These days, every City or Wall Street investment banker seems either to be starting a hedge fund, or threatening to do so. It is a latter-day dotcom boom: this time, it is not MBA students going to start-ups, but middle-aged bankers. The way that banks are trying to deal with it could damage both their finances and reputations.Bankers were never big on corporate loyalty, but even by their standards these are febrile times. Brady Dougan, who becomes chief executive of Credit Suisse First Boston this week, almost left to found a hedge fund. Mehmet Dalman agreed to stay as chief executive of Commerzbank Securities last week after being allowed to start a hedge fund inside the bank.Forming a hedge fund is a tempting idea. It can be lucrative: the partners of a successful hedge fund earn a lot more than a bonus in the single-figure millions. It also means more freedom: instead of enduring the stresses of an office in Canary Wharf or Wall Street, hedge fund managers can determine their own destiny in Mayfair or Greenwich, Connecticut.The exodus reflects a wider change in investment banking. After the Long Term Capital Management debacle in 1998, banks pulled back from proprietary trading. They feared the risk of gambling with their own capital as well as potential conflicts, such as advising customers to buy shares that their traders were selling.Several years of exceptional trading conditions, first in equities and then in debt, changed all that. Goldman Sachs now makes more by trading for itself and for its customers than from advisory work and broking. It is not alone: proprietary trading desks are scattered across many banks. One financier says: “Their attitude towards the old concerns is now: ‘Tough, this is how we make money.’ “When a valuable trader, or an entire trading desk, goes off to form a hedge fund, it has a big impact on revenues. That is why banks either try to bribe them to stay, or offer them a financial partnership. In practice, that can mean a bank investing in its former employees’ funds, introducing other investors, lending them cash and securities, providing them with research and executing their trades.As a result, some investment banks have a diaspora of former employees managing hedge funds. These financial links can be attractive. Hedge funds now account for 30 per cent of equity broking commissions at some banks. Indeed, bankers say the exodus has had advantages: banks have lost traders, but gained a cadre of loyal customers for their broking arms.But this interdependence is riskier than most banks admit, or perhaps acknowledge to themselves. To start with, it means their operations are even more concentrated in trading. An innocent investor reading a bank’s accounts would see that trading made a big contribution to revenues, but assume that advisory and broking business provided a balance.In practice, if hedge funds have become a bank’s dominant customers, any trading downturn will hurt these operations as well. That could easily happen. Conditions for trading are already tougher - the threat of rising interest rates has hurt bond trading. Meanwhile, the sheer number of hedge funds makes it harder for any of them to achieve large returns.The risk of over-concentration is exacerbated by so many funds being founded by investment bankers. One reason for LTCM’s near-collapse was that its trading tactics were being imitated by other hedge funds and trading desks. As a result, when Russia defaulted on its debts, many financial markets became illiquid as all of these funds tried to trade out of similar positions at the same time.The diaspora means that many hedge fund managers not only know each other well, but used to work side by side on the same trading desks. They also retain links with the banks where they used to work through the banks’ prime broking arms, the divisions that serve hedge funds. That makes it likely that they will adopt the same trading strategies as each other and their former employers.It is not a big step from this to insider trading. There is a considerable temptation for an investment bank, or its employees, to share inside information with a hedge fund run by former employees. The bank’s brokers stand to benefit in several ways if the hedge fund does well out of such a tip. Not only will they gain more fees, but any investment by the bank in the fund will rise in value.Inside information can also flow the other way, from funds to investment banks. A bank that acts as a prime broker to a hedge fund has detailed knowledge of its trading activities. If the bank also invests in the fund, that puts it in a privileged position compared with other shareholders. It can see whether the fund is doing well or badly without waiting for data to be released to all investors.Regulators are already worried about the potential for abuse. The Securities and Exchange Commission is investigating alleged cases of hedge funds trading on inside information about companies that were about to raise equity. Indeed, it would be surprising if there had not been some improper conduct. The two sides now depend so heavily on each other that there are likely to be instances of rule-bending.The existence of this financial inner circle should worry other investors. It should equally concern investment banks that increasingly rely on hedge funds, including those run by their former employees. When traders leave, banks must either sacrifice revenues or find a way to stay close to their old colleagues. The latter may look like a sure financial bet, but you can have too much of a good thing.