EUROPE - The German central bank has warned that "competitive pressures" may mean prime brokers are compromising on hedge fund due diligence.

"As analysts of banking sector stability, we have to take into account that the links between large EU banks and hedge funds are intensifying," said Deutsche Bundesbank board member and Banking Supervision Committee chairman Edgar Meister.

"It cannot be excluded that competitive pressures may have forced some prime brokers to compromise on due diligence when dealing with hedge funds," he said in a speech earlier this week at the presentation of the EU Banking Stability in Frankfurt.

He said: "Continuing vigilance therefore remains essential for banks to ensure that they retain a good grasp of their overall exposures to unregulated financial institutions."

But he said the markets have been making "enormous progress" in understanding risks and in aligning their risk management systems.

The report stated that most banks did not see any systematic increase in risk-taking by their hedge fund counterparts.

But it said: "Nevertheless, the opacity of the hedge funds industry affects banks' ability to aggregate their exposures to hedge funds, so that in those few cases where EU banks have exposures to hedge funds, monitoring may nonetheless be called for."

And "crowding" of hedge fund trades could further magnify the risks for banks, especially if banks' proprietary trading used similar strategies.