Double Leverage

What Is Double Leverage?

Double leverage occurs when a bank holding company conducts a debt offering to acquire a large equity stake in a subsidiary bank. Ideally, dividends earned on the subsidiary company's stock finance the holding company's interest payments. While the strategy is attractive for some bank holding companies, regulators caution that the practice might amplify financial risk and undermine stability.

Double Leverage Explained

A bank holding company is a corporation that owns a controlling interest in one or more banks but does not itself offer banking services. Holding companies do not run the day-to-day operations of the banks they own. However, they exercise control over management and company policies. They can hire and fire managers, set and evaluate strategies, and monitor the performance of subsidiaries’ businesses.

With double leverage, the holding company injects capital into a subsidiary bank, which is able to further increase its own borrowings, and thereby compounds the original parent's debt. Note that the parent's stand-alone capital does not change, through double leveraging the parent nonetheless becomes more heavily exposed to the subsidiary.

Because banks have strict capital requirements on the amount of debt they can hold, compared to other types of companies, double leverage can be an indirect workaround to give the bank access to debt-based capital. Some academics suggest that the fact that banks are willing to use double leverage may suggest that regulators should allow banks to use more debt-based financing.

Recent Example of Double Leverage

In April 2018, Reuters reported that certain Business Development Companies (BDCs) had received board approval to increase the amount of debt they were able to borrow. This followed the passing of U.S. legislation in March 2018 that allowed them to double leverage on their funds.

A BDC is an organization that invests in and helps small- and medium-size companies grow in the early stages of development, similar in some regards to private equity or venture capital firms. Many BDCs are distinct in that they are set up like closed-end investment funds. BDCs are typically public companies, in contrast with many private equity firms. BDC shares trade on major stock exchanges, such as the American Stock Exchange (AMEX), Nasdaq, and others.

Specific BDCs that received approval for increased debt levels included Apollo Investment Corp (AINV), FS Investment Corp (FSIC), PennantPark Floating Rate Capital Ltd (PFLT), and Gladstone Capital Corp (GLAD).

Concerns Over Double Leverage

Several financial authorities have raised concerns about the issue of double leverage for two reasons: first, such intra-firm financing may allow for arbitrage of capital; and second, it assumes further risk. A 2018 study by Silvia Bressan shows that bank holding companies are more prone to risk when they increase their double leverage. This specifically occurs when the stake of the parent within subsidiaries is larger than the parent company’s capital in and of itself.

Bressan suggests that policymakers should be more efficient in their regulation of complex financial entities to promote stability. When any entity takes on such a large volume of debt, the ability to repay becomes more and more challenging even if the borrower has a strong cash flow history and diverse revenue streams.