UPDATE 3-RBS privatisation prospects brighten after surprise profit
* RBS was considered years away from privatisation
* Q2 pretax profit of 1 bln stg far exceeded expectations
* Shares up 13.5 pct, on course for biggest one-day gain since 2009
* Taxpayers still sitting on 11.7 billion pound loss
* CEO warns there are still "bumps in the road ahead" (Recasts, adds analyst, further details)
By Matt Scuffham and Steve Slater
LONDON, July 25 (Reuters) - Part-nationalised Royal Bank of Scotland boosted its chances of an earlier than expected return to private ownership, posting a surprise 1 billion pound ($1.7 billion) second-quarter profit as its painful restructuring begins to bear fruit.
The government has already started selling off shares in its state-backed rival Lloyds Banking Group, but RBS's privatisation was considered by banking and political sources to be three to five years away despite drastic cost-cuts, asset sales and the shrinking of its investment bank.
Britain pumped 45.5 billion pounds into the bank during the 2008/09 financial crisis, leaving the government with an 81 percent stake and taxpayers are still sitting on a paper loss of 11.7 billion pounds.
RBS's second-quarter numbers far exceeded analysts' expectations, prompting the bank to report a week early, and sent its shares soaring 13.5 percent to 373 pence at 1030GMT - on course for their biggest one-day gain since April 2009. Yet the price is still 25 percent below that paid by the state.
However, investors in RBS will now be looking for the same upward momentum achieved by Lloyds, the share price of which nearly doubled in the nine months to January, enabling the government to begin selling its stake.
Before Friday's results, 25 analysts had a "hold", "sell" or "strong sell" rating on the stock, with three rating it a "strong buy", according to Thomson Reuters data.
Though some of those analysts may now alter their view on the bank, new Chief Executive Ross McEwan, who took over from Stephen Hester in October 2013, sounded a note of caution, pointing out that RBS is still dealing with significant problems from its past.
'BUMPS IN THE ROAD'
"This includes significant conduct and litigation issues that will hit our profits in the months and years to come," McEwan warned. "I'm pleased we've had two good quarters, but no one should get ahead of themselves here - there are bumps in the road ahead of us."
RBS, which was last year fined 390 million pounds for its part in manipulation of the Libor benchmark interest rate, is one of several banks being investigated over alleged manipulation of foreign-exchange markets. It also faces claims relating to the sale of mortgage-backed securities.
These clouds still hang heavy over RBS, but its prospects have been boosted by Britain's economic upturn, mirroring the a trend in Spain, where Caixabank reported that its bad debts had shrunk as the economy has improved.
Official data on Friday showed that Britain's economy is finally bigger than it was before the financial crisis struck six years ago.
CEO McEwan said the economic revival had helped the bank to recover debts it had previously written off, giving it a net release of 93 million pounds. That compared with 1.1 billion pounds of impairments in the second quarter of last year and analyst expectations of a 500 million hit this time around.
RBS opted to create an internal bad bank in November after Britain's finance ministry had examined and rejected the option of a formal break-up of the bank. The unit was set up to fence off its riskiest assets and leave the remainder of RBS in a better position to lend and support the economy.
A 5.1 billion pound impairment charge on loans in the bad bank contributed to a larger than expected 2013 loss of 8.2 billion pounds, but RBS said on Friday that it has now written back some of the loan losses, selling the assets at better prices than it had expected.
"This is an encouraging sign that the 5.1 billion pound charge taken in the fourth quarter of 2013 was very prudent and will allow RBS to post low impairment charges in the coming years," said Morgan Stanley analyst Chris Manners.
The stronger results - despite RBS setting aside an additional 250 million pounds to compensate customers for mis-selling payment protection insurance and interest rate swaps - lifted the bank's core capital ratio to 10.1 percent at the end of June, up from 9.4 percent three months earlier.
RBS is targeting a Tier 1 capital ratio of 11 percent by the end of 2015 and at least 12 percent by the end of 2016.
A proposed sale of its U.S. business Citizens will boost capital further, but RBS said that the ongoing regulatory investigations and litigation are expected to drag on capital generation over the coming quarters.
For all the concerns, however, McEwan said the results showed the steady progress being made to make RBS "a much simpler, smaller and fairer bank".
"RBS is a fundamentally stronger bank that can deliver good results for customers and shareholders," he said. ($1 = 0.5884 British Pounds) (Additional reporting by Simon Jessop; Editing by David Goodman)