It’s easy to show that size impacts profitability but, in practice, managers frequently can only make decisions that affect size in the medium to long term. In the short term they are highly constrained by their existing set-up, always limited by demand in the market place.

A container lorry.
[image by 28481k, some rights reserved]

All businesses have two types of cost: fixed costs (that do not vary with output) and variable costs (that increase as output increases). To illustrate with a simple example, suppose you had a heavy goods driving licence and wanted to run a trucking service. You buy a truck for £100,000 and you can use it for five years. Before you drive a kilometre, you have a fixed cost of £20,000 a year to pay for the basic equipment. Items such as annual insurance and road tax raise the fixed costs to £25,000. Leaving aside your salary, every kilometre you drive costs (say) £1 in diesel, servicing, tyres and so on. So you have fixed costs of £25,000 and variable costs of £1 per kilometre. In the short term you have to work within those constraints.

The size of your business is critical. If you can sell transport at £6 per kilometre travelled, you need to sell at least 5,000 kilometres to break even:

Suppose the physical limitations are that you can drive a maximum of 75,000 kilometres a year. You can see that your profitability will vary according to the amount of work you do. Below 5,000 kilometres a year, you have no salary and are making a loss. Between 5,001 and 75,000 kilometres a year, every extra kilometre adds £5 to your earnings (£6 price less £1 variable cost) so your earnings rise uniformly to £350,000.

However, the moment you increase your activity beyond 75,000 kilometres, you have to acquire a second truck and hire a driver, so profits would then decrease as size increases. You’re either too big or not big enough at that level of activity.

There is also the issue of whether there is enough business available so that you can expand without limit. Often this is not the case and, as you look to boost business, you have to reduce prices. In an ideal world you would maintain your basic price of £6 for some business and offer special deals to gain extra business. As long as you were getting more than £1 and you were already covering fixed costs, you should increase earnings. However, it is difficult to reduce price in a limited way and you may find that existing business moves down from £6 to perhaps £4, so your increase in size reduces the value of your sales while increasing your variable costs – you’ve got too big.

The effects of size can be both beneficial and damaging.

Size matters at the individual business unit level but it also matters in the multi-unit business. The effects of size can be both beneficial and damaging. On the positive side, a multi-unit business can spread its risks better. A costly, failed business initiative can wipe out a single unit business instantly, whereas a multi-unit business can more easily bear the risk of expansion. Also, a multi-unit business can afford to have in-house specialists who bring extra expertise to aspects of management of the business.

On the negative side, key decisions are usually made remotely from the business unit. Normally the group operates with business budgets that must be agreed the year before and then adhered to. This can build in inflexibility because there is usually resistance to departing from the budget to take advantage of an opportunity that presents itself. Equally, central management will be concerned at managing risk across the group, and may turn down an expansion possibility in one unit because it prefers to take a risk in another. The group will probably establish standard procedures that sometimes do not make sense at unit level.

The bigger a group is, the more remote central decision-makers are from front line businesses and so the more controls the group needs in place to monitor what is happening at the unit level. These added layers add costs and not profits, they cause delays in seizing opportunities and often end up making front line staff feel frustrated and unappreciated. Big can be stifling.

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Professor Peter Walton is a member of the Accounting & Finance Unit at the Open University Business School. His research interests are in comparative international accounting and financial reporting in an international context.

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The crisis in the financial sector and the rapid descent into recession of the UK economy in the past six months have reinforced the downward momentum in the property market that commenced in 2007.

The focus of the media has been very much on the collapse of prices and of the volume of transactions in the residential market where average house prices are now around 20% below their peak in autumn 2007. But arguably the state of the commercial property market is in an even more parlous state.

The findings of market specialists including the Royal Institute of Chartered Surveyors (RICS) paint a truly grim picture:

• Available commercial, property space is rising at a record level with Central London being the worst spot geographically and retail being the hardest hit business sector – particularly following the high profile demise of a number of high street chains.
• Occupier demand and enquiries are now running at their lowest levels for over 10 years
• Activity across all areas of the commercial property market is in decline and the deepening recession seems set only to accentuate this downward spiral.
• Property owners are having to offer increased incentives to secure lettings

In the good times, pubs borrowed money against their property

But this decline in the commercial property market does not just adversely affect those looking to let property space (whilst benefiting those looking for space).

In the boom years, supermarkets and pub chains became so-called ‘property plays’. In a rising property market, they could make easy profits from selling and then leasing back properties. But in a falling market, their share prices have because of the importance of property in the balance sheet. Particularly, as did the pubs, when they borrowed on the strength of their property portfolios.

Indeed, it is partly the leverage behind the pub chains which has led to 39 pubs closing per week! Both shareholders and the lending banks – and HBOS was a major lender on property development – have got their fingers well and truly burnt.

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How did two banking giants, Halifax and Bank Of Scotland, collapse?

About the author

Martin Upton is lecturer in finance at the OU Business School. Previously he spent 20 years in treasury management, including 12 years as Treasurer of Nationwide Building Society. Martin's particular interests are financial services, the housing market, financial markets and risk management.

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Credit Crash Britain

In a series of special reports the Money Programme team investigate the issues that are affecting all of our bank balances: Credit Crash Britain.

Of all the UK casualties of the ‘Credit Crunch’, HBOS (Halifax Bank of Scotland) is to date the biggest and most significant. The planned takeover of HBOS by Lloyds TSB, announced to stunned financial markets on Tuesday 16th September, marks the demise of two giants that have dominated the UK financial sector for centuries. The Bank of Scotland was formed in 1695 and was the first commercial bank in the UK. The Halifax Permanent Benefit Building and Investment Society was founded in 1853. Prior to its demutualisation and conversion to banking status in 1997 the Halifax was, by some distance, the largest building society in the country.

We are too close to these amazing developments to understand exactly how the Bank of Scotland and the Halifax, united by the merger to form HBOS in 2001, found themselves being forced into a rescue by Lloyds TSB – a rescue that the Prime Minister himself took a central role in instigating.

Much has been made in the media that HBOS was a victim of ‘short selling’ by City traders. This practice which involves selling stocks that are not currently owned with the view of buying them back in the future at a lower price is a common trading strategy. The view held by some commentators is that aggressive short selling of HBOS’s shares drove down the share price to the point where public perception was that the bank was in trouble. With the Government and the Financial Services Authority  not wanting a repeat of a ‘run on the bank’ that we saw with Northern Rock in 2007, with savers queuing to get their cash out, the authorities acted swiftly to end HBOS's independent existence.

By placing it in the ownership of Lloyds TSB, the hope was that some semblance of confidence in the banking system would be restored. Given the size of HBOS – at £681 billion of assets it is seven times larger than the Northern Rock was when its problems surfaced in September 2007 – the Government simply could not contemplate a nationalised solution to the problem. Given the perceived impact on HBOS’s share price of the alleged short-selling the Government and the FSA also moved quickly to outlaw the short selling of the shares of other financial institutions.

Was HBOS a victim of short selling or rather an institution that weakened itself through its impaired business strategy?

But was HBOS a victim of short selling or rather an institution that weakened itself through its impaired business strategy? Many observers have pointed to HBOS’s growing reliance in recent years on wholesale funding from the world’s capital markets which made it, like Northern Rock, vulnerable to the illiquid conditions we have seen in the wholesale markets since the emergence of the US sub-prime mortgage crisis in summer 2007. Additionally HBOS was active in enlarging its share of the UK mortgage market just at the point that house prices peaked. The subsequent marked fall in prices has left HBOS vulnerable to bad debts as borrowers with negative equity default. There have also major losses in treasury assets – investments in asset-backed and other securities which have fallen in value in the wake of the sub-prime collapse.

Given the business backcloth it was perhaps hardly surprising that the process of raising more capital by the £4 billion ‘rights’ issue of new shares in HBOS was troubled with many investors refusing to take up their rights to further shares. This also was a factor which placed doubts in the minds of investors about the worth of HBOS’s stock - doubts that became reinforced by the reduction in dividends being paid out.

So was the reality that it was investors - particularly the fund managers - who brought on HBOS’s demise simply by dumping an increasingly unattractive stock? This seems more plausible than simply blaming the bank’s demise on ‘short sellers’.

The bank will be a colossus in the retail financial market with 142,000 employees and a 28% market share

Whatever the cause the outcome and consequences of the takeover by Lloyd TSB are huge in more senses than one. The bank will be a colossus in the retail financial market with 142,000 employees and a 28% market share - in fact if it had not been for the crisis conditions competition law would not have allowed the takeover to take place. The risk of such dominance is that Lloyds TSB will now have greater power to set the prevailing levels of mortgage and savings rates in the UK.

A further consequence is that there will be substantial job cuts given the overlaps between the two banks - for example in the branch networks and in the ‘back-office’ processing businesses.

For Scotland the blow is potentially substantial - both economically and to the country’s self confidence since, with the Royal Bank of Scotland, the Bank of Scotland dominated the Scottish banking industry. Lloyds TSB has, though, pledged to keep jobs in Scotland, retain the use of HBOS’s headquarters in Edinburgh and continue to print Bank of Scotland bank notes.

HBOS building.
[image by JohnConnell, some rights reserved]

Additionally the disappearance of the Halifax - predating by just a few days the rescue of the Bradford & Bingley - represents the failure of the demutualised building society business model. All those societies that converted to banks amidst much heralded plans to grow their businesses and explore new avenues for making money have now, within a handful of years, lost their independent existences.

At the time of writing, however, the approval for the takeover by the shareholders of Lloyds TSB has still to take place. In the light of the further collapse of the share price of banks globally in late September and October, and the move by the UK government to recapitalise the banks, a renegotiation of the original terms of the takeover inevitably had to take place. Under the revised terms made public on 13th October HBOS shareholders will receive 0.605 Lloyds TSB shares for each HBOS share. Additionally up to £17 billion of capital may be invested in the combined institution by the Government.

The amount of State finance will be determined by the shortfall in the demand by existing shareholders for further shares in the banks offered to them via forthcoming ‘rights’ issues. Given the distinct possibility that a substantial proportion of HBOS could end up being owned by the Government - making Lloyds TSB itself partially nationalised if it absorbs HBOS - there remains the risk that Lloyds TSB’s shareholders may not have an appetite for the takeover.

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About the author

Martin Upton is lecturer in finance at the OU Business School. Previously he spent 20 years in treasury management, including 12 years as Treasurer of Nationwide Building Society. Martin's particular interests are financial services, the housing market, financial markets and risk management.

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