The special committee's review recommends that the Financial Industry Regulatory Authority's brokerage examination program be revamped to ensure that detecting and preventing fraud are central elements.
FINRA lacks a central database for its examiners with investors' complaints about firms, so staff members missed numerous "red flags" on Mr. Stanford's firm, according to the review released Friday.
The Securities and Exchange Commission's stunning failure to detect Mr. Madoff's fraud for nearly two decades, despite numerous warning signs raised by outsiders, has brought the federal agency widespread criticism and pressure to revamp itself. The SEC inspector general found the agency bungled five investigations of Mr. Madoff's business between June 1992 and December, when the prominent financier confessed.
Earlier this week, the inspector general issued recommendations for the SEC to avoid another breakdown, including a new system for handling the thousands of tips and complaints the agency receives.
FINRA's internal review, begun in April, was conducted by outside attorneys led by Charles Bowsher, a former U.S. comptroller general.
The organization is developing a reform plan based on the recommendations to be presented to its board in December, FINRA Chairman and CEO Richard Ketchum said in a letter Thursday to the SEC, which oversees FINRA.
FINRA already has taken steps to strengthen its regulatory program, including improving its routine exam programs, Mr. Ketchum said.
The special committee also recommended creating a fraud detection unit within FINRA to ensure that exams involving significant allegations get high priority -- something the organization's management plans to establish.
In addition, FINRA is hampered by limits on its authority, the review said. FINRA can't expand its oversight beyond brokerage firms to other investment operations. The organization made periodic exams of Mr. Madoff's brokerage operation; the fraud was carried out through Mr. Madoff's investment business.
FINRA has suggested that Congress expand its jurisdiction.
FINRA's failure in the Madoff case also shows the need to improve exchanges of information between FINRA and the SEC, the review found. The SEC didn't share tips it received from outsiders on Mr. Madoff's operation.
Federal prosecutors said recently that a search of financial records showed that Madoff investors suffered net losses exceeding $13 billion.