Double Gearing lets two companies hold regulatory capital issued by each other so as to avail mutual benefits and lower the risk exposure.
The most common example of double gearing is one that happens between banks and insurance firms. Insurance companies usually buy shares of a bank in exchange for a loan facility from the bank. This way, both of them hold each other’s capital and reduce their risk exposure.
Double Gearing By Investors:
Individuals can also indulge in double gearing as investors. This happens when an investors borrows a loan from an existing loan and uses that to make further investment. The investments are again used as security for future loans, the amount from which will be used for further investment.
An investor borrows money from a bank using an existing home equity loan. He/she then uses the loan funds for investment. The investment is then used as security and a new margin loan is availed.
Double gearing is a high-risk strategy. In return, it can get one high returns or result in greater losses. The more one invests, the more he/she gains or loses.
Risks of Double Gearing for Investors:
(i) A doubly geared investor will not be able to pay back the loan amount if he/she does not get expected returns from the investment amount. So reliance on investment income alone will not suffice to meet the debt obligation.
(ii) Though double gearing increases chances of getting higher returns through higher investment, it also magnifies chances of losses equally. Say, if the market does not do well, more investment will lead to higher capital loss.