The World Bank is investing in a hedge fund in an attempt to help banks reduce the capital that new rules will force them to set aside against loans to small companies in emerging markets.

The bank’s International Finance Corp arm has invested in private equity for decades but is dipping its toe into hedge funds for the first time by putting $100m into a fund being set up by London and New York-based Christofferson Robb & Co. CRC is raising a further $300m from private investors.

The fund will put up cash to cover unexpected loan losses in return for a cut from the bank. The fund’s cash will lower the banks’ requirements under the Basel capital rules and reduce the impact of planned tighter rules. IFC hopes the fund will encourage an extra $2.5bn to $4bn of lending to developing countries.

Xavier Jordan, chief investment officer at IFC, said there was a risk that banks facing new capital demands would cut back their riskier loans in order to hoard capital. “It’s the implications about constrained access to capital for European banks and the implications for emerging markets,” he said.

The fund will operate mainly with big international banks. They will be required to recycle the money freed up by the “bilateral synthetic capital release securities” that the fund creates back into developing markets.

IFC has been criticised in the past by some aid groups for involvement in structured products and derivatives.

But Mr Jordan said there was nothing inherently wrong with structured finance. “Its very easy to trash structured finance right now because it was an often abused product in the last five to seven years,” he said. “But it is still a product that can have an enormously good impact as long as the products are structured correctly.”

Richard Robb, co-founder of CRC, which manages $1.5bn, said: “Securitisation is maybe not the flavour of the moment, but this transfers risk off banks and lets investors take the risk. If something really bad does happen, the bank can continue to perform its functions and the investors take the losses, which they’re ready for.”

Banks have to convince regulators that a true risk transfer has taken place before they can lower capital needs, making the deals complex and time-consuming.

Banks are under intense pressure to bolster their capital and have been warning of the dangers of tighter regulations and higher capital requirements to the economy, arguing that the rules threaten their ability to lend.

Each deal will be structured to give the Bank a senior tranche with a 7 per cent return target, while private investors will take the riskier tranche, aiming for 20 per cent returns. The fund will have a life of approximately six years.

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