* Q1 underlying pretax up 22 pct at 1.8 bln stg
* To hold talks in H2 to restart dividends
* Margin improves and costs fall
* Bank plans flotation of TSB Bank in next 8 weeks
* Shares up 3.5 percent (Adds comments from finance director, updates shares)
By Matt Scuffham
LONDON, May 1 Lloyds Banking Group's pretax profit jumped 22 percent in the first quarter as costs fell and margins improved, strengthening the bank's plan to pay its first dividend since it was rescued during the financial crisis.
Lloyds, which is 25 percent-owned by the government, said on Thursday it made an underlying profit of 1.8 billion pounds ($3 billion) in the first quarter, helped by a 5 percent fall in costs from a year ago to 2.3 billion pounds.
Under Chief Executive Antonio Horta-Osorio, the bank's financial performance has been turned around and it has slimmed down to focus on domestic lending and meet tougher regulatory requirements on the amount of capital it holds.
"We are supporting and benefiting from the UK economic recovery and are delivering better underlying profitability as well as improved returns for shareholders, from a stronger, lower risk balance sheet," Horta-Osorio said.
The bank, which has cut costs by axing jobs and shutting many of its international businesses, needs permission from the Bank of England to restart dividends and said it would apply in the second half of the year to do so.
"We will go into those discussions with confidence about the business and about our prospects," Finance Director George Culmer told reporters on a conference call.
Before the financial crisis Lloyds had a record of being one of the highest dividend paying stocks in Britain. It paid out just over half of its profit in 2005 and 2006 and the shares yielded between 6.5 and 7 percent.
But the bank has not made a payout since the crisis hit, when the taxpayer pumped in 20 billion pounds to keep it afloat. That left Britain with a 41 percent stake, which the government has started selling at a slim profit.
Restarting dividends is seen as a key prerequisite for Britain to sell any of its remaining stake to retail investors, possibly later this year, and analysts said it could hand out to shareholders more than half of its future earnings.
Lloyds is building up capital and its core Tier 1 ratio - a key measure of its financial strength - stood at 10.7 percent at the end of the first quarter. Horta-Osorio said last month he expects UK regulators to require banks to hold 11 percent.
Analysts say that, when Lloyds reaches that level, it will be in a position to pass on more of its future profit to shareholders.
"Capital build-up will be basically over by 2015 and from there on assuming 4 percent loan growth ... the bank should be in a position to return about 70 percent back to shareholders every year," said Chirantan Barua, analyst at Sanford Bernstein.
Some analysts had expected Lloyds to pay a dividend for 2013, but those hopes were dashed when the bank warned in February it would need to take a further 1.8 billion pounds charge to compensate customers who had been mis-sold loan insurance.
Lloyds has set aside 9.8 billion pounds to deal with claims over mis-sold payment protection insurance or PPI, more than any other bank, and Culmer said he could not say for certain it will not have to pay out more. Analysts say further charges could dent its dividend hopes.
Shares in Lloyds were up 4.6 percent at 0845 GMT, compared with a 0.5 percent rise in the European banking sector.
Lloyds also said it was on track to launch the stock market flotation of its TSB Bank unit in the next eight weeks. It said it will sell a minimum of 25 percent and will offer shares to retail investors.
Sources have said TSB, which has 631 branches and is expected to be valued at about 1.5 billion pounds, is likely to float in mid-June. Lloyds was ordered to sell the business by European regulators as a cost of taking taxpayer support.
Lloyds improved its guidance on future margin and impairment charges and said it expected a 2014 net interest margin of 2.4 percent, an increase of around 10 basis points on previous guidance.
The margin is a key driver of profits for Lloyds and improved to 2.32 percent in the first quarter, up from 1.96 percent a year ago, which drove a 10 percent rise in net interest income.
The government has so far sold shares in Lloyds worth 7.4 billion pounds, reducing its stake to 25 percent, and wants to sell off the remainder before the next election.
($1 = 0.5922 British Pounds) (Additional reporting by Steve Slater; Editing by Toby Chopra and David Holmes)