Universities churning out graduates who do not repay their student debts would face financial penalties under a proposal by Education Minister Christopher Pyne aimed at securing Senate support for fee deregulation.

Despite a 34-30 Senate defeat on Tuesday, Mr Pyne vowed to reintroduce legislation this year to allow universities to set their own fees.

"We will not give up on ensuring that Australia has the higher education system it needs - the best in the world," he said. "Great reform takes time."

Universities Australia chief executive Belinda Robinson warned that without increased revenues university vice-chancellors would consider increasing class sizes, shedding staff, closing campuses and discontinuing some courses.