Not long ago the US appeared to be backing away from the battle against money laundering.

Shortly after taking office, the Republican administration looked to have fallen under the sway of a lobby of small bankers and conservatives calling for the preservation of "financial privacy."

Paul O'Neill, Treasury secretary, said he was starting to question the wisdom of spending $700m annually to combat money laundering.

With US interests more clearly at stake since September 11, there has been a dramatic volte face. Aside from introducing some Draconian measures to impound terrorist assets, the US has threatened to impose sanctions against countries and institutions failing to co-operate.

The wholehearted US participation in the battle against financial crime increases the prospect of success. But stemming the flow of terrorist money still presents formidable challenges.

Tightening regulations in developed financial centres is a start, experts say.

The specific shortcomings of US financial regulations were underlined in June by a survey by the Financial Action Task Force (FATF) - an international body set up in 1989 to fight international financial crime. The report showed that the US was failing to comply with more than a third of its 28 recommendations for action. This poor showing put the US third from bottom in a survey of 29 industrialised nations, with only Mexico and Canada scoring worse.

The main problem, the US said, had been the absence of laws to force insurance companies and bureaux de change to report suspicious transactions. Spurred on by the conservative group, the Free Congress Foundation, the US last year rejected legislation that would have expanded the "know your customer" rules, compelling banks to identify all their clients and beneficial owners of assets.

John Ashcroft, the US attorney-general, admitted in August that the the US had failed to keep pace with developments in financial crime. Since the attacks, the US has enacted sweeping laws allowing the seizure of terrorist assets. Tighter anti-money laundering legislation will enable a broader sharing of intelligence information to help track down terrorist networks.

The role of the FATF has also been expanded. Having previously focused almost exclusively on curbing laundering of criminal money, the FATF's mandate has been expanded to include terrorist financing.

After a meeting at the start of November the FATF called for countries to regulate not only conventional financial institutions but also informal money exchangers and non-profit groups sometimes used to finance terrorist activity.

However, curbing the flow of terrorist funds may prove more challenging than disrupting money from other types of organised crime.

The most obvious problem is that the sums of money involved in terrorism are relatively small - especially when compared with the funds linked to the illegal drugs trade.

With illegal funds from drugs, there is an estimated $500bn for the authorities to identify, according to Mark Pieth, a professor of Basle university and a former member fo the FATF. This compares with a maximum of hundreds of millions of dollars held by terrorist organisations.

US officials estimated that staging the September 11 attacks may have cost less than $500,000. The terrorist leaders are reported to have transferred $100,000 from the Gulf to set up an account in the US, with the rest of the gang opening accounts in cash or with travellers cheques.

It is doubtful that better reporting alone would have brought these transactions to light.

The size of transactions is not the only problem. Unlike the laundered proceeds of money from drugs or arms dealing, terrorist funds often come from legitimate sources.

This poses a fundamental problem for financial institutions in that this means monitoring money not just where it comes from but where it is going. Surveillance systems are not yet set up to meet this challenge.

A system based largely on the subjective judgment of the banks is not without risks. There are some who fear this could provoke accusations of racism, with clients of middle eastern origin being subjected to particularly intense scrutiny.

Another related threat is the prospect of defensive reporting by banks.

Anxious to protect themselves in case funds are later discovered to be linked to terrorists, banks may report even slightly suspicious transactions. Regulators would then be inundated reports.

Perhaps the best overall solution is a thorough enforcement of the "know your customer" rules long championed by the FATF. A bank with an understanding of its clients is less likely to become the unwitting conduit for terrorist funds or resources embezzled by former heads of state.

Recently the US has shown itself among the most reluctant of the FATF members to implement "know your customer" rules. Many are arguing that this failing should now be addressed.