Corrects to say Liberal Democrats are UK's third-largest party in paragraph 6, not the main opposition party

LONDON - Britain launched a probe into alleged fraud by Goldman Sachs four days after the United States shocked markets by accusing Wall Street's most powerful investment bank of duping clients.

The U.S. Securities and Exchange Commission (SEC) has accused Goldman of hiding from investors the fact that U.S. hedge fund Paulson & Co was betting against a subprime mortgage product that it helped create.

Britain's Financial Services Authority (FSA) said on Tuesday it had started a formal investigation into Goldman Sachs International in relation to the SEC allegations, and will work closely with its U.S. counterpart.

UK Business Secretary Peter Mandelson said: We have got to look at the whole system of constituting and regulating banks.

We need a system of regulation, a system of levying banks, which is internationally applied, he said on BBC Radio.

Nick Clegg, leader of the Liberal Democrats, the UK's third-largest party, said: (The allegations) are a reminder, if we needed one, of the recklessness and greed that disfigured the banking industry as a whole.

We believe that Goldman Sachs should now be suspended in its role as one of the advisers to the government until these allegations are properly looked into.

Goldman, which is denying the charges, posted blockbuster earnings on Tuesday.

Its shares were up 1.4 percent in U.S. premarket trade, after a drop of more than 10 percent on Friday.

The FSA's move draws it in to what promises to be one of the biggest legal rows in recent banking history, and both the SEC and Goldman are expected to come out fighting.

In documents submitted to the SEC last year, Goldman said the regulator was using the benefit of perfect hindsight about the magnitude of the sub-prime housing crisis and that there was nothing unusual or remarkable about the transaction.

The documents, a copy of which were seen by Reuters, told the SEC in September that if the matter was litigated a fuller record will underscore that no one in fact considered Paulson's role important and that no one was misled.

The SEC notified Goldman in August through an official Wells Notice that it was facing a civil liability case.

The SEC has accused Goldman and one of its bankers, Fabrice Tourre, of defrauding investors by mis-stating and omitting key facts about a collateralized debt obligation (CDO) tied to the sub-prime mortgage market, whose value collapsed.


Investors including banks, pension funds and local governments lost billions of dollars on complex structured products like the one in the SEC case against Goldman, and many are considering legal action.

German bank IKB said on Monday it was considering action after losing almost all of the $150 million it put into the Goldman mortgage securities product being probed by the SEC.

U.S. insurer AIG is considering pursuing Goldman over losses incurred on $6 billion of insurance deals on mortgage-backed securities, the Financial Times said.

I've always been slightly surprised that investors haven't gone after the investment banks in the way they did after the Internet bubble. It seems like it is just starting, said Bruce Packard, analyst at Seymour Pierce in London.

Goldman's defense document in September said all participants were highly sophisticated institutions and downplayed the role of Paulson & Co in the selection process, which lies at the heart of the SEC's case.

John Paulson's firm made billions from betting on the U.S. sub-prime market collapse, including about $1 billion by betting against the Goldman CDO, according to the SEC.

Goldman said Paulson, was at the time a relatively unknown hedge fund manager.

The overseas support comes as U.S. President Barack Obama prepares to press on with what would be the biggest crackdown on the financial industry since the Great Depression.

British Prime Minister Gordon Brown on Sunday said he wanted a UK probe into Goldman and accused it of moral bankruptcy, but he had no power to force one. Germany's regulator has said it could pursue Goldman.

(Additional reporting by Clara Ferreira-Marques; Editing by Erica Billingham)