Reaction: It was the day that saw the beginning of the end for Scotland�s oldest bank. Perched high on The Mound in Edinburgh, the HBOS global headquarters, a building synonymous with financial stability, was the centre of feverish market speculation.

Lucy Adams, Brian Donnelly and Michael Settle

It was the day that saw the beginning of the end for Scotland's oldest bank.

Perched high on The Mound in Edinburgh, the HBOS global headquarters, a building synonymous with financial stability, was the centre of feverish market speculation.

Founded in 1695, the Bank of Scotland is a national icon. Yet, on Tuesday, Britain's biggest mortgage lender had seen the value of its shares fall by almost 40%, before closing 22% down.

Despite the Financial Services Authority (FSA) taking the unprecedented step of declaring its confidence in the bank's capital position, the company had lost one-third of its value from the start of the week, falling to £9.6bn compared to £15bn.

The turmoil at Lehman Brothers, which until this week was the fourth-largest investment bank in the US, had reached Edinburgh.

Knowing it would certainly not be in the best interests of the government to risk another Northern Rock, with queues of savers waiting to withdraw their money, ministers ratcheted up their discussions.

On Monday evening, at a quiet, private event hosted by Citigroup in London, Gordon Brown discussed the impact of the Lehman Brothers collapse on HBOS and other British institutions with Sir Victor Blank, Lloyds TSB chairman.

Sources claim it was the Prime Minister's direct involvement with a man he "knows well" that was the catalyst for the deal, although officials deny that Mr Brown initiated the process, saying that he "meets with senior financial figures all the time".

While ministers could not openly declare their involvement in the behind-the-scenes discussions, one source emphasised that "the financial stability of the country was at stake".

Faces were glum following Tuesday's pre-arranged meeting at Downing Street between Mervyn King, Governor of the Bank of England, Mr Brown and Chancellor Alistair Darling.

Yesterday morning, HBOS had initially rallied, with shares opening 10% higher after the bail-out of insurance giant AIG boosted the London market. The FTSE 100 Index climbed 100 points.

However, within half-an-hour the HBOS shares went into reverse as concerns resurfaced about the bank's funding position, while higher inter-bank lending rates added to market nerves. The shares dropped by one-third.

The phone lines buzzed with activity. Discussions continued between the Financial Services Agency and Mr Darling who, sources say, was "intimately involved".

At 9am, shares were down by as much as 50%.

Minutes later, news leaked on the BBC that HBOS was in merger talks with Lloyds TSB. The two banks declined to comment, but shares rose by more than 10%. By close of play last night, HBOS shares stood at 147p.

As the flag flew defiantly on the HBOS headquarters, workers said they were "in the dark" over a possible takeover.

One member of staff, leaving for lunch, said: "We haven't been told anything, but I am not worried about my job."

Another said: "It is normal in there."

Critics claim HBOS was humbled by a conspiracy of hedge funds. Analysts claim there has been short-selling of shares, but argue there were also considerable concerns about the bank's future. With a mortgage book of £500bn, the eventual rate of defaults as house prices slide will run into billions.

Vince Cable, economy spokesman for the LibDems, accused hedge fund managers of "hunting in packs" to undermine HBOS.

"It is shocking to see a major British bank brought to its knees by an attack by hedge fund speculators engaged in short selling,"

he said.

"They were only able to speculate because they knew HBOS had a government guarantee and would be bailed out by the taxpayer. If Lloyds hadn't stepped in, the government would have had to take over."

Shadow chancellor George Osborne called for "leadership" from the government, adding: "We have hardly seen the Prime Minister or the Chancellor during this crisis."

As the boards of the two banks met last night to discuss the details of what could become one of the UK's biggest banks, questions remained about its future.

A merged Lloyds and HBOS would have 28% of the UK mortgage market and home loans worth £335bn.

About 22 million people in Britain are HBOS customers. It provides around one-fifth of all mortgages and holds more than £250bn in people's savings.

Both HBOS, led by chief executive Andy Hornby, and the FSA said that the bank remains well-capitalised with good access to funding.

The future for 41-year-old Hornby is bleak, as Lloyds boss Eric Daniels is expected to head up the joint operation.

To facilitate the deal, the UK Government has made clear that it will be willing to amend the Enterprise Act to use the "public interest" clause to maintain financial stability.

This should allow them to over-ride concerns about the huge market share that Lloyds TSB will have, but may require secondary legislation.

The government is particularly keen to help the deal along following reports that depositors and lenders were beginning to withdraw their cash from the bank.

HBOS, which was created by the merger of the Halifax and Bank of Scotland in 2001, is under major pressure from its exposure to the US sub-prime market, and questions linger as to whether it will be able to refinance its debt of more than £100m in the coming months.

As the largest mortgage lender in the UK, it has already been hit by recent weakness in the property market.

It also borrows a large proportion of its funding from the wholesale money markets, where available funding has been drying up.

A deal would be a watershed moment for Mr Daniels, who has been more cautious about expansion than rivals and, as a result, has managed to avoid emergency fund-raising and falling profits since the start of the credit crunch.

The FSA said it was satisfied with HBOS's funding, adding that the regulator had "worked intensively with all major UK banks," since the start of the "current extreme difficulties" in financial markets.

While Lloyds would gain access to a larger share of the UK mortgage market, it would also be a case of "the bigger the better" as it would leave the enlarged bank on a sounder financial footing.

Richard Hunter, head of equities at Hargreaves Lansdown stockbrokers, said: "You can see the logic behind a tie-up between HBOS and Lloyds TSB. It would help stabilise both companies in terms of the jitters we are experiencing in the financial sector."

If the merger takes place, there would be competition and regulation issues that would involve the government and therefore it would be inappropriate for Mr Brown to have publicly issued any "order" to make the deal happen. However, the Prime Minister is clearly anxious to maintain stability of Britain's financial markets.

Kevin Mountford, head of banking at moneysupermarket.com, said: "HBOS is fundamentally a sound institution with sufficient access to capital.

"Its weak share price bears no relation to the undoubted strength of the business. It is not only one of the largest retail deposit takers in the UK, but also has a very diverse business."

He stressed that it was "highly unlikely" that any of the UK's major banks would fail.

He said: "I don't see how industry or government would allow a major institution to disappear in the current climate.

"The banking sector is underpinned by the average person in the street, so confidence is critical."

Last night, as the two boards met, savers were urged not to panic as speculation continued over the terms of a rescue package.

Commentators stressed that people's money was safe with the group. But with a rescue deal set to be announced today, it looks unlikely this Scottish institution will survive another 24 hours.