Britain’s financial regulator and its central bank must develop a better plan for warning banks and investors of high risks, after overseeing the loss of billions of pounds in the global credit crisis, a damning report by MPs will recommend today.

In its second report on last year’s liquidity crunch, the Commons Treasury Select Committee criticises the Financial Services Authority (FSA) and the Bank of England for failing to ensure that financial companies were prepared for the worldwide closure of credit markets. The Government must respond to the charges within two months.

Although the FSA and the Bank gave warning many times that banks were lending too much too easily, they failed to follow up their words with action, the cross-party committee says. John McFall, the chairman, says: “It is clear that many market participants failed to heed warnings about a serious underpricing of risk and the potential for impaired liquidity in financial markets in the mistaken belief that the good times would go on and on.”

The committee will recommend that in future the regulator and the bank should write a letter to financial companies highlighting two or three key risks. The MPs believe that the two institutions should then seek confirmation that the companies have considered the risks and publish a commentary on the responses.

Banks and investors, such as pension and hedge funds, wrote down billions of dollars last year after the value of their investments in asset-backed securities plunged because of a wave of defaults on the underlying American sub-prime mortgages. The banks, investors and credit-ratings agencies that rated the securities also face heavy criticism by the MPs.

Mr McFall says that the “best and brightest at our top investment banks have expended great energy designing ludicrously complex financial instruments, which you need a Nobel Prize in physics to understand”.

The committee has found that top bank bosses did not understand the products sold by their fixed-income teams and that the innovation of cutting securities into risk tranches had made the products even more complicated. If banks do not attempt to make their products less opaque, they should be regulated more heavily, the report says.

The MPs claim that the banks’ development of an “originate and distribute” model - in which they sold packages of mortgages on to investors, who liked them because of the high returns they offered – meant that the banks paid less attention to the credit-worthiness of their home-loan customers. Meanwhile, investors relied too heavily on the ratings agencies to assess the risks of their investments.

Mr McFall accuses investors of engaging in a “bout of collective madness”. “Unfortunately, you cannot regulate against stupidity,” he says.

The ratings agencies did not emerge smelling of roses, either, the chairman says. The report states that the agencies had to prove that the lucrative advisory business that they received from the banks did not affect the credit ratings that they gave to the banks’ products. “We need to have a serious debate about a root-and-branch reform of their business model to tackle perceived ‘conflicts of interest’,” Mr McFall says. “If the agencies procrastinate on reform, then we will have to seriously consider whether new regulation is necessary.” The FSA said that it was considering the report. Banking sources accused the committee of “taking a very populist bent”. “This stuff has all been widely commented on, there’s nothing new here and banks have been working on these improvements for quite a while,” a source said.

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