Investment banking is an organised scam masquerading as a business. It is defined by endemic conflicts of interest, systemic amoral behaviour and extreme avarice. Many of its senior figures should be serving prison sentences or disgraced – and would have been if British regulators had been weaned off the doctrine of " light touch" regulation earlier and if the Serious Fraud Office's budget had not been emasculated by Mr Osborne. It is a tax on wealth generation and an enemy of honest endeavour – the beast that is devouring British capitalism.

The £290m fine on Barclays for rigging the interest rates in the inter-bank market is a defining moment. Not just for Barclays but for every bank with which it colluded. Barclays had the wit to come clean first – the first of many banks to suffer political and moral opprobrium for illicitly inflating its profits. It was also trying to protect itself from "reputational damage" – not wanting other banks' assessment of its creditworthiness to become public .

In the light of what we now know, that seems laughable. But between autumn 2007 and spring 2009, Barclays was fighting for its life as an independent bank. Had the news surfaced that other banks harboured such doubts about its credit standing, Barclays might have ended up being owned by the British taxpayer like RBS and Lloyds.

As the FSA reports, senior treasurers and the corporate affairs department were both keenly aware of those risks and anxious they should be averted. It beggars belief that the top of Barclays did not know what measures it had to take to pull through. It had to lie about the rates it was paying to borrow money.

This came easily because the practice had become habitual. The London interbank offer rate is set each day at 11am in all the key currencies lent and borrowed in London. Each major bank submits the interest rate it is paying to the British Bankers' Association and the average becomes the benchmark rate for most of the world's loans and financial contracts. For example, there are some $554tn worth of so-called interest rate derivative contracts whose price is linked to Libor – manufactured products whose alleged purpose is to hedge the risk of unexpected interest rate changes in a world of floating exchange rates and free capital movements.

In fact, there is no way that these instruments can insure against system-wide movements. Some bank has to lose by being the sucker paying out, then becoming the weak link in the system which, in an extreme case, has to be bailed out by the taxpayer. Derivatives should rather be seen as economically purposeless constructs whose ease of manipulation in opaque markets makes the investment banks rich – while the rest of us take our chances.

Over the past few years, more and more light has been thrown on how banks profit by trading on their own account in so-called "proprietary trading" – dealing in derivatives, while another part of the bank makes a market for buyers and sellers in those self-same products. First of all, they can take positions on a vast scale because they are enormous banks with their deposits effectively guaranteed by the taxpayer. Next, they rig the benchmark interest rate on which the price of many derivatives are based, made easier still because so many derivatives are custom-made. This means that deep non-manipulable markets are hard to construct; it's also easier for derivatives to aid and abet tax avoidance. And lastly, as Goldman Sachs' "Fabulous" Fabrice Tourre revealed, the banks actively manage both the buyers and sellers. Thus they know which way the prices are likely to move from hour to hour.

Managements have little incentive to manage such a business because their own extravagant bonuses depend on its success. Even if they were minded to insist on proper behaviour, so much of the action takes place over hours and even minutes – hence they have to give phenomenal discretion to the teams running the trading desks. Managers cannot possibly monitor their real-time positions or second guess why they have been taken – the reason why rogue traders can lose banks billions, as one recently did at JP Morgan in London.

Much has been said about the rotten culture in investment banking – now from both the prime minister and the governor of the Bank of England. But the regulators, the British government and bank managements – all genuflecting to the wisdom of the age that free markets make no mistakes – allowed a business model to be created in which men and women with very little skill and no moral compass could make themselves millionaires in a very short time. They contributed zero wider economic value but created immense systemic risk for the rest of the economy.

A rotten culture does not emerge from thin air. It emerges from structures that encourage rotten behaviour – and Britain, following the false gods that free markets and financial services were its economic future, created such structures big time, cheered along by a cross-party alliance that extended from Boris Johnson to Gordon Brown. Now is a decisive moment for both the City and the economy. The City's reputation is at rock bottom. Meanwhile the economy acutely needs a financial system that backs wealth-generating innovation. We need a determined root and branch reform of British finance to restore international trust, develop the national economy and to bring an end to the mis-selling scandals. In RBS's case, the bank was even unable to discharge for a week its basic function – allowing its customers to transact financial business.

A start has been made with the promised implementation of the Vickers commission's recommendations to ringfence investment banking from commercial banking. The ringfence, weakened by George Osborne under intense pressure from the banks, should be strengthened to produce a de facto separation. In particular, "prop" trading desks should operate as fully separate units with their own boards, balance sheets and capital. The measures should be rolled out as soon as they become law rather than delayed until 2019.

That is only a start. The banks and the British Bankers' Association can no longer be allowed to set Libor: this task must now be done by the Financial Conduct Authority that is to succeed the FSA. London must also fall into line with international practice and require all derivative trades in the over-the-counter market to post appropriate collateral. London can no longer be the wild west of international finance where American and European law can be flouted. I would go further and require all financial instruments to be traded in organised exchanges.

There is also the question of ownership: shareholders exercised far too little influence over bank managements. Worse, their short-termist behaviour encouraged banks to look for sky-high fast returns to keep them happy. The Ownership Commission ( which I chaired) argued for the creation of new ownership mutuals that pooled the voting rights of institutional shareholders. This would both anchor ownership to set more reasonable profit expectations, and give owners real muscle in a dialogue with managements.

Banks need such better, engaged ownership – and fast. The British government, owning RBS and Lloyds, should give a lead in what it expects from banks. In particular, it should take a lead on remuneration.

In my fair pay review for the government, I argued that private sector executives should put a proportion of their pay at risk to be earned back by doing their job properly; only then should they be eligible for an equivalent bonus. There would be no question of Bob Diamond trying to win brownie points by giving up his bonus. Under earnback it would be automatically forfeited.

The Financial Services Authority has begun to show how regulation could work: five years ago it would never have launched such a bold and revealing inquiry. George Osborne is breaking it up just when it should be backed and reinforced.

The £14m cut in the Serious Fraud Office's budget since 2008 should be restored in full. There should be arrests, trials and imprisonment. And there should be an independent Leveson-style inquiry into investment banking and the causes of the financial crisis.

So far, there has only been the whitewash report in 2009, co-chaired by Sir Win Bischoff and Alistair Darling, arguing that as little as possible should be done to regulate the City. It was a disgrace.

As far as possible, the underlying causes of the over-inflated size of finance should be addressed. If there were less exchange and interest rate volatility, there would be less underlying demand for instruments to protect against it. This is, of course, the case for a system of managed exchange rates and a European single currency.

Instead of deifying floating exchange rates as the magic bullet for all economic ills – the default position of the British economic establishment across the political spectrum — floating rates should be seen as another driver of our over-inflated financial sector.

Britain needs to rebalance and develop its economy – and it needs to start by reforming finance. This could be the moment the process begins, laying the basis for a remoralisation of our economy and a new industrial revolution. But it means confronting the biggest lobby of them all – big finance. Any takers?