Bank sounds alarm on hedge funds

THE BANK of England is increasingly concerned that banks and lending instutitions have forgotten the lessons of last autumn's financial collapse and that complacency is creeping back into their dealings with hedge funds.

The Bank also warns that the amount of "leverage" in the system is again on the increase, raising the prospect that another shock on the scale of the Russian bond default last year could once again pose a severe threat to the stability of the financial system as a whole.

In the June Financial Stability Review, - the Bank's regular survey of the stability of the UK financial system which is published today - the Bank warns that as the memories of the crisis triggered by Long-Term Capital Management last September recede, concern about gearing is fading and banks are becoming particularly lax.

"Some market anecdote suggests that financial instutions may have been rebuilding their positions this year, and that hedge fund activity in particular may have picked up," the Bank says. It adds: "There have also been some suggestion that lenders to highly leveraged institutions may have begun to relax their terms again, for example by reducing or waiving `initial margin' requirements."

The Bank says there is also evidence of risk-management practicies being relaxed. This is in spite of tighter supervision by regulatory authorities of dealings with hedge funds in the wake of the near collapse of LTCM which until the $3.5bn bail-out organised by the US Federal Reserve had threatened to bring the global financial system to its knees.

It also runs counter to the recommendations of the so-called Brockmeijer report drawn up by the Basle Committee of Central Bankers in the wake of the hedge fund crisis which specifically highlighted the waiving or margin requirements and the excessive reliance on collateral as giving serious grounds for concern.

The Bank warns: "The financial shocks of the past two years are a salutory reminder that many threats to financial stability arise suddenly and are unlikely to be anticipated."

It adds: "It is important that these recommendations are implemented by all instutions, even as memories of last autumn's events fade."

The remarks carry considerable weight since the Bank continues to monitor the overall stability of the UK financial system despite having ceded responsibility for day-to-day supervision of the banking system to the new Financial Services Authority last year.

They almost certainly reflect the advice being given both by the Bank of England and the FSA to the UK banks.

The warning is particularly worrying given the growing concern in the City about the prospect of another stock market crash within the coming months, possibly triggered by a rise in short-term US interest rates.

The fact that many financial instutions are again "leveraging up", or increasing their borrowing, raises the threat that any market collapse could again have severe knock-on effects on finanical institutions' appetite for risk and, in some cases, even put their solvency at risk.

Concern has also been expressed recently once again about the performance of some of the larger hedge funds.There has been talk on Wall Street that Tiger Management, the giant hedge fund run by billionaire manager Julian Robertson, is braced for a wave of redemptions this month following several months of poor performance, while George Soros' Quantum Fund has also come under fire for lacklusture performance.

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