What is Double Gearing
Double gearing describes situations where more than one company use shared capital as a way to mitigate risk. The businesses involved in double gearing loan funds to one another. This practice can artificially skew the accounts of the companies, making them appear in better financial health than they are. This practice is common in complex corporate structures, where one large company owns various subsidiaries, each maintaining a separate balance sheet. Those individual balance sheets may appear to show adequate capital, but if analyzed as one entity may reveal overleveraged positions.
BREAKING DOWN Double Gearing
Double gearing is a practice that can disguise risk exposure because more than one business entity may claim the same assets as capital protecting against risk. Sharing seems to be a way that helps to mitigate risk but does not adequately document the actual exposure to risk for each company.
Using double or multiple gearing can result in the overstatement of capital in a conglomerate. Subsidiaries are often deliberately formed by a parent company to segment its business. Subsidiaries, sometimes called daughters, function as separate business entities. This structure allows the parent to file consolidated tax reports with the ability to offset gains and losses between different subsidiaries and enjoy lower taxable revenues.
As funds move around into separate business accounts, the assessment of a group's true financial health becomes muddied. The practice leads to leveraging and overleveraging. Also, it is possible to create middle-tier entities whose only assets are the investments into dependent tiers.
Sometimes banks, investment firms, insurance agencies, and other regulated industries will funnel funds through an unregulated subsidiary using double or multiple gearing. When the parent company lends capital, it will appear on their balance sheet as a debt due to them and on the borrower's balance sheet as income. Double gearing can become multiple gearing as the first borrower, in turn, sends the money downstream to a third-tier holding within the conglomerate's umbrella. Double gearing may also occur in an upstream direction when funds flow from lower tiered businesses upward to a parent company.
Double Gearing Regulated Money into Unregulated Risk
As an example, FistODollars, a financial holding company owns Corner Banking and a Space4U Leasing.
- FistODollars lends Space4U money. The capital will appear on FistODollars balance sheet as funds due to them through the loan.
- Space4U buys shares of Corner Banking stock with the loaned funds. Space4U list these shares as an asset on their balance sheet.
- Corner Banking uses the funds they received from the sale of shares to buy debt securities or CDs to help fund FistODollars. Corner Banking shows the same capital as an asset through the ownership of FistODollars CDs.
The bank and leasing subsidiaries may appear to have appropriate capitalization when viewed independently. But since some of the assets belonging to the leasing company are shares of stock in the bank, it is putting both businesses at risk.
If one subsidiary holds capital issued by the other subsidiary, the entire holding company may be overleveraged. Leveraging is using borrowed capital as a funding source. As these companies take on more debt, their chance of default risk increases. When a business is said to be overleveraged it is carrying so much debt that it is no longer able to pay interest payments, principal repayments, or maintain the businesses' operating expenses.
Doubling Down on Double Gearing
In 2016 the Australian Securities and Investments Commission (ASIC) reviewed the practices of six margin lenders representing 90% of the Australian market. ASIC found that five margin lenders had approved margin loans which were double geared. Following the ASIC review, margin lenders have taken action to better address the risk of double geared margin loans. Although not illegal in Australia, one lender ended the practice after the ASIC’s review and the other lenders took steps to make sure margin loans met higher standards for responsible lending.
In 2002 Standard & Poor's Ratings Services lowered the insurer financial strength and counterparty credit ratings of five Japanese life insurance companies. The discovery of double gearing between those insurers and the Japanese banks caused the rating agencies to take action. Reduced scores are because “asset risks assumed by the insurers in their excessive exposure to the domestic banks have increased due to the weakened credit profiles of the banks.”