Capital One’s Rush to Acquire Discover Raises Red Flags

Capital One’s plan to acquire Discover has sparked debate about the potential merger’s implications for consumers. This issue warrants careful exploration, as rushing into such a significant move could have far-reaching consequences.

Financial institutions contemplating a merger should not hastily proceed to the altar. Instead, they should engage in a prolonged period of engagement to better understand each other. With the combined entity poised to become America’s sixth-largest bank, regulators, investors, and credit analysts must meticulously examine the credit, liquidity, and operational risks associated with these institutions, which could escalate if left unchecked.

Analyzing Capital One and Discover through the CAMELS framework, my primary concern lies with asset quality. This aspect evaluates the diversification, credit quality, and interest rate risk of loans and securities. The merger would likely lead to significant concentration risk, meaning a large portion of their assets would be sensitive to the same economic and market factors. This concentration could prove detrimental to the new institution’s liquidity and earnings in an economic downturn or recession.

Capital One’s concentration risk stems from its high level of consumer and auto loans, with credit card loans representing 47% of its portfolio. Discover’s credit card portfolio represents an even higher 79% of its loan portfolio. While Capital One holds a long-term credit rating of A- from Fitch Ratings, its risk profile and asset quality are at a BBB+ level. Delinquency rates and charge-offs have risen in its key asset categories in recent quarters, particularly in its credit card loans to near prime or subprime individuals.

Discover, with a BBB+ long-term rating, has also experienced rising delinquency and charge-off rates in its credit card portfolio, exacerbated by loosening underwriting standards in 2021. Both institutions need to analyze how to hedge or sell parts of their portfolios to mitigate asset quality risks, especially with rising corporate defaults across sectors.

Despite these concerns, both banks appear well-capitalized. Capital One reported a Tier I Risk-Based Capital Ratio of 14.2% and Leverage Ratio of 11.2% in Q4 2023, well above Basel III requirements. Discover’s Tier I Risk-Based Capital and Leverage Ratios are also significantly above minimum requirements.

However, operational risk should not be overlooked. Operational risk includes potential earnings loss due to people, processes, technology, and external events. Discover has faced operational challenges, including consumer compliance management shortcomings and fines exceeding $275 million since 2000. Capital One has also faced significant fines primarily related to anti-money laundering, consumer protection, privacy, banking, and wage and hour violations.

Bank regulators should scrutinize both banks’ due diligence processes and operational risk management, as weaknesses in this area often lead to bank failures. Without addressing asset quality and operational risks, the merged entity could face a Too Big To Fail challenge.

In conclusion, while a Capital One-Discover merger could offer potential benefits, such as synergies, both banks must first address their portfolios’ credit quality and operational risks. Regulators should ensure these risks are adequately mitigated before approving the merger to safeguard consumers and the financial system.