Northern Rock breached capital rules six months before its collapse, yet failed to tell shareholders and continued to be given favourable “light touch” treatment by financial regulators, it emerged yesterday.

Details of the breach and fresh information on the catalogue of mistakes made by the Financial Services Authority (FSA) were revealed as the regulator published an expurgated version of its review into its flawed supervision of the bank.

Rock reported a capital ratio of 9.74 per cent at the end of March 2007, which was “in breach of its capital requirements”, and told the FSA on April 19 last year, the regulator revealed. This was months before it faced serious difficulties in the wholesale markets in July and August and before the run in September.

The FSA normally regards capital shortfalls as extremely serious, but despite a catalogue of other warning signals it continued to allow Rock to waive the standard Risk Mitigation Programme required of almost every other bank.

Rock made no mention of the problem to its shareholders and in April talked of having “excess capital” on its balance sheet that it planned to return to investors in the form of higher dividends.

In June 2007 it remedied the capital shortfall by selling an £833 million commercial mortgage book to Lehman Brothers and issuing £328 million of subordinated debt, but again failed to mention the capital rule breach.

Northern Rock finally owned up to an £85.5 million shortfall in its capital position in the annual report, published last month.

The FSA also revealed in yesterday’s report that it had been alerted by the Bank of England to risks in the Rock’s wholesale funding model as early as October 2006.

A senior FSA official, a head of department in the Major Retail Groups Division, appeared so to be concerned at the time that he remarked in an e-mail: “Northern Rock’s business model means it should certainly receive additional scrutiny.” However, nothing was done.

Details of the Bank warning were blanked out in the FSA report yesterday. The regulator said that it was constrained from full disclosure by the Data Protection Act and the need to keep commercial information confidential. The Bank paper was a follow-up to two previous papers on the liquidity risk posed by institutions heavily dependent on wholesale funding, such as Rock. A Bank spokesman confirmed that it had forwarded a paper to the FSA in October 2006.

The FSA admitted in yesterday’s report that it had failed to heed eight warning signs suggesting weaknesses with the Rock. FSA officials were described as “defensive” and “territorial” in the face of problems.

Supervisors dismissed warning signs in February and March 2007 – seven months before the collapse – as “just a blip”. FSA regulators even seem to have been influenced in their complacency by brokers’ notes. E-mails show that Rock’s supervisors at the FSA read a Merrill Lynch report in April last year describing Rock as “still a fantastic long-term story”.

The FSA may also have been cowed by “strong and aggressive characters within Rock’s management team”, the FSA suggested, adding that the bank was dominated by a triumvirate including Adam Applegarth, the chief executive at the time. There was also “scope to question” the suitability of Matt Ridley, then the chairman, because he had no career experience in finance.

Last month Hector Sants, the FSA’s chief executive, said that the regulator's performance had been unacceptable when he published the conclusions of the review. He and Sir Callum McCarthy, the chairman, are expected to be questioned closely by MPs on the Treasury Select Committee next week.

Northern Rock was nationalised in February after abortive attempts at private sector rescues.

A Rock spokesman said last night: “We believed the matter was dealt with in the appropriate correspondence at the time and subsequently disclosed.”

Danger signals the regulator missed

1. In January 2007 Northern Rock announces its ambitious target to become third-biggest mortgage lender in Britain

2. Classified

3. Classified

4. The bank expands into the retail savings market in Denmark in February 2007

5. It reveals that net lending grew by 34 per cent in first quarter of 2007

6. Northern Rock sells £833 million of commercial loans to Lehman Brothers in June 2007 after breaching capital rules

7. Classified

8. “Most importantly”, in January 2007, the former building society signals that it plans to pay out an even greater proportion of its profits in dividends

Source: FSA Internal Audit Division

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