INVESTMENT banks in the UK are braced for closer regulatory scrutiny of their relations with hedge funds, amid allegations of improper conduct.

The Financial Services Authority, the City watchdog, has been visiting hedge funds and their advisers over the past few months and is expected to publish its findings by the end of June.

It is focusing particularly on prime brokerage — an American term used to describe the lucrative services provided by investment banks to hedge funds.

The subject was thrown into the spotlight this week when it emerged that a dossier detailing the allegedly over-cosy relationship between one London investment bank and its hedge fund client was circulating in the investment community. The bank has emphatically dismissed the allegations as a dirty tricks campaign.

Some critics say that investment banks are so reliant on huge fees from prime brokerage that they may be tempted to favour hedge funds at the expense of other clients.

The FSA recently indicated that it was concerned by the relationships between banks and hedge funds when it spoke of “the danger that firms may misuse information entrusted to them by customers in one area in order to secure gains in another area”.

At least one London-based hedge fund has an arrangement with its stockbrokers whereby it willingly pays commission above the going rate. This has raised worries that investment banks may favour it with superior information at the expense of other clients.

The growing power wielded by hedge funds was also highlighted this week by John Sunderland, President of the CBI, who mounted an attack on the lack of openness and accountability of investment institutions in general and hedge funds in particular.

One gripe among company chief executives is that they are put under pressure by their investment bank advisers to make presentations to hedge funds, knowing they are unlikely to be long-term, supportive shareholders.

“It may be old-fashioned,” said Mr Sunderland, who is chairman of Cadbury-Schweppes, “but I view a shareholder as a share owner — someone whose interest in the success of the company lasts more than three weeks.”

Regulators have raised prime brokerage as a concern before. Many respondents in a study by the Centre for the Study of Financial Innovation saw “unhealthy links” in prime brokerage.

Many hedge funds, although run from London, are registered in offshore tax havens and are unregulated, limiting the scope of the FSA inquiry. While hedge funds have their detractors, some regulators see them as beneficial, because they assist market liquidity and can dampen volatility.

But Charles Prescott, managing director of Fitch Ratings, said of them: “No outside body supervises their risk control systems; they owe considerable amounts to major world banks, with whom they have close relationships, which could lead to the development of systemic risk.”

London is the hedge fund capital of Europe, home to an estimated 600 funds that control $190 billion (£99 billion) of assets.

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