The Financial Services Authority (FSA) said its supervision of the now-nationalised group "was not carried out to a standard that was acceptable" in a long-awaited internal report into the Northern Rock debacle.
The FSA identified four key failings in its work with the group, including inadequate supervisory resources and a "lack of oversight and review" by FSA line management.
The regulator said there were continuity problems with the managers responsible for supervising the bank, with three different heads of department in the role during two-and-a-half years.
It also admitted that none of the heads of department had met Northern Rock since January 2005, despite managers on average meeting one of the firms under their charge every week.
The FSA is proposing to recruit an extra 100 staff to boost its risk assessment and supervisory capability in light of the review.
The regulator said it had cut supervisory staff numbers by 5 per cent over the past two years as part of a policy to reduce the workforce "to fund better-quality individuals".
But it said it would now ensure there would be a minimum requirement of employees in charge of firms classed as higher risk.
Hector Sants, chief executive of the FSA, said: "It is clear from the thorough review carried out by the internal audit team 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, although whether that would have affected the outcome in this case is impossible to judge.
"However, 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 added: "Demonstrating our willingness to examine ourselves critically and learn lessons is central to giving the financial services industry and consumers confidence in the FSA, although, like any organisation, we cannot and do not claim infallibility, and we cannot, and should not, attempt to remove all risk from the system."
Treasury Select Committee chairman John McFall insisted that the FSA needed more and "better quality" staff.
"This isn't just a failure of the supervisors at Northern Rock, it is a failure of the management at the FSA and a fundamental change is needed," he said on the BBC Radio 4 Today programme.
"I think there's a big agenda to make sure there is a change in the FSA and a change in the financial services."
Today's FSA report identified a string of errors in its handling of Northern Rock, which led to the first run on a UK bank in nearly 150 years.
The FSA said Northern Rock was initially supervised by a department whose primary responsibility was for insurance groups.
The bank was only supervised alongside deposit-taking peers from February 2007 during the two-and-a-half years under review.
Northern Rock was also the only firm classed as high impact not to be issued with a so-called "risk mitigation programme".
The FSA said that alongside the recruitment of more staff, it will seek to give greater priority to the task of supervising individual firms, with more involvement of senior management in the process.
A new group of supervisory advisory specialists is set to be created, while the FSA said it will also co-ordinate better with the Bank of England at "working level" and international regulators.
The report said there will also be an increased focus on the competence of firms' senior management, but it stopped short of calling for an inquiry into the conduct of the former directors of Northern Rock.
The Newcastle-based group was nationalised in February and currently owes around £25 billion to the Bank of England after soaring borrowing costs forced it to seek emergency funding.
The FSA has already borne the brunt of criticism from MPs on the Treasury Select Committee, which in January accused the regulator of a "systematic failure of duty" by failing to spot the bank's "reckless" business plan.
Liberal Democrat spokesman Vince Cable described Northern Rock's former managers as a "bunch of cowboys" but criticised the FSA which, he said, "did nothing to rein them in, or even appear to see there was a problem".
Last week saw the announced departure of Clive Briault, the managing director of the FSA's retail banking division and the man directly in charge of supervising Northern Rock at the time of its collapse.
Northern Rock fuelled its rapid growth by borrowing most of its cash for lending in wholesale money markets rather than relying on deposits, but the business model imploded when the credit crunch effectively cut off its funding supply last August.
MPs have suggested a beefed-up role of Bank of England deputy governor and head of financial stability - backed by staff from the Treasury and the FSA - to act as the main adviser to the Chancellor on potential crises.
They also want authorities to be able to step in with swift action to help at-risk banks, and a "special resolution" regime to keep failing banks running without recourse to insolvency laws which could tie up depositors' cash for months or even years.
Meanwhile, Northern Rock's staff are set to pay the price for the crisis at the company.
Ron Sandler, the new executive chairman of the nationalised lender, set out plans last week to axe around a third of the company's 6,000 jobs to slim down the business and pay off its vast borrowing before a return to the private sector.
Disgruntled investors in the lender have also seen Northern Rock's value slump to less than a tenth of its £5.3 billion stock market peak a year ago before its shares were suspended.
They have threatened to sue the Government unless it pays fair compensation for their shares and have accused it of a breach of human rights.
Comments