Royal Bank of Scotland is to further shrink its investment bank arm and cut more jobs after the euro zone debt crisis saw third quarter profits slump, hampering its turnaround.

RBS, which is 83 percent-owned by the UK government after it was bailed out during the 2008 financial crisis, said on Friday it expects a tough fourth quarter after it took a further hit on its Greek government bonds and sold most of its Italian bonds.

The bank reported an underlying profit of 267 million pounds ($426 million) for the three months to the end of September, down 63 percent from a year ago.

They ... highlight the external pressures facing banks, and economies more broadly, which are making the road to recovery longer and bumpier than hoped for, said Chief Executive Stephen Hester.

Hester is halfway through a five-year turnaround plan, which has included halving the size of its investment bank, global banking and markets (GBM). He has previously said 2,000 more jobs could go in the division.

It's clear given the external market environment and given the change in regulation in the UK that we will have to go further than that and the bank will need to shrink further in order to be sustainable and attractive in both funding and profitability terms, he told reporters on a conference call.

Its tougher stance on costs meant it did not set aside any bonuses for staff in its investment bank during the third quarter, a spokesman said. Such a move is rarely seen in the industry.

By 1050 GMT RBS shares, which have fallen nearly 50 percent over the last year, were up 4.91 percent at 23.92 pence as analysts and investors said they were reassured by the bank's underlying business performance and capital position.

The banks have built up their balance sheets, and that takes a bit of the pressure off them, said Cavendish Asset Management fund manager Paul Mumford, who holds 4.5 million RBS shares.

RBS is a high-risk stock but over a five-year period you could double or treble your money, he added.

RBS said it will shift its balance even further toward its retail and commercial businesses, and its funding model will shift further toward getting deposits.

Hester said he expects to achieve the turnaround issues he can control, but the recovery in share price or profits looks set to be hampered by the tough outside environment.

There are outside manifestations, be it in share price or profitability, that will be delayed by the external environment. The things we can control, I think we will do within five years, he said.

Lifting return on equity for the core bank over 15 percent and getting its costs down to less than half of income is now likely to take longer than the 2013 target date originally planned, but other targets are on track, Hester said.

ITALIAN CUTS

RBS took a further impairment loss of 142 million pounds on its exposure to Greece during the third quarter, marking sovereign bonds there down to 37 percent of face value.

It also sold 2.5 billion pounds of Italian bonds, following rivals including BNP Paribas , ING and Barclays in selling down sovereign debt in the face of euro zone turmoil.

Its holdings of sovereign debt from Portugal, Italy, Ireland, Greece and Spain was down to 772 million pounds at the end of September, from 4 billion at the start of the year.

Income in the third quarter slumped 18 percent from the previous quarter to 6.4 billion pounds, but losses from bad loans dropped by a third to 1.5 billion pounds.

The bank followed the likes of Barclays and Morgan Stanley in benefiting from a debt accounting gain, with a 2.4 billion pound gain inflating its reported profit to 2 billion pounds for the quarter.

Despite the endless additional political and regulatory roadblocks placed in its way, against all the odds, RBS is, slowly but surely, making progress, Evolution Securities analyst Ian Gordon said, keeping a buy rating on the stock.

The shares remain far below the average 50p price at which the British government bought its stake, leaving taxpayers sitting on a 24 billion pound loss on paper.

As part of its restructuring RBS aims to dispose of its insurance arm, possibly via a stock market flotation, in the second half of 2012.

RBS was rescued in October 2008 after its finances were stretched by the credit crisis and its part in the acquisition of Dutch bank ABN AMRO in 2007.

The Scottish bank was propped up with a total of some 45 billion pounds of taxpayers' money, causing the eventual resignation of then chief executive Fred Goodwin.

RBS had a core Tier 1 capital ratio of 11.3 percent and said it had a liquidity poll of 170 billion pounds.

($1=0.627 British Pounds)

(Editing by Mike Nesbit and Hans-Juergen Peters)

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