ROLLING BACK the frontiers of state through privatisation and deregulation, a process kicked off by the governments of Margaret Thatcher and Ronald Reagan in the 1980s, was a policy intended to unleash pent-up entrepreneurial forces and boost economic growth. In financial services, however, the policy - which gathered momentum after "Big Bang" shook up the City - almost worked too well.

Alan Greenspan, the former chairman of the Federal Reserve, was one its most persuasive advocates. Such was his faith in the self-correcting powers of free markets, he was able to persuade politicians and regulators, not just in the US but elsewhere, to share his faith in the "efficient-market hypothesis".

Against their better judgment, policymakers and regulators allowed themselves to be convinced that it would make sense for swathes of the financial markets - notably hedge funds, credit derivatives and mortgages - to exist in a regulation-free zone. The Basel Committee on Banking Regulation also became convinced that the use of complex derivatives would limit risk and boost market efficiency. In Britain the "light-touch" Financial Services Authority, which took over responsibility for bank supervision in 1997, adopted a similar laissez-faire approach (though its chief executive Hector Sants now denies that the body ever used the phrase "light-touch").

However, many of the underlying assumptions behind this Greenspan-ian creed were in fact deeply flawed. Rather than ensuring perfect markets, a regulatory vacuum coupled with a taxation system that favoured debt finance actually gave rise of a massive "shadow banking system". In this, regulators were powerless to rein in an orgy of reckless lending. Unregulated markets had also become the perfect stamping ground for fraud.

It took the shocking events of September and October 2008, when several US, European and British banks came within a whisker of collapse, to persuade the policymakers and regulators of the error of their ways. The Bernie Madoff case, in which the former Nasdaq chairman allegedly defrauded to the tune of $50bn, further reinforced the urgent need for reform.

President-elect Barack Obama is making all the right noises. He attacked regulators, including the SEC, in the wake of the Madoff scandal. He said that financial markets "desperately needed" greater accountability and that one of his administration's first initiatives will be to assemble a detailed plan for overhauling financial regulation. "We have been asleep at the switch," said Obama. "We've had a White House that started with the premise that deregulation was always good."

However, the financial services industry is not going to abandon some of its cherished freedoms without a fight. Even though it has been deeply humiliated and parts of it are now answerable to the taxpayer, some of the old arrogance survives. Some observers predict that 2009 is going to be characterised by turf wars between policymakers, regulators and the regulated over the best way forward.

The financial services industry, free-marketeers and right-wingers, will be arguing that stringent new regulations could be self-defeating, since the super-smart brains of Wall Street and the City would soon find ways around them. People in this camp will also warn that if any single jurisdiction, such as say the UK, were to introduce draconian new rules, then financial services firms will migrate to more loosely regulated jurisdictions such as Ireland.

The rival camp favours more and smarter regulation and is made up of a rainbow alliance of market realists, believers in financial justice and even some diehard Marxists.

To many in this group, the injustices inherent in the financial services industry (including the 340-times pay differential between RBS's call-centre workers and its former chief executive Sir Fred Goodwin) are tolerable when the industry is performing well. However, when parts of the industry are effectively bust and owe their continued existence to the generosity of taxpayers, the need for reform is self-evident.

Bill Hambrecht, the founder and chairman of pioneering brokerage WR Hambrecht + Co and OpenIPO, believes one solution for the mispricing of derivatives - which was ultimately what lay behind the breakdown in trust that gave rise to the crisis - is to force all trading in these complex instruments on to regulated stock exchanges. He believes this would ensure that pricing of hard-to-price instruments would rapidly become more fair and transparent.

Like many others, Hambrecht also believes that the credit rating agencies, which were prepared to slap AAA ratings on questionable financial instruments, must also be reformed. He suggests that their ratings might in future be funded through a tax on trading, rather than paid for by issuers and underwriters.

According to Nouriel Roubini, a professor of economics at NYU Stern School of Business, the bonus-driven culture at banks also needs to be overhauled. He says: "The system of compensation of bankers/traders should be re-evaluated. It is an important factor which distorts lending and investment decisions."

Roubini, one of the few who can truthfully claim to have seen the current crisis coming, also believes the regulatory net needs to be extended. "If non-bank institutions including SIVs and conduits are to benefit from the government's safety net, then the same regulation and supervision that is applied to banks should be applied to these systematically important financial institutions, and on a permanent basis. Otherwise the moral hazard would be serious and severe."

Some believe that a global, treaty-based organisation such as the International Monetary Fund ought to be given the additional mandate of providing a more co-ordinated global approach to regulation and bank supervision - thereby reducing the scope for so-called "regulatory arbitrage". This is when private-sector players play one jurisdiction off against another.

Carmen Reinhart, a professor of economics at the University of Maryland and Kenneth Rogoff, a professor of economics and public policy at Harvard University, recently argued for a more international approach to bank regulation. In an article for the Financial Times they wrote: "Finding ways to insulate financial regulation from political meddling is critical to creating a more robust global financial system in the future.

"A well-endowed, professionally staffed, international financial regulator would offer a badly needed counterweight to the powerful domestic financial service sector lobbies."

At their summit in November, the leaders of the world's 20 largest economies were edging towards a consensus on such issues, saying that containing leverage must be a primary focus of any revamp of the global financial system.

Ngaire Woods, professor of political economy at Oxford University, believes there is also a need for "a special-function international court" that would be charged enforcing new global rules in banking and finance, reviewing global regulators, adjudicating in disputes, and offering uniform authoritative interpretations of the rules.

At a UK level, a number of specific reforms have been proposed. Professor Stewart Hamilton, a Scots professor of finance and accounting at Lausanne-based business school IMD, believes that a key reason that banks such as RBS and HBOS nearly collapsed last year was the incompetence of their boards, particularly the non-executive directors.

He says: "I would strengthen the capability of people sitting on the boards of PLCs. They need to be people who are capable of exercising independent judgment. They should also have a proper understanding of business and a sufficient number must be reasonably experienced in the industry in which the company is involved."

Other suggestions include that the Bank of England should resume responsibility for bank supervision and that there should be a much more concerted campaign to root out financial fraud.

Robert Skidelsky, professor emeritus of political economy at Warwick University, has already argued for a global exchange-rate system to replace the "broken" Bretton Woods agreement.

Overall, however, Skidelsky believes the world is facing is a stark choice. "The effective choice is between a more regulated global capitalist system and its possibly violent break-up into a menagerie of warrior nationalisms."