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American Express, Discover see plenty of new opportunities

American Express and Discover Financial Services appear to be in a hurry to make up for more than a decade's worth of lost time, during which Visa and MasterCard rules prevented most financial institutions from issuing competing cards.

February 20, 2005

American Express and Discover Financial Services appear to be in a hurry to make up for more than a decade's worth of lost time, during which Visa and MasterCard rules prevented most financial institutions from issuing competing cards.

The Justice Department brought an antitrust case against Visa and MasterCard in 2001, which the card associations lost. The ruling was later upheld by an appeals court and, last month, by the U.S. Supreme Court.

Both American Express and Discover have filed lawsuits seeking unspecified damages as compensation for harm caused by Visa's and MasterCard's business practices.

While no dollar amount is specified in either suit, an American Express statement said the company "is expected to seek damages in the billions of dollars."

"Now that Visa and MasterCard's anticompetitive bylaws have finally been struck down as unlawful, we are moving forward with our business plans and are seeking triple damages for the harm that those violations have caused us," said David Nelms, Discover's chairman and chief executive officer, in a statement.

Some of the nation's biggest banks and card issuers, which were members of one or both of the associations' boards of directors when the restrictive rules were adopted, are also named as defendants in the suits.

Howard Mason, a securities analyst for the Bernstein investment research firm, said during a presentation at last week's BAI Retail Delivery Conference & Expo, that American Express and Discover see the suits as an opportunity to inflict further financial damage on Visa and MasterCard, which earlier this year agreed to pay more than $3 billion to settle a suit brought by Wal-Mart and other retailers.

Any financial losses adversely affect the associations' branding efforts, which are part of what Mason calls "the upward spiral of brand appreciation." He said, "The more investment in the brand, the more appeal it has to issuers and the more merchants are pressured to accept it."

American Express uptake

Earlier this month, American Express introduced its first credit card associated with a partnership with a U.S. financial institution, MBNA. American Express is not seeking damages from MBNA and has agreed to reimburse MBNA for certain costs which may be imposed by MasterCard or Visa as a result of its lawsuit.

Mason said MBNA has already issued 300,000 American Express cards and will increase the number to two million -- some 20 percent of its overall card volume -- by the end of 2005.

One of Amex's advantages, Mason said, is its 2.1 percent interchange rate, higher than Visa's and MasterCard's 1.9 percent rate and Discover's 1.3 percent rate for credit card purchases. Interchange is increasingly important to issuers, he said, because it is used to fund the rewards programs they use to try to attract new business.

According to Mason, interchange accounts for a whopping $20 billion of annual revenue for all credit cards -- half of which is plowed back into rewards programs for consumers. And for good reason, he said. Twenty-seven percent of consumer spending was on rewards cards in 2003, up from just 7 percent in 1993.

Amex's higher interchange rate is expected to result in 60 percent higher profits on MBNA accounts Mason terms "active" rather than "revolving," in which balances are paid off each month.

Outside the U.S., American Express has established 85 card-issuing arrangements with financial institutions in more than 90 countries. According to its statement, the company is "currently engaged in conversations with a number of other card issuers about possible network partnerships."

Mason downplayed the idea that American Express' card issuing business is in direct competition with FIs, after several questions concerning a possible conflict of interest were submitted by members of his audience at Retail Delivery.

"I think that's an idea that's been put out there by Visa," he said, noting Amex's network services business does not share customer information with its card issuing division.

Card issuance accounts for 20 percent of Amex's equity, compared to 50 percent for network services -- which carries no credit risks or funding costs. "The network business is the better business opportunity," he said.

"Who is Visa?" Mason asked. "Bank of America, JP Morgan Chase and Wells Fargo. Don't kid yourselves. You're already promoting a competitor's brand. A disproportionate amount of membership fees go to the largest issuers."

The real threat

A bigger threat, Mason believes, is the general ability of credit cards to displace banks by effectively inserting themselves between customer accounts and merchants.

The chances of this kind of displacement occurring will decrease if interchange becomes subject to increased regulation, as it has in countries like Australia and the United Kingdom, a possibility Mason considers unlikely.

Another setback would be the introduction of requirements for card companies to hold capital against unused credit lines. "Then you have the risk of potential loss without income," he said.

Financial institutions could also fight back by enhancing the utility of checking accounts, Mason said. An example he cited: offering consolidated reports of all spending activities online, so that consumers could more easily monitor their finances.

Discover and debit

While Discover has not yet announced any agreements with issuers, it has announced plans to purchase the Pulse EFT Association, an EFT network with some 4,100 financial institution members, for $311 million.

Stan Paur, Pulse's president and chief executive officer, said the Pulse board has recommended the acquisition; the association's members must still vote to approve it. With the addition of Discover, Pulse members will be able to take advantage of a "one-stop solution" with both signature- and PIN-based debit, as well as prepaid products, he said.

"The value proposition that Discover could make to financial institutions is the ability to offer debit and credit on the same platform. It would make sense for Discover to consider introducing a product with debit and credit functionality on the same card," said Ali Raza, a vice president at consulting firm Speer & Associates.

Based on the recent Supreme Court decision, the deal clears the way for Discover to introduce a third signature-based, or offline, debit brand at a time of continued strong growth in that market. According to ATM&Debit News, Visa- and MasterCard-branded offline debit cards were used to initiate 8.35 billion signature-based transactions in the first nine months of 2004, up 17 percent from 7.12 billion transactions during the same period of 2003.

According to ATM&Debit News, Pulse is the country's third-largest PIN-based debit network, behind First Data's Star and Visa's Interlink. The Discover deal "will position Pulse to aggressively compete with Interlink," Mason said.

Both Discover and Pulse will benefit financially from the deal, said Bill Bradway, group vice president of Banking for Financial Insights, a market research advisory subsidiary of IDC. "(Discover owner) Morgan Stanley is well capitalized, and Pulse will provide a nice annual revenue stream."

Bradway said the Pulse acquisition is likely part of a broader product strategy for Discover. "I'd look for them to introduce new products that can be leveraged through the Pulse network."