UPDATE 1-UK's Osborne says actively considering RBS "bad bank"-paper

LONDON, Oct 18 (Reuters) - British finance minister GeorgeOsborne said his ministry was actively looking at breaking upthe state-backed Royal Bank of Scotland to create a "badbank" to house its problem loans, the Daily Telegraph newspaperreported on Friday.

Osborne, who asked investment bank Rothschild inJune to examine if RBS, 81-percent owned by taxpayers, should bemade to hive off its soured assets into a separate legal entity, has made sorting out the bank's future his top priority for thenext two to three weeks, the paper said.

"We are looking at the case for a bad bank and if not a badbank what is the alternative strategy that really gets on top ofthe problems in that bank and goes on being what I want it to bewhich is a bank supporting the British economy," Osborne toldthe Telegraph in an interview in China.

Rothschild's review is due shortly and the paper said thegovernment was "understood" to be considering three options fordealing with RBS's problem assets.

These are creating a bad bank inside RBS run by anindependent team; following the model used by Swiss bank UBSwhich created a bad bank supported by the Swiss central bank; orsetting up an entirely separate taxpayer-backed bad bank.

U.S. asset manager BlackRock, hired to analyse RBS'sportfolio, had identified 50-60 billion pounds ($81-97 billion)of assets to be placed into any bad bank, the Telegraph added.

The paper said the go-ahead for the break-up would be givenwithin the next few weeks however a Treasury spokeswoman saidearly on Saturday no decision had been made.

"As the Chancellor has said, the government is currentlyexamining the case for creating a bad bank of the Royal Bank ofScotland's risky assets," she said. "That review is ongoing, andwill be published in the Autumn."

Advocates of a break-up, including former Bank of EnglandGovernor Mervyn King and ex-finance minister Nigel Lawson, havesaid it would leave the bank better placed to lend and supportthe British economy.

The Telegraph said Osborne had said there was no chance thebank could remain in its current form.

On Friday, RBS's new chief executive, Ross McEwan, said thegovernment review into a possible break-up was distractingexecutives looking to revive the bank's fortunes.

"The debate you read about in the papers - and that hastaken up too much time of the management team - has been aboutwhat is now a small proportion of our activity. We are takingresponsibility for resolving these debates," McEwan said in amemo to staff.

Osborne also told the Telegraph there was no prospect ofselling the government's stake in the bank, bailed out in 2008at a cost of 45.5 billion pounds ($73.7 billion), before thenext election due in 2015.

However, he said they were pushing ahead with a plan to sellshares in part-nationalised Lloyds Banking Group toprivate retail investors.

"We are now looking actively at a retail offer for the nexttranche of Lloyds shares," he said. "With RBS we are not, at themoment, close to the stage of being able to sell RBS shares.

"RBS was a much more complex bank. To be fair to managementpast and present it was a bank that was in a lot more trouble.The clean-up job has been more difficult but we have got to makethese decisions now about the future for RBS."