By Matt Scuffham and Steve Slater
LONDON (Reuters) - Royal Bank of Scotland <RBS.L> has reported its strongest underlying profit since the financial crisis, potentially paving the way for Britain to sell its 82 percent stake if some big hurdles are overcome.
The bank had to be rescued in a 45.5 billion pound ($68.9 billion) state bailout during 2008 but the government has begun looking at ways to sell off its holding as RBS starts to return to financial health.
"The light at the end of the tunnel is coming closer," Chief Executive Stephen Hester said on Thursday. "Our job is to deliver a company that is doing its job well and that other investors will want to invest in."
RBS made an operating profit of 3.5 billion pounds ($5.2 billion) last year, up from 1.8 billion the year before and the highest since its 2008 bailout.
The bank paid out 607 million pounds in bonuses for 2012, down 23 percent from 2011.
RBS has cut about 302 million pounds from bonuses, clawed back from past awards or to be cut from future payments to account for behavior related to the rigging of interest rates, for which the bank was fined $612 million.
Bankers in Europe will have bonuses capped in future after agreement in Brussels on pay limits to try to curb financial sector excess.
Hester, brought in following the government rescue, has overseen what he describes as the largest turnaround in corporate history. RBS has shed around 900 billion pounds worth of assets while he has been in charge.
Chairman Philip Hampton said the bank was "much closer now to being in the good financial health that would allow shareholders to receive a dividend and the government to start to sell its stake".
Britain is considering a range of options for privatizing the bank including giving shares away or selling shares to the public at a discount.
In the meantime, RBS will further reduce the scale and scope of its investment banking business. The bank plans to cut its risk-weighted assets by 20 percent to 80 billion pounds from 101 billion at the end of 2012.
RBS and other big British banks are under pressure from the government to lend more to households and small businesses to help to revive the country's weak economy.
Finance Minister George Osborne welcomed RBS's plans to shrink its investment bank further.
"I want to see RBS as a British-based bank, focused on serving British businesses and consumers, with a smaller international investment bank to support that activity rather than to rival it," he said on Thursday.
RBS said it planned to sell part of its U.S. business Citizens in the next two years and would likely float a batch of 315 UK branches it has struggled to offload. Hester said RBS would probably sell about 25 percent of Citizens through a share sale in New York around two years from now.
The bank said it also expected to float a batch of 315 branches in Britain that had been earmarked for a sale to Santander <SAN.MC>, which pulled out of the deal in October.
Hester said there were a lack of buyers for UK bank assets at present, so a share sale using the Williams & Glyn's brand was now its "baseline" plan.
European competition authorities ordered RBS to sell the branches as a consequence of taking state aid. The bank said it expected to ask for an extension to an end-2013 deadline to shed the branches.
RBS said it had set aside a further 450 million pounds to compensate customers mis-sold payment protection insurance, taking its total provision to 2.2 billion pounds. Some 1.3 billion pounds has already been paid out.
The bank has also set aside 700 million pounds to compensate small businesses mis-sold complex interest rate hedging products.
RBS made a pretax loss of 5.2 billion pounds, hit by a 4.6 billion charge for losses on the value of its own debt.
Liberum Capital analyst Cormac Leech said the results were "on the weak side" despite good cost control.
By 1045 GMT RBS shares were down 2.4 percent, underperforming a 0.5 percent rise by the EU bank index <.SX7P>. That leaves taxpayers currently sitting on a paper loss of 14.5 billion pounds.
($1 = 0.6608 British pounds)
(Additional reporting by Tim Castle; Editing by Mark Potter and Jane Merriman)