Double Gearing

What Is Double Gearing?

The term double gearing refers to an agreement between two or more companies to mitigate risk by pooling together capital into one. Double gearing requires companies to loan funds to one another. It is common in complex corporate structures, where one large company owns multiple subsidiaries while each maintains a separate balance sheet.

Double gearing can artificially skew the accounts of the companies, making them appear in better financial health.

Understanding Double Gearing

Double gearing is a practice that takes place in the corporate world. Companies may pool their resources together—notably their capital—in order to cut back on their risk. This happens when one company involved in the agreement puts money into the other(s). Companies that engage in double gearing often operate in the same industry or sector. For instance, a bank may loan money to an insurance company that, in turn, invests capital in the bank.

Not only does the practice serve to cut down on risk, it also disguises risk exposure. That's 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, which function as separate business entities, are often deliberately formed by a parent company to segment its business. 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 muddled. The practice leads to leveraging and overleveraging. It is also possible to create mid-tier entities whose only assets are the investments they make into dependent tiers.

Special Considerations

Sometimes banks, investment firms, insurance agencies, and other regulated industries funnel funds through an unregulated subsidiary using double or multiple gearing. When the parent company lends capital, that money appears on its balance sheet as a debt due to them. It also shows up on the borrower's balance sheet as a form of income.

Double gearing may occur in an upstream direction when funds flow from lower-tiered businesses upward to a parent company. It can also become multiple gearing as the first borrower sends the money downstream to a third-tier holding within the conglomerate's umbrella.

Regulatory Impact of Doubling Gearing

Standard & Poor's (S&P) lowered the insurer financial strength and counterparty credit ratings of five Japanese life insurance companies in 2002. The discovery of double gearing between those insurers and the Japanese banks caused the rating agencies to take action, realizing the double gearing increased the risks of the entities.

The Australian Securities and Investments Commission (ASIC) reviewed the practices of six margin lenders representing 90% of the Australian market in 2016. ASIC found that five margin lenders approved margin loans that 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 while the others took steps to make sure margin loans met higher standards for responsible lending.

Example of Double Gearing

Here's a hypothetical example to show how double gearing works. Financial holding company First Holdings owns Corner Banking and Space Leasing. In turn:

• First Holdings lends Space Leasing money. This capital appears on First Holdings' balance sheet as funds due to them through the loan.
• Space Leasing buys shares of Corner Banking stock with the loaned funds. Space Leasing list these shares as an asset on their balance sheet.
• Corner Banking uses the funds it received from the sale of shares to buy debt securities to help fund First Holdings.
• The money that First Holdings initially lends out has cycled its way back to it in the form of the debt securities that Corner Banking purchased from them.
• The same capital that is on First Holding's balance sheet lent out as funds due from Space Leasing is also capital received from Corner Banking to fund operations.

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 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.