding more generous rewards and dabbling in airport lounges, endeavoring to catch the eye of wealthier borrowers. But it’s the merger with Discover that could open the floodgates. The $35 billion deal—one of the biggest so far this year—would unlock at least $1.2 billion in annual revenue for the card issuer, a good chunk of which will be deployed to the kinds of travel, entertainment and experiences that customers have traditionally gone elsewhere to find.
Capital One expects to complete the merger early next year, Chief Executive Officer Rich Fairbank said on the company’s third-quarter earnings call Thursday, but the deal is still waiting for bank regulators to sign off. Even with a green light, the US Justice Department could sue to block it. New York State Attorney General Letitia James is also investigating the deal on antitrust concerns.
Regulators have reasons to balk: It would make the firm a behemoth, the biggest credit card issuer in the US by loan volume, and consolidate options for subprime borrowers, a development that Consumer Financial Protection Bureau Director Rohit Chopra told Bloomberg is a “pretty significant concern.”
On the other hand, the deal would also create new competition for Visa Inc., Mastercard Inc. and American Express Co., which dominate the infrastructure that merchants rely on—and pay for—to process transactions. Last month, the DOJ sued Visa for its alleged monopolization of the debit card market. The company says it doesn’t have a monopoly.
In the spring, a former bank mergers and acquisitions official at the Federal Reserve put the likelihood of approval at 70% to 80%, according to a research note from Bank of America Corp. The analysts themselves weren’t so sanguine. “This was surprising to us,” they wrote, “and higher than what we’ve heard in our conversations with ex-regulatory officials, investors, and industry consultants.”
A Data Gold Mine
Since its founding, Capital One’s advantage has been an almost unique ability, willingness and desire to use customer data to guide its lending. By looking at, for example, checking account activity or even motor vehicle records, the bank could infer whether a card applicant’s financial habits were better than her FICO score might suggest. “The fact that you've had a checking account with me for nine years, and you've never overdrawn, and I know that you get a check every month for $5,000 is gold,” said Nigel Morris, a co-founder of the bank who went on to establish QED Investors, a fintech venture capital firm.
As a result, Capital One’s subprime loans have performed better than its competitors’. Shares have returned an average of 13% per year since it went public in 1994, well above the sector broadly but slightly behind American Express, which is rewarded for its higher-end clientele.
“The true, core strength of Capital One is their ability to underwrite subprime,” said Sanjay Sakhrani, an analyst with Keefe, Bruyette & Woods. “They have done an excellent job through their history of managing the risk there really well” — including in the last few years, when consumers have been squeezed by higher interest rates and inflation.
Building a product for the other end of the market requires a different strategy. Good-credit cardholders are, by definition, low-risk, and most pay off their balances every month, limiting interest income. Where Capital One and their competitors make money from those consumers is in the interchange fees—the tiny fraction of every purchase that the card companies siphon off the top of each transaction. The more times customers swipe, insert or tap, and the more they spend, the more Capital One makes.
Winning this volume game requires Capital One first to persuade these customers to sign up, then to motivate them to use its cards as often as possible. Its marketing budget has nearly tripled in the past decade. After releasing the VentureX card in late 2021, promotional spending grew 30% to more than $4 billion a year. “We continue to be very pleased with our quest to win at the top of the market,” Fairbank said Thursday.
Unlike competitors, Capital One doesn’t break out how many new cards it’s issued, let alone which kind or how customers are using them, and it doesn’t host investor days. But, buried in its annual reports, one metric indicates that cardholders are warming up. In the past decade, “customer rewards expense” — a rough proxy for rewards earned — has quadrupled to more than $8 billion, with a 30% jump since 2021.
If Capital One is successful in its appeal to more lavish spenders, it would flip the conventional credit-card playbook, which typically splits the market between high-income, low-risk cardholders and everyone else. The two segments require different business strategies, and historically, customers haven’t often moved from one category to the other.
Capital One, though, says 42 million of its subprime customers have improved their credit enough to qualify for better products and pricing. With its existing troves of consumer data, it believes it’s well positioned to serve everyone—especially if the Discover deal goes through.
Regardless, though, the bank says it will continue its campaign up-market. It recruited from the Fontainebleau and the Four Seasons to staff its entry into lounges, now in Dallas, Denver and Washington D.C. airports, with more planned for Las Vegas and for JFK in New York.
On a recent Tuesday in the lounge at Washington Dulles International Airport, some travelers enjoyed cucumber-and-yuzu sodas in handmade ceramic mugs. Others opted to grab mango-papaya a?ai bowls to go. It’s an elevated version of the bank’s cafes, with more food and a bar to boot. Like American Express lounges, top-tier cardholders get complimentary access. Unlike the category leader, Capital One makes day-passes available for anyone at a price of $90.
“We don’t aspire to be a snobby brand,” said Capital One’s Dean. “We want to deliver against a customer’s premium needs, and be consistent with what they’re experiencing in other parts of their lifestyle.”
With or without the added revenue from the Discover merger, Capital One still believes strongly in its ability to mine customer data better than anyone else and that it can be as relevant for the high end of the market as the subprime. The bank’s migration into the cloud, among other technology investments, made it possible for every part of the enterprise to talk to one another.
And with every reward it offers customers, whether a murder mystery dinner party with actor Neil Patrick Harris or a trip to Spain with celebrity chef José Andrés, it’s learning more about what they value. Even the airport lounges employ the kind of video surveillance more common to big-box stores to monitor which areas and features are popular, which aren’t, and to tweak the layouts accordingly.
As Capital One tries to increase its pool of higher-end customers, today’s cardholders function as a focus group. They’ve chosen Capital One not because of its brand, but almost in spite of it, said KBW’s Sakhrani. “They’re choosing them based on the value proposition of the product.”
That’s the point, said Celia Karam, president of retail banking at Capital One. “A lot of companies out there start from what we’ll call the premium end of the market—they’ll sort of build for the high-net-worth first, and then maybe eventually they’ll build what I will describe as, like, watered-down products for the rest of us,” she said. “That isn’t our way.”
By solving “some of the most complex needs for customers that are more marginalized,” she added, “we created a great solution for them, but it’s a great solution for everyone else as well.”
