Leverage
Leverage
The use of borrowed funds or other liabilities to increase financial exposure relative to the amount of equity committed.
Leverage is the use of borrowed funds to increase financial exposure.
Leverage Amplifies Both Gains and Losses
Leverage allows an investor, business, or bank to control a larger pool of assets with a smaller amount of equity capital.
If asset values rise, returns on equity can be magnified. If asset values fall, the same structure magnifies losses and can quickly erode the equity cushion.
What Is Leverage?
Leverage describes the relationship between total financial exposure and the capital that ultimately bears losses. Borrowing is one common source of leverage, but balance-sheet liabilities more generally can create leveraged exposure.
Banks are naturally leveraged institutions because a large share of their assets is funded by deposits and other liabilities rather than equity alone.
A Simple Example
The effect can be seen by comparing an unleveraged and leveraged position.
More equity supports each dollar of assets, so gains and losses have a smaller proportional effect on capital.
Less equity supports each dollar of assets, so the same asset-price change has a larger proportional effect on capital.
Leverage on a Bank Balance Sheet
A simplified chain is:
Why High Leverage Can Become Fragile
When the equity cushion is small relative to assets, even modest losses can materially reduce capital. If losses become large enough, the institution can become insolvent.
Leverage can therefore improve returns during favorable conditions while increasing sensitivity to defaults, asset-price declines, interest-rate changes, and funding stress.
Why It Matters for Monetary Literacy
Leverage connects bank balance sheets to financial stability. It explains why the size of a bank or market position matters less than the relationship among assets, liabilities, liquidity, and the capital available to absorb losses.
Leverage makes a balance sheet more powerful in good times and more fragile when asset values move against it.
Explore the Banking System
Continue exploring how commercial banks, deposits, credit, balance sheets, liquidity, and monetary policy interact throughout the modern monetary system.