The financial regulator should have blocked Royal Bank of Scotland's (RBS) takeover of its Dutch rival ABN Amro in 2007, according to MPs.
The Financial Services Authority (FSA) was criticised in a report by Parliament's Treasury Select Committee for the part it played in RBS' near-collapse and subsequent £45.5bn bailout by taxpayers.
Following the FSA's failure to intervene in the "calamitous" deal - worth almost £50bn - MPs said banks needed a regulator with the self-confidence to intervene, even if it causes short-term destabilisation.
Their report urged the Government to include an explicit requirement for the regulator to approve major bank acquisitions and mergers in forthcoming legislation - to prevent a repeat of the disastrous deal.
"There is no substitute for the exercise of judgment," the committee's chair, Andrew Tyrie, said.
RBS' demise came after a string of takeovers and aggressive expansion saw it overstretch itself with the ABN deal.
The FSA's inaction throughout the takeover "reflects a grave weakness in the corporate governance of the FSA", the report said.
"It should have intervened at an early stage. It should and could have intervened at a late stage, albeit with more difficulty," it said.
It added: "The FSA's failure to assess the risks of the deal represents a serious misjudgement on the part of the supervisory team and the senior management."
The regulator’s own report into RBS was also condemned by the committee, which said its failures "amount to a serious indictment" of bosses at both the bank and the regulator.
The FSA's chairman, Lord Turner, was also criticised for his initial reluctance to publish a full report into RBS.
An spokesman for the regulator said it would "consider the report's findings and recommendations in detail", adding the FSA had put in place "a completely new model of supervision since the financial crisis".
The FSA is being scrapped next year to make way for a new banking supervisory unit at the Bank of England - the Prudential Regulation Authority- and a new watchdog, the Financial Conduct Authority.