Sidebar: What's the Hard Part? Innovation Never Ends

Capital One scored some early victories in the credit-card game by changing the rules. Its founders invented the "teaser rate" -- the banking equivalent of a cheap mortgage that gets adjusted up after a certain period. The teaser attracted millions of customers, and eventually competitors began to mimic the idea. The result was a merry-go-round of so-called teaser hoppers. People would move their balance to a low-introductory-rate card; as soon as the rate expired, they would switch to another card. Over time, Cap One was being eaten alive because of customer attrition.

The lesson: Companies that thrive on change can never rest. Competitors are quick to copy good ideas. The way to compete on innovation is to keep innovating.

That's the hard part. And that's why Capital One is so obsessed with making its own innovations obsolete. Consider the teaser rate. "Customers have gotten smarter about this game," says Dan Friedman, 29, a credit-card product manager. "But customers don't want to play it." What do they want? People want a simple card with a good rate, says Friedman. So, for two and a half years, Friedman's team offered prototype no-fee, fixed-rate cards to a wide spectrum of Americans. The cards had slightly different rates, slightly different credit limits, slightly different terms: "We were doing at least a dozen tests each quarter."

The team absorbed data about which rates appealed to which kinds of customers, about how customers used the new cards, and about which set of factors produced the most profitable card. "We found a rate at which we got good loyalty and low attrition," says Friedman. "That's what we wanted." There was just one problem: The card wasn't profitable.

"That is where smart people come into play," says Friedman. Two of Friedman's analysts concluded that they needed to attract customers who were better credit risks -- in other words, people who defaulted less often. "They suggested different underwriting standards. As soon as we had that hypothesis, we could test it with data that we already had."

The result of all this experimentation: Early in 1998, Capital One began offering a permanent, fixed-rate card to a select group of customers. The card has a fixed annual rate of 9.9% and no annual fee. The company that changed the game with the teaser rate is changing it again. Today, in fact, Cap One doesn't even offer a teaser-rate card to new customers.

Sidebar: Testing, Testing

At Capital One, the essence of innovation is experimentation. Every idea for a new product starts with a test, or a series of tests. If a test succeeds, the company ramps up fast.

Each test offer is handled by a small group of reps, whose opinions about the products are also taken into account. Cap One tracks not only whether people buy something but also whether they use it. The company has shelved products that customers didn't buy or didn't use. Selling software didn't work. Neither did selling mutual funds (although plans are under way to launch another mutual-funds sales program). Behind every test is a three-person team: someone from marketing, someone from operations, someone from IT. There are no silos at Capital One. Each business unit has a "business information officer" who is responsible for making technology work in that unit.

Testing doesn't apply only to products. Cap One hired more than 100 people a week in 1998, but it doesn't conduct anything resembling routine job interviews. Instead, applicants take tests, sit through guided interviews, and do role-playing exercises. In the case of customer-service reps, supervisors never even meet candidates; they meet only the people who get hired. "We found out that interviews by line managers didn't predict job performance at all," says Dennis Liberson, 43, the company's HR chief. That discovery was made, of course, through follow-up testing -- through comparing actual performance of employees with what their supervisors had predicted when they were first hired.

This year, 1,000 of Capital One's 11,000 employees will sit down to take tests. HR has developed 10 new pre-employment tests, and it wants to see how good they are. It will administer those tests to selected current employees, who will in turn have their job performance evaluated. Test results will then be anonymously correlated with how well those employees do their work. "We think these tests will predict certain competencies," says Liberson. "But before we start using them, we want to make sure."

In other words, the testers have a new test that they need to test. The company's testing culture is so deeply intricate, so wound around itself, that a senior executive recently pointed to an M.C. Escher print in his office -- a print of people climbing or descending a series of interlocking staircases -- and laughed: "That's our organizational chart."