The worst economic and financial crisis since the Great Depression is causing significant changes in the global financial system.

Most of the traditional and shadow banking system in the US and western Europe has been seriously damaged and, in some cases, destroyed by runs on their short-term liabilities. Hundreds of non-bank lenders have gone bust in the last two years because their wholesale financing has dried up, while the structured investment vehicles and conduits that were a feature of the early period of the credit crunch have disappeared amid a decline in asset-backed commercial paper financing. Of the five major US investment banks, two (Bear Stearns and Lehman Brothers) have disappeared, one (Merrill Lynch) has been forced into a merger and the last two (Goldman Sachs and Morgan Stanley) have been converted into bank holding companies and subject to much tighter regulation.

The securitisation and structured finance market is moribund – for now. It will not be resurrected, without public subsidies, unless much greater transparency, liquidity and standardisation is introduced. The roles of New York and London as major financial centres are being reduced as the financial crisis reveals the weakness of the Anglo-Saxon model of lightly regulated finance. Over time, alternative financial centres, both traditional (Tokyo, Singapore, Hong Kong) and new (Dubai, Shanghai, Mumbai, São Paulo, Moscow) will emerge as the Bric countries (Brazil, Russia, India and China) and other emerging markets (especially in the oil-exporting Gulf) increase their share of global GDP.

Greater regulation, more capital requirements and lower leverage will make it harder for financial institutions to achieve the high returns on equity of the boom years. Banks’ earnings may be recovering in the short term, but as monetary policy is normalised, achieving high returns will become more difficult, especially as innovation is likely to be constrained by tighter supervision.

The asset management industry is in trouble, as investors tire of the high fees imposed by sub-performing asset managers who fail to deliver the promised “alpha”. The private equity industry is in crisis, as its old business model, based on highly leveraged buyouts, becomes unworkable in a world in which credit spreads are much higher. Hedge funds have also been squeezed by a serious amount of deleveraging.

Bankers, hedge fund managers and private equity executives are all going to have to prove that the returns they make are based on superior skills – rather than on unsustainable leverage.

In my view, the virtues of capital account liberalisation have been greatly exaggerated. Emerging market economies, in particular, are likely to pursue such liberalisation much more slowly than many believe. At the same time, the risk of financial protectionism is growing as countries try to defend their own financial system, which is leading to a greater risk of de-globalisation.

Given the need for a deleveraging of financial institutions and households in most advanced economies, credit growth – when it resumes – will be weak compared with the boom years of the credit bubble.

Thus, the ability of the financial sector to finance residential investment, purchases of consumer goods and capital spending by the corporate sector will be greatly constrained, which will lead to a fall in economic growth.

The crucial challenge now is to design a better system of regulation for banks and financial institutions. There is no doubt that the previous model has failed miserably. What we need is much stricter and simpler regulatory rules. Leverage should be much lower, capital and liquidity buffers considerably higher and capital requirement more counter-cyclical.

We must also deal with the “too-big-to-fail” institutions, an issue that has actually been exacerbated by government bail-outs. As well as causing even greater moral hazard, the bail-outs have led to the consolidation of financial institutions into even larger financial behemoths – which still need to be broken up. A new bankruptcy regime that allows the orderly wind-down of important financial institutions needs to be legislated. Such institutions should have higher capital requirements than smaller ones and their activities should be supervised and regulated on an international basis.

But the true solution to the too-big-to-fail problem requires more radical choices. In addition to an insolvency regime, such institutions should be broken up and unsecured creditors of insolvent institutions should have their claim automatically converted into equity. A separation of commercial banking and risky investment banking should also be considered. Thus, some variant of the Glass-Steagall Act should be reintroduced.

The issue of executive compensation should also be addressed. Distorted financial incentives fuelled the excessive risk taking and high use of leverage that, in the boom years, boosted short-term bonuses at institutions, while putting the medium-term viability of these institutions at risk. Monetary policy must take into more active consideration the risks posed by asset bubbles, and include asset prices in the determination of both policy rates and credit and leverage limits. Global current account imbalances should also be reduced to avoid further accumulation of external deficits and debts and a disorderly collapse of the US dollar.

As markets begin to mend and financial institutions return to profitability, the drive to reform the regulation of the financial system is losing political momentum. There is now a serious danger that risky practices and leverage could return.

If another systemic crisis were to occur, the backlash against global finance and the free market would be even more severe. To prevent another asset bubble from building into a financial crisis, reform must be implemented with haste.

Nouriel Roubini is professor of economics at the Stern School of Business, New York University and chairman of RGE Monitor