Alliance & Leicester shares shot up yesterday after reports that the bank had held takeover talks with Abbey owner Santander.
The two groups are thought to have held discussions in mid December about a deal that would have valued A&L at more than £2.7 billion.
But the negotiations are understood to have faltered when the parties were unable to agree a price, although it is said Spain's Santander has not ruled out resuming talks with the lender.
The speculation lifted A&L shares by more than ten per cent in early trading.
The company is regarded as a perennial takeover target but its shares still slid 43 per cent last year because of concerns about its liquidity position. A&L's management are thought to have been reluctant to sell at a time when the company's market value was depressed.
A&L has repeatedly denied it is facing any liquidity issues and in November it issued a trading statement in which it said it had put in place additional funding facilities, making it pre-funded until the third quarter of 2008.
However, it added that a total of £137 million had been written off on investments such as mortgage-backed securities, whose values plummeted in the summer due to the global credit crunch, and this would reduce its pretax profits for 2007 by around £55 million.
Abbey is currently the UK's third biggest mortgage lender, after Halifax and Nationwide, with a market share of just over nine per cent.
An acquisition such as A&L would not only help Santander boost its share of mortgage lending, but would also increase its branch network. The company has almost finished its three-year integration of Abbey National,
which it bought for £9.5 billion in November 2004.
Santander recently said it planned to begin opening branches in 2009 with a target of increasing its 700-strong network to 1,000 by 2012.
Last month, Abbey chief executive Antonio Horta-Osorio was reported to have said: "We are always open to consider opportunities, but we are very focused and our main priority is this project of internal growth."
An Alliance & Leicester spokeswoman declined to comment on the reports, saying: "We never comment on market rumour."
One Madrid-based trader said any tie up between the two firms would be welcomed.
"A move by Santander toward A&L makes a lot of sense and would be a good mix in the UK with Abbey," he said.
A London-based analyst agreed. "There is definitely a strategic f i t b e t w e e n Santander's Abbey and A&L's mortgage business," he said.
The main question was really the price A&L management had in mind for the business, he added.
"A&L management have built a good business. Of course, the share price is currently very low and they would understandably loathe to sell at this point, but they have to make an assessment of the prospects for the next year and our overall outlook for the UK banking sector is bad," he added.
"In this context, there is probably room for A&L and Santander to eventually agree on a price."
Shares closed up 106p at 754p.