Under fierce questioning by the House of Commons' Treasury Committee the watchdog's chief executive, Hector Sants, said the regulator's "stress tests" had been too weak, it had not properly considered the possibility of a general liquidity crunch, and it did not challenge Northern Rock's business model strongly enough.
Mr Sants said: "There are lessons to be learnt here with regard to our supervision processes... In terms of getting into difficulties, we had [Northern Rock] as low probability, and that now seems to be incorrect.
"I don't think any reasoned professional would have anticipated these circumstances, but as a regulator we should have engaged in extreme stress tests."
John McFall, the committee's chairman, asked if the FSA had warned Northern Rock about its rapid growth in mortgage lending in the first half of the year. "Did your advice include saying: 'Hey, guys, this could be very risky for you'?" Mr McFall asked.
Mr Sants replied that the bank's strategy was the responsibility of its board, but that "we should have been in more intense dialogue earlier".
The two-and-a-half hour session was the second in a series of grillings the committee is holding to get to the root of the Northern Rock crisis. The Bank of England's Governor, Mervyn King, appeared last month and was criticised for his high-handed approach to the credit crunch and his unwillingness to provide easier terms to banks seeking funding.
Northern Rock was hit by the freezing up of financial markets on 9 August, which cut off almost all its sources of funding and forced it to seek emergency backing from the Bank of England on 13 September. With thousands of alarmed savers queuing to get their money out of the bank, the Treasury had to guarantee its deposits to prevent the bank from collapsing.
A week before the crisis erupted, Northern Rock had come close to being sold to Lloyds TSB, but the talks had broken down because, with all banks worried about funding, Lloyds could not get an agreeable commitment of funding support from the Bank of England.
Mr McFall and fellow Labour MP George Mudie asked the regulators if they believed the Bank of England should have made liquidity available earlier.
Mr Sants told Mr Mudie: "It clearly is the case that if liquidity had been made available to Northern Rock earlier then it might not have had to resort to the Bank of England."
He added that on the wider question of injecting liquidity against wider collateral, it was for the Bank of England to decide, but that the FSA had made sure the Bank knew that Britain's banks were asking for it.
The Northern Rock affair and the credit crunch that caused it have drawn stinging criticism from the banking industry for apparent regulatory confusion caused by the three-way arrangement between the FSA, the Bank and the Treasury.
When asked about the terms that were asked for by a bidding bank to buy Northern Rock, Mr Sants told Mr Mudie the FSA made it clear what terms were needed to do a deal but that the Tripartite Committee decided they were not acceptable.
Sir Callum McCarthy, the FSA's chairman, came in for criticism from the MPs, who accused him of failing to give straight answers. Mr Sants had to step in a number of times to clarify the FSA's response.
When asked if he had told the Bank of England it needed to provide more liquidity, Sir Callum said he was not going to answer the question at all. Mr McFall responded: "It's dead easy if you answer a question simply."
In a speech last night, Mr King warned that the credit squeeze was not over and that some markets remained virtually closed. He stuck by his hard line, saying smaller banks who rely on wholesale markets should buy adequate liquidity insurance, as Countrywide of the US did and Northern Rock did not.
Beleaguered bank secures fresh guarantee
Northern Rock announced new arrangements with the Treasury and the Bank of England yesterday to give it breathing space as it tries to avoid an emergency sale.
The Treasury agreed to extend its guarantee of the bank's deposits, which stopped at 19 September, to include any made after that date. Northern Rock will pay a fee to the Treasury on new funds to make sure it does not get a commercial advantage from the arrangement.
The Bank of England has lowered its criteria for the assets Northern Rock can offer as security for loans and will let it put up any of its assets. Northern Rock has borrowed nearly £11bn from the Bank since the emergency funding facility was set up nearly four weeks ago.
Northern Rock is in talks with Citigroup to borrow up to £10bn to help fund its business. The Bank of England's acceptance of lower-quality collateral would allow Northern Rock to use higher-quality assets to get funding from other banks on better terms.
The plan gives Northern Rock a slightly better chance of remaining independent and reduces the urgency of talks with potential bidders. To underscore the point, Northern Rock gave itself until February to "pursue the full range of its strategic options".
A number of potential bidders have expressed an interest in Northern Rock, including private equity groups JC Flowers and Cerberus. Shareholder groups and the Northern Rock Foundation charity have expressed alarm about the prospect of a sale on the cheap.
The new arrangement means the Bank of England could take the mortgage lender's Together mortgages on to its books. These lend at up to 125 per cent of a property's value and can include 30 per cent of unsecured personal borrowing. The Bank declined to comment on the loans, but it is likely to impose a "haircut" on how much it lends against the assets.
Northern Rock shares surged 20 per cent to 206.75p, their highest price since 20 September.
Sean Farrell
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