* Plans to partially sell U.S. arm Citizens in next 2 years
* Batch of 315 UK branches unlikely to be sold, plans float
* RBS to further reduce "scale and scope" of investment bank
* Operating profit 3.5 bln stg, highest for five years
* Shares close down 6.6 percent
By Matt Scuffham and Steve Slater
LONDON, Feb 28 (Reuters) - Bowing to political and regulatory pressure, part-nationalised Royal Bank of Scotland said on Thursday it will cut down the size of its already shrunken investment bank and sell off a stake in its U.S. business Citizens.
Top management also said they were hopeful that the government would start selling its 82 percent stake next year but market concerns that the new round of restructuring would reduce its future growth potential hit the share price.
The shares closed down 6.6 percent at 324 pence, valuing the bank at just short of 19.7 billion pounds ($30 billion), less than a third of its 65 billion-pound valuation before its troubles began six years ago.
"Clearly pressure from (regulator) the FSA to shore up its capital buffers has forced RBS to announce more restructuring which is likely to further dilute the future returns potential at RBS, said Espirito Santo analyst Shailesh Raikundlia.
The businesses earmarked for sale or to be shrunk provide almost a quarter of the "core" RBS's profits prospects.
Citizens accounted for 12 percent of the core bank's operating profits last year of 6.3 billion pounds, the investment bank contributed 24 percent, the batch of 315 UK branches for sale 5 percent and the Direct Line online retail insurer floated in October contributed 7 percent.
Britain pumped 45.5 billion pounds into RBS during the 2008 financial crisis in order to keep it afloat, wiping out 90 percent of its value for shareholders. The bank has since shed around 900 billion pounds worth of assets and is focusing on lending to British households and small businesses.
The plan to shrink further means RBS's prospects are now inextricably linked to those of the British economy and Hester said the economic and regulatory environment would remain tough in 2013.
"Growth prospects in the UK, the group's most important market, remain subdued," Hester said.
Hester also said the bank had "accommodated" concerns held by the regulator and would sell between 20 and 25 percent of Citizens via a stock market flotation in New York in the next two years.
The bank will also reduce the "scale and scope" of its investment banking business, which accounted for about 60 percent of operating profits prior to the bailout.
"We believe both these actions will prove negative for future returns potential," said Espirito's Raikundlia.
RBS reported a pretax loss last year of 5.2 billion pounds, hit by a 4.6 billion-pound charge for losses on the value of its own debt. It also set aside a further 450 million pounds to compensate customers mis-sold payment protection insurance, taking its total provision to 2.2 billion pounds, and provided for 700 million pounds to compensate small businesses mis-sold complex interest rate hedging products.
However, its underlying operating profit nearly doubled to 3.5 billion pounds, the highest level since the bank was bailed out, and chairman Philip Hampton said the bank was now "much closer" to being in a position for the government to start selling shares, believing it was a "reasonable aspiration" that Britain could start selling in 2014.
The bank still has several obstacles to navigate, however. It suffered another setback last October when the planned sale to Santander of 315 UK branches fell through, and said on Thursday it is now likely to sell them via a flotation on the London Stock Exchange.
Ordered by the European competition authorities to sell the branches as a consequence of taking state aid, RBS said it now expected it would ask for an extension to an end-2013 deadline.
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.
RBS also said on Thursday it paid out 607 million pounds in bonuses for 2012, down 23 percent from 2011, after cutting about 302 million pounds from planned bonuses and clawbacks on past awards as a result of it being fined $612 million over attempts to manipulate the setting of benchmark interest rates.
Bankers across Europe are now set to have their bonuses capped under new industry rules agreed in Brussels.
'MAKE IT SMALLER'
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.
Hampton admitted that the bank's relationship with the government and regulators had at times been strained, even though the government set up UK Financial Investments to manage its investments in RBS and Lloyds "at arm's length".
"Nobody would have designed this model," said Hampton. "Occasionally we have difficult discussions and even more occasionally we have very fraught discussions about some of these issues."