Britain and US crack down on hedge funds blamed for crisis

An unprecedented crackdown on speculators preying on falling share prices began on both sides of the Atlantic yesterday, as Gordon Brown promised to "clean up the financial system" after days of turmoil.

The Financial Services Authority (FSA) banned "short selling" of bank shares from midnight last night, after warnings that the practice helped fuel market turmoil that forced the dramatic £12.2bn takeover of HBOS by Lloyds TSB. This came as the New York Attorney announced his office had launched an investigation into illegal manipulation to profit from short selling. The move is to uncover whether speculators have spread misleading information or acted in concert to purposely drive down share prices.

Wealthy hedge fund traders, heavy users of the shorting strategy, have sparked fury after making millions from the collapse in value of UK banking stocks.

Until yesterday, shorting was not outlawed as it is regarded as a legitimate trading practice in a stable market. However, it has contributed to falling prices in the vulnerable banking stocks, forcing regulatory action.

But markets were buoyed last night by reports from the US over the creation of a government "bad bank" to soak up mortgage debt causing a late revival on Wall Street. The Dow Jones Industrial Average enjoyed a late surge towards the end of the day to close 410 points up on the expectation that the Treasury Secretary, Hank Paulson, would announce a rescue plan this morning to tackle the crisis.

The FSA's chief, Hector Sants, said: "We have taken this decisive action ... to protect the fundamental integrity and quality of the markets and guard against further instability in the financial sector." The FSA was prepared to extend the ban to other sectors "if it judges it necessary".

The Securities and Exchange Commission, the FSA's counterpart in the US, has moved to prevent certain short-selling trades.

Traders can short a stock by borrowing it from a long- term investor, usually a pension fund or insurance company, for a small fee and immediately selling it on the open market. They return the stock at a pre-arranged date and if the value has fallen in the meantime, they pocket the difference.

Hedge funds, including Harbinger Capital, GLG Partners and Lansdowne Partners, have all taken short positions in UK banks this year including HBOS and Bradford & Bingley.

This came after the Prime Minister bluntly demanded reform of international markets and condemned the "irresponsible behaviour" that has led to meltdown in the world's markets.

He also attacked the culture of greed in the financial world and called for action to end market excesses that have brought down five of the world's largest institutions. "We will deal with some of the problems that have arisen because of irresponsible behaviour," he said. "I have said for some time we need reforms of the system. We have got to clean up the financial system."

Mr Brown spoke as central banks around the world, including the Bank of England, launched a fightback, pumping £100bn ($180bn) into the global banking system to end panic.

The Prime Minister is planning to press for tighter international rules on company disclosure and better co-operation between international regulators when he travels to New York next week. He will hold talks on the issue at the European Council and also hopes to develop an improved early warning system to head off market meltdown.

Mr Brown declared: "I have proposed a number of things to our international colleagues because global action is needed.

"In our own country we will do whatever is needed to make sure people have confidence in the system and we restore the prosperity of the country." He told Sky News: "It is not acceptable that people fail to declare bad assets and leave us in a position where we're going to have to face the cleaning up of that."

David Cameron, the Conservative leader, pledged support for efforts to stabilise the markets yesterday. He said: "Anything the Prime Minister and the Government do to help will have my full support."

Andrew Baker, the deputy chief executive of AIMA, the hedge fund trade body, said: "The fundamental factor it the loss of confidence in the stocks. People think they are overvalued in the current environment. The falls are not the fault of the short sellers."

Callum McCarthy, the chairman of the FSA, said: "This is a measure which reflects the present turbulence in markets. It is designed to have a calming effect – something which the equity markets for financial firms badly need. I hope that practitioners will support both the ambition and the chosen means of achieving it." He said it would run initially for 120 days.

But pressure was mounting last night on the Government to tighten regulations on traders. John McFall MP, the Labour chairman of the Treasury Select Committee, said the key was getting rid of anonymity and creating transparency in the markets.

Vince Cable, the Liberal Democrat shadow Treasury spokesman, said: "Who is next? It looks as if they may now be turning to other banks. The FSA must insist that hedge funds declare their position. It must outlaw collusion between hedge funds – they are now hunting in packs."