How Capital One Makes its Profits

Banking is a somewhat static business with few moving parts and little place for visible technological advancement, at least compared to the petroleum or computer industries. Not coincidentally, most of the largest banks in the United States are the ones that started early and have managed to stick around since. Each of the four biggest banks by market capitalization are more than a century old. Wells Fargo & Co. (WFC) was founded in 1852 and Citigroup Inc. (C) in 1812. JPMorgan Chase & Co. (JPM) can trace its origins all the way to 1799. Bank of America (BAC), the pup of the quartet, dates back only to 1904. Only.

This raises an important question: how did Capital One Financial Corp. (COF), founded in 1994, grow quickly enough to take its place alongside the established titans of the industry?

Capital One began its independent life as the credit card operater of a larger bank, just as the American penchant for instant gratification was coming into its own. If you think people in 2018 have trouble comprehending the concepts of “minimum payment” and “annual percentage rate,” you should have seen the landscape back when credit cards were really starting to come into their own. Some of the methods Capital One used to grab market share seemed extraneous then and hardly worth mentioning now, but they were critical. Moves as simple as giving cardholders the ability to design their own cards, or include the logo of their football team or college, gave cardholders a sense of pride that translated into more frequent spending. That’s something that a card with just a MasterCard Inc. (MA) or Visa Inc. (V) logo could not do.

Capital One has three reporting segments. In descending order of size, those include credit cards, consumer banking, and commercial banking. Even though the company is known almost exclusively for extending consumer credit, Capital One can also loan you money for a mortgage or a business.

In fiscal year 2017, Capital One's total net revenue was $27.2 billion. That figure sounds impressive, and rightly so. The previous year, the company netted $25.5 billion. The expenses that Capital One spent to earn that interest are minimal, as well. Non-interest expenses were less than $14.2 billion in 2017, which gives backing to the fact that credit cards are incredibly profitable. All the omnipresent promotion, advertising, and marketing that Capital One undertakes is nothing compared to how much money the company earns from those unassuming but powerful little cards. They make up 62.4% of the company's revenue and 60.9% of its income.

Consumer banking remains an adjunct to Capital One’s credit card business, albeit a substantial one. The segment accounted for $2.26 billion in revenue last year, large in absolute terms. Like many big companies, and banks in particular, Capital One seems to be approaching its limits. For that you can blame (or credit, as it were) the growing number of non-bank and other non-traditional financial firms including the PayPal Holdings Inc. (PYPL) generation of lenders. 

With Fed rates as low as they are, how does a credit card issuer make money? Fed rates represent merely a baseline for lenders. Jerome Powell, the hawkish fed chairman, has raised rates thrice since taking over in February 2018. If Powell continues to hike rates, an economist might expect Capital One and its competitors to follow suit. Fortunately for Capital One, its customers don’t think that way.

Capital One would be a niche company if only people saw credit cards for what they are: an addiction to instant gratification, rather than a convenient way to put off today’s purchases until the end of the month. If not niche, then certainly not a $41.5 billion powerhouse. Fortunately for Capital One’s investors, the company’s penchant for analyzed, personalized offers continue to distinguish it from most competitors.

Capital One might appear to offer a commonplace product, but those cards are anything but. Each credit card is a delicate instrument, precisely tuned to get as much money out of each cardholder as possible. As long as the cardholders remain willing participants in this unilateral affair, Capital One should only continue to grow.