I never liked dwarves in M1. They were powerful but most quests could be beaten before you even got a level 3 palace.
Dwarves did not require a level 3 palace. They required a level 2 palace and level 3 blacksmith. Believe me, only have 3 dwarves to a guild causes problems when you need 12 for a level 3 palace and end up with 11 heroes due to this restriction.