Bank of England frets over hedge fund risks

The Bank of England is growing increasingly concerned at large inflows of money into hedge funds as institutions and individuals are prepared to take higher risks than in the past in pursuit of high investment returns.

Releasing its twice-yearly financial stability review, the Bank said the British and international financial systems are currently relatively benign and near-term risks low.

But this could be storing up problems, the Bank said. "In the present benign environment, there is a possibility that lenders, borrowers and investors may be inclined to under estimate long-run vulnerabilities and take on too much risk," said Sir Andrew Large, the Bank's deputy governor responsible for financial stability.

Given subdued bond yields and low asset price volatility, the review said it was "difficult to find investments with the prospective returns that many investors still expect and so the 'search for yield' has been continuing."

But the central bank said various sectors might not be taking sufficient account of future risk when making lending or investment decisions. It singled out unsecured lending, commercial property and hedge funds. It also sounded a warning about "large complex financial institutions" expanding into sectors like energy and commodity trading.

A hedge fund is an institution which borrows heavily to take positions in markets where it thinks an asset is wrongly valued.

Many are based in London and there are reports of new ones being opened almost daily, many in small offices in the West End of London.

The Bank is concerned at the rapid increase in inflows. Until three years ago up to $20bn a year was flowing into hedge funds, but in 2003 the total hit $70bn and this year it is set to double that.

"Some market contacts have expressed misgivings at the scale of investor demand for risky and potentially illiquid assets" the Bank said. "Unexpected economic developments could trigger the attempted simultaneous unwinding of common positions, possibly leading to strains on market liquidity."

It said the heavy inflows of money into hedge funds came in spite of the relatively modest returns the funds were generating. These returns were generally below 5% a year, it said.

This in turn was leading many hedge funds to move into less efficient markets where mis-pricing, and therefore potential gains, were greater. This had been particularly evident in credit markets, it added.

Funds are better placed to withstand shocks if they managed to lock investors in for a longer time period. But many, especially funds of hedge funds, are still offering monthly or quarterly liquidity "and are thus potentially more at risk of sharp withdrawals in the event of a change in sentiment".

The review was also worried about the rapid growth of unsecured, or non-mortgaged, borrowing in Britain. It said while banks had improved their credit-scoring models and so-called "stress tests", a period of economic downturn may lead to lenders making it more difficult for borrowers to roll over their unsecured loans and cause wider repayment problems.

The Bank also expressed concern that more than half of all corporate lending in the year to September was to the commercial property sector where, it said, returns were falling. "In the light of recent weak rental growth and high vacancy rates, it is unclear whether investors' expectations of rental income will be met."