Bank warns of hedge funds threat

A flood of speculative cash into hedge funds run by "less-experienced" managers has raised the risk of a sudden correction that could trigger instability in financial markets and push the world back into recession, the Bank of England warns today.

The Bank says investors have taken on increasingly risky positions to maximise their profits in an otherwise low-yield environment of falling interest rates and volatile share markets.

The Bank is also concerned that British banks have relaxed their lending criteria as interest rates fell and the housing market boomed, leaving themselves exposed to a surge in arrears as households struggled to pay off their record debt burden.

In its biannual review of financial stability, the Bank warns that large moves in interest rates and sharp falls in asset prices could force investors who have taken out large positions without hedging their risk to unwind their positions in a hurry.

It said that so far, investors had managed to sell out of their bets without triggering any financial stress or causing large and dangerously volatile movements in financial markets. "Nonetheless, further price changes could trigger other sharp asset price movements or market liquidity problems were investors simultaneously to try to unwind common positions, leading to 'one-way' trading," the report says.

"These risks may have been exacerbated by the rapid growth and proliferation of hedge funds over the past year, possibly bringing in less-experienced fund managers."

It said that hedge investment surged from zero in the spring of 2002 to US$40bn in the final quarter of last year. The Bank said hedge funds' leverage was "moderate" compared with 1998 - the year when the collapse of Long Term Capital Management came close to wiping out Wall Street - but admitted that might "not be a sensible benchmark".

Launching the report, Sir Andrew Large, the Bank's deputy governor for financial stability and a member of its interest rate setting committee, said: "To the extent that these developments reflect higher risk appetite or misperceptions of risk, they raise an issue for financial stability.

"And if the 'search for yield' has seen market participants adopt similar trading strategies, a change in economic conditions could trigger sharp asset price movements or market liquidity problems."

The Bank is growing increasingly concerned about the risk of a sudden collapse in asset prices - particularly housing - and the danger that it might trigger a rush by households to increase their savings and cut their spending plans.

On a domestic level, it wants to see the boom in house prices, which are currently rising by 20 per cent a year, cool before it becomes a speculative bubble that could burst with similar disastrous consequences as the last property crash in the early 1990s.

Mervyn King, the Governor, has made repeated attempts over the last fortnight to warn homebuyers not to assume that house prices will always go up and interest rates stay low.

In today's report, the Bank highlights the £1 trillion mountain of debt held by UK consumers as the major threat to the financial stability of Britain's banking system.

It said high levels of debt in both the household and corporate sectors meant that the impact of increases in interest rates would be greater.

It added: "There may be a tendency for the rigour with which corporate credit quality is assessed to slacken when interest rates have been low, recent default experience has been good and loan demand is subdued."

It urged banks to follow the Governor's advice to borrowers and "stress test" their lending books against a scenario of rising interest rates and surging unemployment.

However, it concluded that the near-term risks to UK financial stability from financial losses by the major institutions had eased.