A deal has reportedly been agreed involving the merger of Lloyds TSB with Halifax Bank of Scotland, creating a banking giant which will take on a third of the savings and mortgage market in the UK. The Government will waive competition rules to allow the dramatic rescue of the mortgage giant.

Earlier, Mr Brown had discussed the impact of the collapse of Lehman Brothers, the American bank, on HBOS and other British institutions with Sir Victor at a private event hosted by Citigroup in London.

This afternoon, the Bank of England agreed to extend its Special Liquidity Scheme (SLS) to banks after Governor Mervyn King said last week it would close on October 21.

The SLS allows banks to swap hard-to-trade securities linked to past mortgage lending for easier-to-sell Treasury bills issued by the Government.

Since Monday, when Lehman filed for bankruptcy, HBOS shares have fallen by as much as 68.7 per cent as investors dumped stock on fears about the bank’s exposure to the mortgage market and its ability to secure funding.

Earlier today, the Financial Services Authority (FSA), the City watchdog, was forced to issue a statement on the strength of HBOS’s business to stop a freefall in its share price. Shares in HBOS had dropped by more than 50 per cent earlier this morning to just over 80p as panicked investors dumped their stock.

HBOS stock rebounded when news of the talks with Lloyds TSB emerged but the shares closed 19 per cent down at 147.1p.

Any merger could lead to as many as 40,000 job cuts and the closure of at least 1,000 branches, according to a senior source at a rival bank.

It is understood that the deal would be effected as a takeover of HBOS by Lloyds, at a premium to its share price, although it is not known at what share price. Sources dismissed talk of a “nil premium” merger whereby Lloyds would effectively assume control of HBOS with no money changing hands.

The conversation between the Prime Minister and Sir Victor took place at a reception in the St James area attended by Citigroup’s directors, who were in London for a board meeting, and other City financiers and clients in the late afternoon.

Sources close to the situation said the two banks were locked in talks with their bankers with the hope of announcing a deal as soon as tomorrow.

“After Northern Rock, the FSA, the Treasury and the Bank of England have really learnt their lesson and they are being absolutely ruthless…in intervening when a bank is in trouble and driving together this type of combination”, one of the sources said.

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