What it means
Imagine a parent company that raises $100,000,000 from outside investors. It puts $40,000,000 of that into a subsidiary as share capital.
The parent's accounts show $100,000,000 of capital, and the subsidiary's accounts show $40,000,000 of capital, but only $100,000,000 has actually come from outside the group. If someone simply adds the two entities' capital together, they get $140,000,000, which overstates the true loss-absorbing strength.
The same money has been counted at two levels. This is the essence of double gearing: the apparent capital in the system exceeds the capital actually available to absorb losses.
It can happen in other ways too. Two companies might hold each other's shares or debt, with each funding its capital by borrowing from the other.
A holding company might borrow money and inject it as equity into a subsidiary, so the group has debt on one side and apparent equity on the other, but no new external capital. Regulators care because capital is the cushion that protects depositors, policyholders and creditors.
If a bank or insurer appears to have more cushion than it does, it can lend or underwrite more than is prudent. When losses arrive, the missing cushion becomes obvious and the group may fail faster than expected.
For this reason, regulators usually require groups to prepare consolidated accounts and to deduct holdings in related entities when calculating regulatory capital. These rules remove the double counting and show the group's true external capital.
The details differ by country and sector, so firms need to follow the rules that apply to them. In ordinary corporate life, the idea is a reminder to look through group structures.
Lenders and investors who study a group should ask where each dollar of equity came from, and whether the same dollar supports more than one entity. A simple chart showing who owns whom and who funded what often reveals the issue.
In practice
Real-world examples.
Example
A banking group owns an insurance subsidiary and funds it with equity from the parent. If both are measured separately and added together, the same funds count towards the capital of each, and regulators require an adjustment. The group accounts must remove the investment in the subsidiary to give a true figure.
Example
Two insurers each buy subordinated debt issued by the other. On paper, each has raised new capital, but the money has simply moved in a circle and no outside investor has added anything. Regulators would look through the arrangement and treat the new capital as zero.
Example
A property group borrows $10,000,000 and injects it as equity into a development company it owns. A lender comparing the two sets of accounts sees strong equity in the subsidiary and fails to notice that it is funded by the parent's debt. He asks the company to produce consolidated accounts before he approves any further lending.
Formula
Calculation
Double-counted capital = sum of capital reported by each entity - external capital actually raised
Worked example: A parent company raises $100,000,000 from external investors and reports $100,000,000 of capital. It invests $40,000,000 of that in a subsidiary, which reports $40,000,000 of share capital.
Sum of reported capital = $100,000,000 + $40,000,000 = $140,000,000.
External capital actually raised = $100,000,000.
Double-counted capital = $140,000,000 - $100,000,000 = $40,000,000.
As a share of the apparent total, the overstatement is $40,000,000 / $140,000,000 = 28.6% (rounded). On a consolidated basis, the group's capital is $100,000,000, not $140,000,000.Case study
Seen in the real world.
Calloway Financial Group is a fictional company with a bank and an insurance business under a single parent. Each business reported healthy capital ratios in its own accounts.
In this illustrative case, a regulator reviewing the group found that the parent had borrowed money and injected it into both subsidiaries as equity. Adding the two subsidiaries' capital to the parent's own overstated the group's real external capital by a considerable amount.
After consolidation and deductions, the group's capital ratio fell below the required level. It raised new equity from outside investors and simplified its structure. The illustrative lesson is that capital must be measured at the level of the whole group, not entity by entity. The regulator later published guidance reminding groups that capital must be measured on a consolidated basis.
Watch out
Common mistakes.
- Adding up entity-level capital to judge group strength. This counts internal investments twice and overstates real capital. It is a common beginner error and hides how much real cushion exists.
- Treating intra-group debt as outside funding. Money lent within a group does not add to the group's total resources. A related party has no more resources than the group itself, so the money is not new.
- Assuming the practice is always illegal. Group structures are normal, but regulators require adjustments to remove the double counting. The point is the adjustment, since the double counting must be removed when measuring capital.
Questions
People also ask.
What does double gearing mean in simple terms?
It means the same capital is being used to support two or more entities, so the group looks stronger than it is. Ask whether the same dollar of capital is supporting more than one entity.
Why do regulators care?
Capital protects customers and creditors from losses, so overstated capital increases the risk of failure. When capital is overstated, the group can lend or insure more than it can safely cover.
How is it dealt with?
Through consolidated accounts and rules that deduct holdings in related entities when calculating regulatory capital. Rules differ by country and sector, so firms should follow local regulatory guidance.
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