Financial regulators, lulled into inaction by soaring bank and Wall Street profits, failed to protect Americans from the 2008 financial crisis, a senior U.S. official told an investigative panel on Thursday.

In testimony that urged stricter oversight in future while admitting past errors, Federal Deposit Insurance Corp Chairman Sheila Bair headlined the second public hearing of Congress' Financial Crisis Inquiry Commission.

Not only did market discipline fail to prevent the excesses of the last few years, but the regulatory system also failed in its responsibilities, she said.

Record profitability within the financial services industry also served to shield it from some forms of regulatory second-guessing, Bair told the commission.

The 10-member panel, in its first public hearing on Wednesday, heard a tale of misjudgments and regret from top banking executives, but got no outright apology or any new explanations for the debacle that shook world markets.

The bankers acknowledged taking on too much risk and having choked on their own financial cooking in the subprime mortgage market, but they defended their pay packages and the huge size of their businesses in the face of proposals to break them up.

On Thursday, in addition to Bair, the commission heard from Securities and Exchange Commission Chairman Mary Schapiro, who said the SEC is reviewing investment bank practices in markets for subprime mortgage-backed securities and collateralized debt obligations during the real estate bubble before the crisis.

We are seeking to determine whether investors were provided accurate, relevant and necessary information, or misled in some manner, Schapiro said.

U.S. Attorney General Eric Holder told the panel that the Justice Department's goal is not just to hold accountable those whose conduct may have contributed to the last meltdown, but to deter such future conduct as well, according to his prepared testimony.

The Federal Bureau of Investigation is investigating more than 2,800 mortgage fraud cases.

FDIC, SEC DEEPLY INVOLVED

Both Bair and Schapiro are the leaders of agencies that were deeply involved in the run-up to the crisis that peaked in late 2008 after the collapse of former investment banking giant Lehman Brothers.

Bair made waves this week with an FDIC proposal to tie banker pay to deposit insurance fees. The idea, opposed by other bank regulators, calls for banks with risky compensation schemes to pay higher levels of deposit insurance premiums.

It reflects Bair's readiness to experiment with using the FDIC's policy levers to influence bank behavior in ways that transcend the agency's main job of insuring deposits.

Bair was an early critic of subprime mortgage market excesses that helped inflate a historic housing price bubble well into 2007. When it broke, the aftershocks paralyzed capital markets and panicked the Bush administration.

Multibillion-dollar taxpayer bailouts and the deepest recession since the 1930s followed, saddling President Barack Obama with profound economic challenges and a political backlash that is still far from over.

The commission, chaired by former California State Treasurer Phil Angelides, is beginning its work amid rising public fury over the crisis, its aftermath and what to do to prevent something like it from happening again.

We have a lot of digging to do, and I believe our work will illuminate what happened, Angelides said after Wednesday's session. It will be the last and best chance for the American people to examine these issues.

Also slated to testify on Thursday were law enforcement officials from Illinois, Colorado, Texas and Florida.

PECORA PANEL A MODEL

The Angelides panel is modeled after the Pecora Commission, which probed the 1929 Wall Street crash. Its findings helped lead to the creation of the SEC and other reforms. Whether the new commission will be as substantive remains to be seen.

Its work coincides with efforts in Congress to overhaul financial regulation, a process now more than a year old and in which Bair has emerged as a key innovator.

The House of Representatives last month approved a sweeping reform bill over the objections of Republicans and lobbyists for banks.

The Senate Banking Committee is in sensitive negotiations over its own bill. Analysts expect the Senate will act on a final measure in the coming months.

By summer, a compromise House-Senate bill could reach President Barack Obama, who has been pushing Congress for months to complete its work.

(Additional reporting by Karey Wutkowski, Jeremy Pelofsky, Rachelle Younglai; Editing by Tim Dobbyn)

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