Merger mania has hit the Republic's financial sector. The frenzied consolidation that has gripped the banking and insurance industries in the US and Europe is finally taking hold here.

Over the coming months the entire Irish financial services sector will be transformed. Irish Life and Irish Permanent have begun preliminary discussions to create a formidable third force in Irish banking after AIB and Bank of Ireland. The State-owned ICC Bank may soon be subsumed within that enlarged entity or another institution. And a marriage between TSB and ACCBank seems to be just a matter of time.

These developments are seen as the first phase of a widescale transformation of the financial services industry as we know it.

Earlier this year, AIB chief executive, Mr Tom Mulcahy, warned that no Irish financial institution was immune from being taken over by a large overseas group. "Their continued independence cannot be taken for granted, although it would be a loss to the country not to have at least one of our major banks managed in Ireland," he told the Institute of Bankers.

His comments must have made an impact on the attendance at that select gathering, particularly as AIB is viewed as perhaps the least vulnerable to a takeover bid by virtue of its size. It is capitalised on the Irish Stock Exchange at around £8 billion and there will only ever be a limited number of predators with access to such a war chest. However, some form of link-up with a major European or US player cannot be ruled out in the long term.

Bank of Ireland's relatively smaller size - capitalised at £6 billion - makes it a more affordable target. It would be highly attractive for a British mortgage-focused group as it already has a substantial exposure to that market through its Bristol & West subsidiary.

Deals of this magnitude are more likely to happen in the medium term and will tend to follow further regionalisation and consolidation in Europe, according to ABN-Amro analyst Mr Eamon Hughes.

There are currently 14,000 European banks compared with 9,000 in the US, catering for broadly the same number of customers. Mr Hughes believes that once further consolidation has been achieved, particularly between the French and German banks, the focus will switch to other locations such as Ireland.

NCB Stockbrokers analyst Mr Shane Nolan also maintains it will be some time before AIB and Bank of Ireland customers have to contend with a new owner.

To date, even in Europe, where major groups such as Union Bank of Switzerland and Swiss Bank Corp joined forces in a $20 billion (£13.3 billion) transaction, few banking mergers have been on a larger scale than the value of the Republic's two dominant banks.

"Takeovers on this scale are hard to do. Bank of Ireland or AIB couldn't be taken out in an all-cash deal. They would have to look at share deals. Given their size it would be a little harder to do," he explains. "Only a few of the bank mergers in Europe have been bigger than either of the two main banks."

The trend towards increased consolidation has been given impetus by the phenomenal growth in the Irish economy, the Republic's participation in the single currency next year and the phasing in of a standard rate of corporation tax of 12.5 per cent by 2003.

Irish banks are something of a phenomenon within Europe with their ability to generate much larger profits than their European rivals - in some cases, twice as much.

For US groups, in particular, Irish institutions offer a foothold in the euro zone, while all financial companies will be further attracted by the low rates of corporation tax available here in the years ahead.

International attention will focus on the main players, with AIB, Bank of Ireland and a combined Irish Life/Irish Permanent featuring prominently in the leading European stock indices from next year.

The Irish Life/Irish Permanent merger - if it goes ahead - is primarily a defensive move by both organisations and in the short term may fend off an early takeover. But within a three to five-year term, the £3 billion bank assurer, will itself become a prime takeover candidate.

The group would begin its new life with three strategic shareholders already on board, British bank Abbey National, Belgium's Kredietbank and the French AGF group. From the outset, each would hold between 3 per cent and 4 per cent of the total stock and would also have trading relationships with the new company.

From a European perspective, Kredietbank would be interested in principle in fully controlling the Irish group. Abbey National, which was the odds-on favourite to control Irish Permanent after legislative restrictions on a takeover expire next year, would also seriously consider such a move.

The combined Irish Life/Irish Permanent will represent the biggest life assurance and mortgage group in the Irish market once their operations have been fully integrated. It, in turn, will have around £1 billion to spend on acquisitions and is expected to aggressively seek to bring additional operations under its wings fairly quickly.

Irish Permanent, Bank of Ireland and Anglo Irish Bank have already indicated their interest in buying the State-owned ICC Bank.

The process of selling that bank is due to get under way soon and an overseas bidder cannot be ruled out.

ICC Bank's main attraction is its dominance in the small and medium enterprise sector. For Irish Permanent/Irish Life it would bring this important commercial mix to its largely retail operations. And with such cash resources the new group could also look at buying Anglo Irish Bank, National Irish Bank or the combined TSB and ACCBank group.

Anglo Irish Bank, which is also a major player in the small business banking segment, could attract the attention of any institution, domestic or international, looking for greater exposure to that sector. The main Scottish banks are heavily focused on small business banking, as are the large British banks.

And the ownership of a merged TSB/ACC bank is also something that will be closely watched. If the group is floated on the stock market, a strategic player could build a significant stake in the company at an early stage, similar to the move made by Abbey National at Irish Permanent. Mr Hughes says the combined group has a very strong franchise that would be highly desirable to another institution. "It will depend on the share structure and whether it gets a strategic partner early on. That would make it more takeover-proof in the medium term."

A question mark has been placed over the future ownership of National Irish Bank (NIB) this year following the controversial revelations about its operation of an offshore scheme for investors. It's parent, National Australia Bank, is thought to be weighing up its options in the Irish market.

NIB, which has a market share of around 3 per cent, continues to be profitable but its long-term growth prospects seem quite restricted. National Australia also owns Northern Bank and may yet decide to dispose of both operations. Bank of Ireland has been mentioned as a possible buyer in this scenario, as would be Ulster Bank, with the Northern Bank enjoying a strong franchise in the Northern Ireland market.

Meanwhile, Ulster Bank might come on the market if its parent, NatWest, was to merge with another British bank. Both NIB and Ulster Bank would provide an entry point into the Irish banks' clearing system and would have a strong franchise.

Talk of a takeover at the State's newest financial stock, First Active, is for another day. Building society legislation protects it from any such development for the next five years. But, in the interim, a financial player may build up a minority stake.

The Irish Nationwide and EBS building societies can both afford to stay as mutuals, although the former is keen to bring a strategic investor on board.

Over the coming months and years, the pace of change in the financial sector will only accelerate.