Political Economist

The level of leverage in the world's financial system now appears to be rising, partly as a result of growing activity by hedge funds and private equity groups, a senior financial regulator warned yesterday.

Meanwhile, there are now some increasingly "crowded" trades in parts of the the foreign exchange market, including the so-called "carry trade" - which involves borrowing heavily in currencies such as the yen and investing the money in higher yielding assets.

These two factors could potentially create some nasty jolts to the financial system in the future, particularly given the economic wider imbalances now building up in the world, warned Malcolm Knight, general manager of the Bank for International Settlements in Basel.

"There is rising leverage in the financial system . . . and we have some very crowded trades in some areas of the foreign exchange markets," Mr Knight said, speaking at the World Economic Forum in Davos. "Together these could create the potential for a very rapid repricing in financial market."

Mr Knight's comments are likely to be closely watched in financial markets, since the BIS acts as a meeting point for the world's central banks and has historically had more freedom to air its concerns. It is also the official organisation that attempts to measure the extent of carry trades, something Mr Knight believes to be almost impossible.

His remarks came amid intense behind-the-scenes discussions between senior bankers and regulators yesterday about the risks which could potentially destabilise markets in the coming months.

Mr Knight did not specifically identify the yen as a threat yesterday. However, the BIS is understood to have been monitoring the yen carry trade very closely in recent weeks, amid signs that hedge funds and other investors have recently been borrowing heavily in yen.

But Kenneth Rogoff, Harvard professor and former chief economist of the International Monetary Fund, was more explicit. He said: "The most puzzling currency is actually the yen."

Some bankers believe that pressure to unwind the carry trades would occur if the yen strengthened to around Y111 to Y114 to the dollar; the yen was yesterday trading at around Y121 to the dollar. In 1998 it swung from Y147 to around Y115 in a matter of days, when the carry trades unwound, triggering jolts to the financial markets around the world.