What Is Double Gearing?
Double gearing is when more than one company uses shared capital as a way to mitigate risk. The businesses involved in double gearing loan funds to one another, which can artificially skew the accounts of the companies, making them appear in better financial health than they are.
Double gearing 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.
- Double gearing is when more than one company uses shared capital to mitigate risk.
- The practice of double gearing is common in complex corporate structures with subsidiaries.
- Companies that practice double gearing loan funds to one another, which can show increased assets on the balance sheet, but are not reflective of true risk.
- Entities that employ double gearing can be overleveraged because more than one company can claim an asset, effectively increasing risk.
- Multiple gearing refers to a parent company sending money down past a subsidiary to a third-tier entity.
Understanding 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, 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. Also, it is possible to create middle-tier entities whose only assets are the investments into dependent tiers.
Double gearing can also refer to borrowing money against an asset to buy stocks and then borrowing against the stocks to open a margin loan to buy more stocks.
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.
Regulatory Impact of Doubling Gearing
As a historical example, in 2002, Standard & Poor's 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, realizing the double gearing increased the risks of the entities.
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 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 and the other lenders took steps to make sure margin loans met higher standards for responsible lending.
Example of Double Gearing
As an example, First Holdings, a financial holding company, owns Corner Banking and Space Leasing:
- First Holdings lends Space Leasing money. The capital will appear 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 lent 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 it 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.