THE Government was last night warned that legal action over the Northern Rock crisis could drag on for years - and a report by the City watchdog into its handling of the affair would provide more ammunition for disgruntled shareholders.

The Financial Services Authority (FSA) admitted its supervision of the now nationalised bank had not been acceptable and outlined a number of failures in processes and staffing.

But its long-awaited internal report was seen in some quarters as merely handing ammunition to shareholder groups, who plan to sue in order to receive fair compensation for their shares.

Last night, Newcastle Central MP Jim Cousins, a member of the Treasury Select Committee, predicted that the FSA report would only be good news for highly paid lawyers and said court action by shareholders could drag on for years.

Mr Cousins said it suited many of those involved in the saga for the FSA to "fall on its sword" since it took the heat off the likes of the Bank of England and Northern Rock's former directors.

He said: "If the FSA is trying to achieve a situation where they fall on their sword, draw a line under this and package it all up neatly that is not going to work.

"With the FSA 'fessing' up to regulatory failure, the shareholders and the hedge funds involved are going to be looking at that and if they don't get the right sort of deal when it comes to the share price, they will have the Government in the courts using this report as evidence.

"What has happened is going to be very good news for highly paid lawyers in the City.

"This report gives them ammunition and the Government could find itself in the courts for years and years."

In its report the FSA said there were continuity problems with the managers responsible for supervising the bank, with three different heads of department in two-and-a-half years.

It also admitted that none of the heads of department had met Northern Rock since January 2005.

FSA bosses said they would recruit about 100 staff to its supervisory teams in an attempt to guard against another Northern Rock-style crisis.

The Newcastle-based bank was forced to go to the Bank of England for billions of pounds of emergency funding last year when its funding lines dried up amid the credit crunch.

Thousands of customers queued to withdraw money in the first run on a UK bank in more than 140 years.

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."

The FSA said it would seek to give greater priority to the task of supervising individual firms, with senior management more involved in the process.

It said it would also co-ordinate better with the Bank of England at "working level" and international regulators.

The report said there would 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 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.

Last week saw the departure of Clive Briault, 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.

Meanwhile, Northern Rock is due to reduce its 6,000 workforce by about a third in an attempt to slim down the business before a return to the private sector.

Disgruntled investors in the lender have also seen its value slump to less than a tenth of its £5.3bn stock market peak a year ago before its shares were suspended.

Robin Ashby, a spokesman for the Northern Rock Small Shareholders' Association, dismissed the FSA report.

He said: "Clearly, the FSA failed to do its job. But this is scant consolation for the 2,000 people who will lose their jobs and the 180,000 small shareholders who have lost their wealth.

"Those former directors - people who were in extraordinarily well-paid jobs who cashed in their shares at the very top of the market - are also not being held to account."

A spokesman for the Northern Rock Shareholder Action Group, which was set up by the UK Shareholders' Association, said it believed legal action was justifiable.

The association, which has launched a fund to pay for a legal challenge, has been angered by the Government's decision to nationalise Northern Rock and the likely minimal valuation of the shares.

A spokesman said: "We have taken legal advice on these issues and we believe there are good grounds to pursue legal action to challenge many aspects of this process and the likely compensation that will be offered."