Few eyebrows would have been raised at the sight of Sir Victor Blank, the larger-than-life chairman of the Lloyds Banking Group, deep in convivial conversation with the prime minister at an exclusive City dinner in London's St James's.

But that meeting between the two men last September has become infamous as the moment when the deal was sealed for Lloyds to buy the troubled HBOS, a merger that suited both sides at the time - allowing Blank to complete a deal he had been trying to set up for two years and Gordon Brown to avert the looming collapse of a high street bank which could have wrecked confidence in the British financial system.

Six months later, there is a private acceptance even within government that the deal may have been an enormously expensive mistake and that the billions of pounds worth of bad assets against which Lloyds finally insured itself yesterday appear increasingly toxic - not just to the City, but to Brown himself.

Government insiders insist it is nonsense to suggest, as one put it, that the deal was cooked up in a panic during a "cocktail party conversation". The two banks had been circling each other for months before the crisis gave Lloyds a chance to pounce, and Blank and Brown had discussed the merger at least once before in July on a flight back from a trade delegation trip to Tel Aviv.

But it was the government that made the deal possible last September, by waiving competition rules. At the time, Downing Street seemed keen to highlight its involvement in saving a major bank from ruin. Now, as it emerges that more than four in every five pounds worth of bad loans put into the insurance scheme by the new Lloyds superbank came from HBOS, there will be calls for a more detailed inquiry into how closely Brown was involved in a deal that may have hobbled the black horse.

Stephen Timms, the treasury minister, yesterday admitted that the government wasn't "passive, in the sense that we were very anxious to ensure that HBOS didn't collapse", although he insisted that the prime minister had not pushed the Lloyds board into anything. "We took the view at the time, given the difficulties that HBOS was heading into, that it was right to waive the competition rules and allow the merger to go ahead," he told BBC Radio Four's Today programme.

The scale of the toxic loans covered under the scheme has, however, shocked City insiders, particularly the £151bn of commercial and leveraged loans - much of it issued by former HBOS executive Peter Cummings. Under Cummings, HBOS became the UK's biggest commercial real estate lender, backing deals fronted by the likes of Sir Tom Hunter - the Scottish tycoon who snapped up some of the country's biggest housebuilders at the peak of the market. Many of these loans have become worthless as land and house prices have shrivelled.

The £74bn of residential mortgages injected also reflects the number made at high loan-to-value ratios, raising fresh questions over HBOS's lending policy.

Treasury insiders say the reason why yesterday's deal took a week longer than expected to negotiate was because Lloyds chief executive Eric Daniels was determined to keep the government's shareholding below 50%. That he could not may be a signal that he could quit.

The more pressing question, however, for ordinary homeowners and employees needing loans will be the degree of operational independence that the newly insured Lloyds Banking Group - and any other bank helped through the toxic assets insurance scheme - will enjoy. Can a bank that is 65% owned by the taxpayer really operate at arm's length, or will politicians inevitably pull the strings now so much taxpayers' money is at risk?

Treasury sources insisted yesterday that the bank would be run as a commercial concern and that ministers would not get involved in who should be on the board, despite widespread expectations in the City that either or both Daniels and Blank will go.

John Redwood, the Tory MP and former merchant banker, said the government now had a clear responsibility to intervene. "If you are the owner of something that large and that risky, then you hire the people who run it and you tell them what you want them to do."

He was backed by Vince Cable, the Liberal Democrat treasury spokesman, who said it "must be right that when so much taxpayers' money is being used to save this bank that there is effective public control." Although the Treasury insisted on Lloyds agreeing to issue £28bn of lending over two years as a condition of getting help, the bank will make its own lending decisions. However, ministers now risk being dragged directly into controversial lending decisions and held accountable for any resulting job losses, with casualties of the recession likely to lobby politicians directly for help from taxpayer-controlled banks.

George Osborne, the shadow chancellor, called for a full parliamentary statement on the deal and last Thursday's historic decision to begin so-called quantitative easing - creating more money to be injected into the economy. "It is shocking that the government has not been prepared to subject either of these huge decisions to proper parliamentary scrutiny," he said.