View from City Road: Banks may have to limit their hedging

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German financial conservatism is not to be despised, since it has served the economy well. In a speech yesterday, Hans Georg Fabritius, a Bundesbank council member, attacked those who play down the risks of derivatives - the volatile instruments used to bet on changes in underlying securities - and called for a tough regulatory framework. He also called for curbs on speculative offshore hedge funds.

In derivatives, German banks have been well behind those in London and New York. Many in Frankfurt see this as a blessing, since when the crash comes it will be others that suffer. But Mr Fabritius worried that German growth rates in derivatives are now between 40 and 65 per cent a year, with the holdings of some banks reaching twice the value of their balance sheets.

The Basle commitee of banking supervisors is slowly grinding out a massive document, which could emerge this spring. Outline proposals a year ago suggested a trade- off in which banks will back their derivatives exposure with capital - which makes speculation more costly - but in return they will be allowed to net off their long and short positions.

However, that will not solve the problem of the hedge funds. These speculate in derivatives, but the risks they pose to the financial system are different. First, they borrow from banks to gear up their investments. That could be curbed by giving their loans a higher risk weighting in bank capital requirements.

Second, banks often sell derivatives deals to the funds. The risk of default in that area is harder to solve by Basle-style diktat. The likeliest solution will be to warn banks to limit their dealings with individual hedge funds.