Merrion Stockbrokers has warned that uncertainty over the extent of AIB's DIRT liabilities could have implications for dividend growth and will further limit the bank's capital flexibility.

In a detailed report on AIB, Merrion analyst Mr Seamus Murphy warns that AIB's current capital position is limited and as a result the bank is not in a position to do a large-scale share buyback to improve the technical position of the shares.

The Merrion analyst states that any significant acquisition over the next two years will have to be done through a stock swap rather than cash, which is problematic given the low rating of AIB shares. While a merger between AIB and Bank of Ireland would create significant value through cost reductions, such a merger is unlikely to receive regulatory approval.

As an alternative, the Merrion analyst suggests that a deal with Irish Life & Permanent would be logical and would provide enhanced returns through cost synergies and cross-selling opportunities.

Overall, however, Merrion expects AIB to concentrate on organic growth in the medium term but does not rule out a sale of its All-first business in the US if significant investment in Poland or Singapore is required.

The Merrion report warns that at its current share price level, AIB is vulnerable to a bid. "The current 40 per cent discount to its peers . . . provides a window of opportunity to predators and AIB now makes a more plausible takeover candidate," says Mr Murphy.

He warns, however, that without a bid, recovery in AIB's discount to the sector and its share price will be gradual over the next 18-24 months. This is because Irish institutions who hold 24 per cent of the shares are seen as natural sellers of the stock due to asset reallocation.