WASHINGTON, March 21 (Reuters) - Capital One's $35.3 billion merger with Discover Financial will boost competition and be good for financial stability, the bank said in its regulatory application filed overnight, according to people familiar with the matter.

CapOne also argued the deal will not harm credit card competition because the combined entity will account for roughly 13% of credit card purchasing volume, which they argue is the best measure of credit card market share, the people said.

The deal unveiled last month will create the biggest U.S. credit card issuer by balances and the sixth-largest bank by assets. It will also give Capital One control of Discover's credit card payment network, which is the fourth major payment network operator after Visa, Mastercard and American Express.

The potential for the merger to create a viable competitor to Visa and Mastercard, whose dominance of card payments has been criticized by lawmakers, is CapOne's leading argument for the deal, the people said. Discover's network has ceded market share over the past decade and CapOne can provide the additional scale and volume its needs to be competitive, the U.S. consumer bank said in its filing.

It also made the case that the deal would be good for financial stability by ensuring Discover is taken over by a safe pair of hands that will invest in risk management, the people said. The credit card company's share price and profits have been battered by compliance lapses and declining credit quality.

Visa and Mastercard did not immediately provide comment.

When unveiling the deal, CapOne said that it would scale up Discover's network, which some antitrust experts speculated would be its key selling point. But the arguments CapOne made in its filing to the Federal Reserve and Office of the Comptroller of the Currency (OCC), which will review the merger with input from the Justice Department, have not been reported.

They will be scrutinized by investors and likely draw pushback from antitrust advocates and Democratic lawmakers who have called for regulators to block the deal, arguing it will increase costs for consumers and threaten financial stability.

The deal comes as regulators are ramping up scrutiny of bank mergers under Democratic President Joe Biden's administration. The debate over the risks and benefits of bank mergers has intensified after JPMorgan and New York Community Bank were allowed to snap up failed bank assets last year.

"This is a key test of the federal merger review framework," said Jesse Van Tol, CEO of the National Community Reinvestment Coalition, an influential community lending advocacy group which

opposes

the deal.

JUSTICE DEPARTMENT SCRUTINY

While the Justice Department has traditionally focused on depositors and branches when assessing the competitive impact of bank mergers, the agency said last year that it will look at a broader scope of issues.

It may review the CapOne deal under new 2023 guidelines that take a tougher stance on deals in highly concentrated markets, think tank American Economic Liberties Project (AELP) said in an analysis published on Thursday.

Shahid Naeem, AELP's senior policy analyst who wrote the report, said the Justice Department had taken a dim view of the type of "vertical integrations" CapOne was proposing in its takeover of Discover's network when reviewing deals in the tech sector.

A court dismissed similar "merge-to-compete" arguments JetBlue made defending its Spirit Airlines takeover, he added. "It seems very unlikely that those arguments will hold up," said Naeem. "It's not about pros and cons, it's about whether a deal will reduce competition in a market."

AELP is an antimonopoly group and opposes the merger. Its founder Sarah Miller last year become chief of staff at the Federal Trade Commission, another competition watchdog.

"This analysis from AELP is a great window into how people like Jonathan Kanter and other Biden administration officials might be approaching this deal," said Jeremy Kress, a University of Michigan professor, referring to the Justice Department's top antitrust attorney.

While bank regulators are leading the review, it is unlikely they would ignore Justice Department objections, especially given they are under pressure from the White House and lawmakers to take a tougher stance on deals, lawyers said.

Spokespeople for the Fed, OCC, and Justice Department did not immediately respond to requests for comment. (Reporting by Michelle Price; Editing by Jamie Freed and Franklin Paul)