What is a bank? Fifteen years ago, there was an easy answer to that question. It was a financial institution that lent people money. That was also the answer to the question on Friday.

At the end of last week, commercial banks like JPMorgan Chase and Citigroup suddenly found themselves on the hook for billions of dollars as the market for loans to back private equity acquisitions dried up and investors pulled back.

It is a shock to banks to have to hold such big loans on their balance sheets and bear the risk of customers defaulting. Worries about a resulting credit crunch led to a sharp fall in markets last week. But it is worth remembering that, not long ago, banks did this all the time. In the intervening years, they stopped taking such risks and moved into another business. Instead of lending money, they took fees for arranging loans and getting other investors to bear the risk.

This was a superior way to earn a living. Instead of depending on loan interest and having to write off capital when clients defaulted, they became intermediaries. They took fees, did not risk capital and were clear of the scene when things went wrong. Their return on equity went up, their earnings grew less volatile and investors loved them.

Banks, in other words, turned into investment banks. The latter had to take a bit of risk when underwriting initial public offerings or buying and selling blocks of shares, but they passed it on to investors as quickly as possible. Similarly, banks came to treat loans as just another tradable security to be packaged, sold and forgotten about.

What took them so long?

Well, this is going to sound very strange to younger readers, but a long time ago, there was no such thing as a credit derivative. Banks shuffled loans around among themselves in syndicates so none was too exposed to the collapse of one company. But they had no way of slicing up loans, securitising them and selling them to European insurers. Imagine that!

Once banks could do it, they did. They securitised and sold loans in every market, from residential mortgages to leveraged finance. The hurdle for doing business ceased to be whether a bank trusted a borrower to be a sound long-term credit risk - the craft in which bankers had been trained. Instead, the question was whether it could collect a fee and sell a credit-rated security on to someone else.

Chuck Prince, Citigroup's chief executive, summed up the new world of banking neatly a couple of weeks ago when asked whether private-equity buyouts were about to hit trouble. "As long as the music is playing, you've got to get up and dance," he said. "We're still dancing." A short while after he spoke, the music duly stopped.

Which brings us to Friday.

From the perspective of financial stability, credit derivatives brought a lot to the party. Because credit risk is spread across investment and financial institutions around the world, even multibillion-dollar failures of companies or funds can be absorbed without any single bank being fatally wounded. But the change in banking created two dangers that are now becoming obvious.

First, lending standards loosened. Banks used to balance two factors in deciding whether to make a loan - how much a borrower would pay in interest and fees and how likely it was to default. They refused to lend if they thought the risk of default outweighed the reward because they would be the ones to suffer.

But, as the risk that they would be hit if borrowers ran into problems receded, they became less cautious.

You would have expected this to result in banks arranging more loans for riskier borrowers who paid bigger fees. That is indeed what occurred, for residential mortgages and private equity. Subprime mortgage borrowers were encouraged to take out those loans not only by intermediaries but also by banks.

Private-equity funds are the institutional equivalent of subprime mortgage holders. They have been willing to pay big fees for banks to arrange and securitise high-yield loans and exotic forms of bridging finance.

As the private equity market has stuttered, bankers such as Jamie Dimon of JPMorgan Chase grew nervous about such instruments but too late to prevent their banks from getting caught last week. Second, debt securities have become so complex that investors have not understood precisely what kind of credit or market risks they are taking on. That was made clear last month when two Bear Stearns hedge funds got into trouble. Their values fell suddenly, although the securities in which they invested were not publicly traded.

Investors are now reading across from mortgage-backed securities to other debt instruments, worrying that the latter face a similar reckoning. The market faces a credit crunch: not the traditional kind in which banks that made losses pulled back from lending, but a new variety caused by debt investors worrying that they have been taken for a ride.

So banks find themselves back in their old business. Their balance sheets are stuffed with loans that could be there for a long time. Instead of passing on risk quickly and profitably, they may have to live with it.

Lucy Kellaway is on leave