* Underlying operating profit 242 mln eur vs 413 mln in 2011
* Bad debt provisions fall 11 pct, mortgage arrears seen stabilising
* In talks on pension deficit, looking at pref share options
* Shares rise 3.8 pct to 0.14 euros
DUBLIN, March 4 (Reuters) - Bank of Ireland said there were signs that a firmer Irish economy in the second half of 2012 continued into this year after it posted a better than expected 40 percent drop in underlying profit for the year as a whole.
The only Irish lender to escape nationalisation after an unprecedented property crash, the bank saw underlying profit dip by two-thirds in the first half but ended the slump as job cuts and mortgage rate rises fed through in the second half.
Those actions will continue to aid the gradual recovery of Ireland's largest bank this year in a stabilising Irish economy, chief executive Richie Boucher said on Monday.
"I think there are definitely signs that the economy is starting to grow again and definite signs that for the bank itself, all the work we've been putting in is starting to come through in the financial numbers," Boucher told reporters.
"If we look at our deposit books, there is cash in the economy. People are still cautious about spending, however we are certainly seeing them starting to spend on smaller ticket consumer items."
Ireland's bailed-out economy is forecast to grow for the third year in a row this year and Boucher said that while customers were still deferring bigger purchases like cars, the demand for mortgages was increasing on the back of "very clear signs of stabilisation" in the housing market.
However, a wider recovery is unlikely to come soon enough for the bank to meet its own target of increasing its net interest margin - the gap between what it charges for loans and pays to borrow - to 2 percent by 2014 after it rose to just 1.25 percent from 1.20 percent six months earlier.
The half-year figure represented a trough, Boucher said, but the 2014 target would not be met unless there was a dramatic change in the cycle of central bank interest rates.
Shares in the bank, which had dropped to 0.8 euros six months ago, were 3.8 percent higher at 0.14 euros by 1030 GMT.
"It's baby steps, but they're all good baby steps and they are helped by an underlying improving macro-economic situation," one Dublin-based trader said. "It just looks like things are a little bit better than the market had been expecting."
Irish general insurer FBD Holdings Plc also said on Monday that economic uncertainty had reduced in Ireland and that domestic demand had stabilised.
Operating profit before provisions fell to 242 million euros ($314 million) on high funding costs, a limited appetite for new credit and a fall in higher-earning assets. Five analysts polled by Reuters had expected a slightly sharper fall to 237 million.
Including provisions for bad debts of 1.72 billion euros, a drop from the 1.94 billion provided for a year ago, underlying pretax loss fell two percent to 1.49 billion euros.
Alongside the momentum seen filtering through to 2013, in particular from a 9 percent cut in the workforce in the second half of 2012, the bank's path to profitability will also be aided by the removal later this month of a state guarantee on bank deposits that cost 388 million euros last year.
A stabilisation in house prices, which have halved since their peak in 2007, and in unemployment, down to 14.2 percent, also helped the rate of growth in problem mortgages slow with the proportion of the bank's owner occupier mortgages in arrears for more than 90 days up just a touch to 9.9 percent.
The level of arrears among properties bought by investors to rent out was 23.4 percent, up from 20.8 percent at half-year.
"There are no negative surprises, which gives confidence that the positive momentum witnessed in the second half of the year will continue and lead to a much improved 2013 result," said Stephen Lyons, credit analyst at Davy Stockbrokers.
"Deposit re-pricing, the exit of the guarantee, further cost action as evidenced through increased restructuring provisions should all combine to protect the bank's capital position, which remained high at 14.4 percent at year-end."
The 15 percent state-owned bank also said it had begun talks on reducing a pension deficit that has trebled to 1.2 billion euros at end-2012.
Boucher added that the bank will likely deal with the state's 1.8 billion euros of preference shares via a combination of actions ahead of a step up in the redemption cost next year.