* Lloyds H1 profits jump 32 pct to 3.8 bln stg
* Bad debts drop 58 pct, margins rise
* PPI bill tops 10 bln pounds after extra 600 mln hit
* Santander UK adds 1.1 million current accounts
* Spin-off bank TSB profits drop as costs rise (Adds details of misconduct charges, competitors)
By Matt Scuffham and Steve Slater
LONDON, July 31 (Reuters) - State-backed British bank Lloyds said it had strengthened its case to restart dividend payments for the first time in six years after reporting a one-third rise in profit for the first half.
The bank, which is 25 percent-owned by the government after being rescued during the 2008 financial crisis, said it would ask Britain's financial regulator in the second half of the year for permission to begin paying "modest" dividends again.
Lloyds was one of Britain's highest dividend paying stocks prior to its 20.5 billion pound ($34.7 billion) state bailout.
The bank reported an underlying profit of 3.8 billion pounds, ahead of analyst expectations and up 32 percent on the year before.
Including charges for restructuring and penalties related to past misconduct, Lloyds made a statutory profit of 863 million pounds. It said it expected statutory profit in the full year to be significantly higher than in the first half, an indication that the scale of charges for misconduct will decline as the year goes on.
Its core tier-one capital ratio - a key measure of its financial strength - rose to 11.1 percent from 10.3 percent at the end of 2013.
Sanford Bernstein analyst Chirantan Barua said Lloyds should eventually be able to return around 70 percent of earnings to shareholders each year.
"We feel the second half will be strong for the bank - especially post the imminent disposal of the government's remaining equity in the bank; a factor which has remained an overhang in recent times," said Barua, who rates Lloyds shares "outperform", with a target price of 100 pence.
The government is keen to sell its remaining shares in Lloyds before the next election in 2015, having already sold a 13.5 percent stake, raising 7.4 billion pounds for the state. However, the bank's progress has been hampered by past misconduct, resulting in charges totalling 1.1 billion pounds.
MORE CHARGES FOR PAST MISCONDUCT
Lloyds said it would set aside another 600 million pounds to compensate customers mis-sold loan insurance, taking its total bill to 10.4 billion, the most of any bank.
In addition, it has paid out fines of 225 million pounds related to the attempted rigging of benchmark interest rates and the manipulation of fees it paid under a government lending scheme and set aside 225 million pounds to cover potential pay-outs relating to the sale of investment and protection products. Another 50 million was set aside to compensate small businesses mis-sold interest rate swaps.
Citi analyst Andrew Coombs, who rates Lloyds "neutral" and has an 80 pence share price target, said the charges "may take some of the shine off these results". Lloyds' shares, which were up 1.4 percent in early deals, were down 2.7 percent at 0910 GMT.
Lloyds' profit benefited from improving economic conditions, with losses from bad debts more than halving to 758 million pounds. Its net interest margin - the difference between the interest the bank lends at and what it pays to savers and a key driver of income - jumped to 2.4 percent in the first half from 2.01 percent a year ago. Lloyds said it expected the margin to rise to average 2.45 percent for 2014.
"The things that matter are being able to demonstrate a statutory profit and a strong capital position. These half-year results show both of those. I do think they strengthen our hand. We go in in a good position," Finance Director George Culmer told reporters.
Lloyds, Britain's biggest retail bank, is facing increasing competition. Santander's British arm said on Thursday that it added 1.1 million current account customers in the past year, helping drive an 18 percent rise in pretax profit and making it the biggest contributor to the Spanish bank's profit.
Santander UK, which is expected to be spun off and separately listed in London in the next 18 months, said it made a pretax profit of 545 million pounds.
Santander UK said its 123 current account, which has been backed by a television advertising campaign featuring Rory McIlroy and racing driver Lewis Hamilton, had added 600,000 new customers so far this year, lifting the number of 123 accounts to 3 million from 1.9 million a year ago.
Meanwhile, TSB, the new bank spun out from Lloyds last month, showed the scale advantage that Lloyds and the UK's big banks have when it reported a 17 percent profit drop compared with the previous six months due to far higher costs. ($1 = 0.5913 British Pounds) (Editing by Tom Pfeiffer)