The Northern Rock bank was nationalised on 21 February
The UK financial watchdog, the Financial Services Authority (FSA), has admitted that it failed to regulate Northern Rock adequately.
The FSA said there had been "a lack of adequate oversight and review" by the agency of the troubled bank.
It said too few regulators were assigned to monitor Northern Rock, which ran into trouble in August.
The FSA said it would be overhauling its procedures as a result of the weaknesses identified.
Meanwhile, Mervyn King, the governor of the Bank of England, told MPs that world credit markets were "still fragile" and pledged to increase the Bank's short-term lending to UK commercial banks.
The Bank of England made £5bn in loans available to the banks last week, and plans another auction on Thursday.
The Bank has joint responsibility with the FSA and the Treasury for monitoring the health of the UK financial system.
Newcastle-based Northern Rock was nationalised in February after the credit crisis forced it to seek a Bank of England lifeline to fund its mortgage loan book.
Last week it said it would cut about 2,000 jobs by 2011 and reduce its residential mortgage lending by half under plans to turn around its fortunes.
Northern Rock must also pay back Bank of England loans worth about £25bn.
Hector Sants, FSA chief executive, said that it was "clear that our supervision of Northern Rock in the period leading up to the market instability of late last summer was not carried out to a standard that is acceptable".
But he added that it was "impossible to judge" whether that would have affected the outcome in this case.
"I am determined through the programme of work that I am announcing today, that proper standards will apply to all significant firms supervised by the FSA," he said.
John McFall, chair of the Parliamentary Treasury Committee, called the report an "honest appraisal of the situation", which demanded a "root and branch reform of the FSA".
But he told the BBC there were "lessons to be learned" by the financial services industry, Bank of England and government too, not just the financial watchdog.
BBC business editor Robert Peston said a key part of the review was that the watchdog expected the Bank of England to bail out any malfunctioning banks when commercial lending froze last summer, which is why it did not feel the need to supervise it more stringently.
"Which is formal confirmation that the FSA was urging the Bank of England to pump money into the markets over the summer, but the Bank refused, fearing that it would be in effect bailing out the banks for their past recklessness," he added.
The review, carried out by the FSA's director of internal audit, identified what it said were a number of areas for improvement in its supervision of banks.
As a result, it plans to beef up its team with staff that will regularly review the supervision of what it called "high-impact" firms to make sure procedures are being adhered to.
It also planned to upgrade its training of FSA staff and put more focus on assessing the "competence of firms' senior management".
It is hoped that these measures will prevent some of the key failings identified in the case of Northern Rock from occurring again.
The failings include:
- A lack of sufficient supervisory engagement with the firm, in particular the failure of the supervisory team to follow up rigorously with the management of the firm on the business model vulnerability arising from changing market conditions.
- A lack of adequate oversight and review by FSA line management of the quality, intensity and rigour of the firm's supervision.
- Inadequate specific resource directly supervising the firm.
- A lack of intensity by the FSA in ensuring that all available risk information was properly utilised to inform its supervisory actions.
FSA framework upheld
Despite its shortcomings, the FSA review upheld the watchdog's philosophy of operating within a framework of principles-based regulation, rather than rules-based.
And it suggested that ultimately the blame for the collapse of Northern Rock should sit at the feet of the bank's senior management.
"The boards and managements of regulated firms carry the primary responsibility for ensuring their institutions' financial soundness," the FSA said.
The British Bankers' Association (BBA), the UK banking body, agreed.
"No amount of regulation can ensure that wrong decisions are never made," it said.
It said it would work closely with the FSA to make sure that it hired "people with comparable skills" to those who work at banks and who are "able to look clearly at the whole business rather than concentrating on one or two particular areas".
Meanwhile, Robin Ashby, a former shareholder in Northern Rock, urged the government to take legal action against the disgraced former management of the bank for risking small investors' wealth, while being paid out vast sums when leaving the firm.
Northern Rock will not disclose the payout that chief executive Adam Applegarth received when he was forced to resign last year, but it is thought to be about £1.5m.