Sir Keir Starmer was warned that Lord Mandelson's relationship with Jeffrey Epstein posed a "reputational risk" before he was confirmed as US ambassador.
Documents released by the government include advice sent to the prime minister which said the pair's relationship continued after the financier's conviction for procuring an underage girl in 2008.
The PM's chief secretary Darren Jones said the due diligence process "fell short" and the government had already taken steps to address "weaknesses in the system".
The files also suggest Mandelson explored the possibility of a severance payment of more than £500,000 after he was sacked, although the BBC understands he takes issue with this claim.
The Treasury ultimately agreed to a payment of £75,000.
