Inside a company, gearing describes how much of the business is funded by debt rather than equity. Interest is a fixed claim, so when operating profit rises the surplus left for shareholders rises faster, and when profit falls shareholders absorb the fall first. The same logic explains why some borrowing can lower the overall cost of capital while too much raises it, and why lenders write covenants on multiples of debt to EBITDA. Banks are a special case. The Bank of England's Prudential Regulation Authority applies a leverage ratio that sets capital against total exposures, on and off the balance sheet, without risk weights, as a simple backstop to the risk-based capital rules.
Leverage in trading products
Retail caps in the EU and UK
In markets, leverage arrives through margin accounts and through derivatives such as contracts for difference, where a small deposit controls a far larger exposure. ESMA's product intervention measures, which the FCA made permanent for the UK in 2019, cap the leverage a retail client may use when opening a CFD position, from 30:1 for the major currency pairs down to 2:1 for the most volatile underlyings. They add a margin close-out rule and negative balance protection, and require providers to publish the proportion of their retail accounts making losses.
The arithmetic shows why: with thirty times leverage, an adverse move of one thirtieth consumes the whole deposit. Leverage also undoes diversification, since a spread portfolio bought with borrowed money can still be forced to sell everything at once. The subject runs through trading and derivatives and financial risk and compliance.