UPDATE 1-S.Korea KDB eyeing Korea Exchange Bank -paper

(Adds background, KEB reaction, share price)

SEOUL, May 7 (Reuters) - State-owned Korea Development Bank (KDB) may buy Korea Exchange Bank (KEB), majority owned by U.S. private equity firm Lone Star [LS.UL], ahead of the sale of a stake in KDB by the government, a newspaper reported on Thursday.

Previous attempts over the past few years by Lone Star to sell its 51 percent stake in South Korea's sixth-largest lender, valued at 2.5 trillion won ($2 billion) by Wednesday's close, to Kookmin Bank and HSBC (HSBA.L) fell through due to pricing differences.

The Chosun Ilbo daily cited an unnamed KDB senior official as saying the state-run bank was also keeping a close eye on the South Korean banking arm of Citigroup (C.N) for a possible acquisition to boost its deposit base and grow as a commercial bank.

"(KDB) is interested in buying a bank up for sale such as Korea Exchange Bank (004940.KS)," the official told the newspaper.

"Now that the government is planning to sell a stake (in KDB) within the next five years, we will push for mergers and acquisitions of other banks before that happens."

Shares in KEB rallied by 14.1 percent shortly after the market opening before trimming gains to 12.2 percent by 0016 GMT, versus a 1.3 percent rise in the broader market .

KDB spokesman Sung Joo-young said that an acquisition of a rival bank might be considered to raise KDB's value before it goes public later on.

"But it's wishful thinking for now," he added.

KEB declined to comment.

Under a government plan KDB will be split into a holding company including Daewoo Securities (006800.KS), one of the country's most valuable brokerages, by the end of September and a state fund later on.

Legal revisions passed last week will allow the policy financing bank to engage in household lending to help it transform into a commercial lender.

It has 45 domestic branches, compared with 1,200 for KB Financial Group (105560.KS) unit Kookmin Bank, the country's largest bank.

KDB was in talks to buy a stake in Lehman Brothers before the U.S. investment house collapsed last September.

($1=1284.6 Won)

(Reporting by Kim Yeon-hee; Editing by Jonathan Hopfner)