Ever since the financial crisis engulfed us last year, there has been lots of discussion about the failure of free markets and the need for tighter regulation of the financial sector. It is evident from the printed word and the ongoing chatter that there are diverse views about the degree of efficiency of free markets and their potential for generating crises. In addition, there are powerful special-interest groups intent on protecting their turf, not speaking of those with a pro or anti-market ideological programme.

Few people were prepared for the extent and depth of the crisis. You may remember that confidence in the equilibrating capabilities of markets was so strong, at least among the faithful, that even when the downward slippery slope was evident in 2008, the defenders of the faith continued to believe that the system would soon rebalance itself. The rapid deterioration of the financial system and its repercussion on the economy surprised the believers.

How else can one explain the decision by the government (the blame has been put on Timothy Geithner) to let Lehman fail, when the entire system was clearly teetering on the edge. Policymakers misread the situation and exacerbated the downturn before being panicked into taking drastic measures to prevent systemic collapse.

As for realists, they aren't taken in by ideology. Those with money at risk need a sharp sense of market reality. An astute investor or trader would be sceptical when presented with comfortable assumptions about the state of things. He would have a keen interest in capital preservation and risk management based on a realistic interpretation of economic and market trends.

Still, it is remarkable how many people in government and on Wall Street lose sight of the distinction between real and fictitious worlds. Witness the axiomatic faith that Alan Greenspan had in the smooth functioning of the financial system, the quality of its innovations and the effectiveness of risk management methods. Contrast this with, for example, George Soros' viewpoint based on a realistic understanding of market psychology and system behaviour.

Before governments attempt tighter regulation, they have to determine what the weak points are in the financial system, and the potential for market failure. Unfortunately, there may be plenty of disagreement among observers on how to interpret the evidence on deficiencies. In addition, influential interest groups with considerable clout will have a major say on the extent of new regulation.

This is not just an agency problem. You may recall that this situation often arises when a particular regulator loses some of its objectivity by taking on the role of defending the interests of the regulated. It is also the case that powerful figures in government have close liaison with upper management in the financial services sector and share a similar worldview.

In addition, pro and anti-market ideology will cloud the issue of how much regulation is optimal. It is evident that the stance taken by some governments in the Eurozone is ideologically biased against free markets. Meanwhile, in the United States there is a bias in favour of unfettered markets, to the extent of overlooking their deficiencies.

Globalisation of financial markets is more advanced than any other sector of the world economy. But their regulation is very much local, and largely uncoordinated at the global level. The crisis has focused attention on the need for a higher degree of coordination among national regulators. However, this is easier said than done. Witness the current fragmentation even within the European Union, for example.

At the global level, to the extent that there will be jurisdictions with looser regulatory schemes, they may act as magnets for financial firms and activities, allowing practices that will have an impact on other jurisdictions. There are already differences of opinion between governments in France and Germany, favouring tough rules, and those in the US and the UK, opting for a less rigorous approach.

A balanced solution may be difficult to find. An attempt to over-regulate will squelch innovation and curb the sort of controlled risk-taking activity that is beneficial for productivity growth. At the same time, underwriting the failures of large financial institutions opens the door to the inevitability of another financial crisis in the future.

Iraj Pouyandeh is a strategist and senior portfolio manager at LOM Asset Management. He manages the LOM Global Equity Fund. For more information on LOM Asset Management please visit www.lomam.com