The gunman's sister has told police he suffers from schizophrenia and had stopped his medication making him "particularly agitated", according the police outside the bank.
A relative is being brought to the scene to talk to him.
Merah killed three French paratroopers before turning his guns on a private Jewish school, where he killed a rabbi and three young children in March. He had also claimed links to al-Qaeda.
One local woman who runs a restaurant next to the CIC bank told Paris Match she had heard a gunshot. Police have asked residents to remain at home, fearing the gunman could open fire if they attempt to evacuate the area.
"We have no idea if his claim to be linked to al-Qaeda is serious or fantasy," a police union spokesman told Reuters.
On Wednesday, a school near the bank, where children were due to sit their baccalaureat examinations was evacuated.
It is the second time in a month Toulouse, known as the "pink city" because of the rose-coloured stone of its public buildings, has been the scene of a hostage-taking.
Two weeks ago, a 50-year-old man brandishing a shotgun took a security guard hostage at the headquarters of Météo France, the French weather service.
An elite squad of police marksmen shot the man, who remains in a critical condition in hospital. The security guard escaped without injury.
Cedric Delagean, an official for the police union, Unsa, told Reuters the hostage-taking appeared to be an attempted armed robbery that went wrong.
"The most probable hypothesis is that this guy is crazy, but that doesn't make him less dangerous," a police source told journalists at the scene, who were pushed back from the scene as police sharpshooters took up their positions around the bank.
Intellpuke: You can read this article by Guardian Foreign Correspondent Kim Wilsher, reporting from Paris, France, in context here: www.guardian.co.uk/world/2012/jun/20/toulouse-hostage-bank-al-qaida