Do bank regulations affect hedge funds? New banking regulations are designed to make banks safer by requiring them to hold more of their own capital against financing activities. However, these rules also make certain balance-sheet-intensive activities—including lending to hedge funds—more costly. Because hedge funds rely heavily on banks to finance their trades, stricter bank regulations may adversely affect their performance.

We examine this question by leveraging the gradual rollout of stricter capital requirements for the world’s largest banks under the Basel III framework. We find that hedge funds connected to more heavily regulated banks subsequently exhibit lower returns, alphas, volatility, and Sharpe ratios. The negative effects are more pronounced for funds that are more sensitive to increases in financing costs. To partly offset these higher financing costs, hedge funds tend to tilt their portfolios toward higher-beta stocks.

Policy insight: Banks do not merely lend to firms and households; they also perform a critical financing function in capital markets by providing leverage to non-bank financial institutions. When regulators design rules to make banks safer, they should also consider potential spillovers: tighter bank regulations can constrain hedge funds and, ultimately, affect broader capital-market outcomes.