* RBS sells further 17 pct Direct Line stake for 507 mlnpounds
* Takes holding below 50 pct before end-2013 deadline
* Scrutiny on UK banks' capital before key regulator meeting
* Direct Line shares down 3 pct, RBS down 2 pct (Adds analyst's comments, details)
By Steve Slater
LONDON, March 13 (Reuters) - Royal Bank of Scotland has sold off a further stake in UK insurer Direct Line for 507 million pounds ($755 million), taking advantage of abuoyant market to cut its holding well ahead of an end-of-yearregulatory deadline.
The state-backed bank, which sold 34.72 percent of DirectLine in its stock market float in October, said on Wednesday it sold a further 17 percent stake to institutional investors for201 pence per share, a 4 percent discount to Tuesday's close but20 percent up on the flotation price in October.
The sale will have a minimal impact on RBS's capitalposition, as it has exchanged an asset that was on its books for216p per share for cash, but comes at a time when banks rescuedin the financial crisis are under pressure from the UKgovernment and regulators to bolster their capital andrestructure to focus on their core domestic banking businesses.
The Bank of England's Financial Policy Committee (FPC),which looks out for trouble spots in the financial system, hassaid banks need to strengthen their capital, a message whichanalysts say is seen as being directed particularly to thepart-nationalised lenders RBS and Lloyds Banking Group.
The BoE said banks need more capital to cushion themselvesagainst losses from loans, compensation bills for mis-selling tocustomers and regulatory fines. The FPC has been discussing theissue with the banks before a March 19 meeting.
Banks should be able to address capital shortfalls by restructurings, shrinking their balance sheets, using debt thatcan convert into capital and other methods, but there was a riskthe FPC sees RBS in particular as short of capital, saidInvestec analyst Ian Gordon.
"The FPC looks less willing to look through to what balancesheets will look like in the future," he said.
Lloyds, which is 39 percent state-owned, this week sold a 20percent stake in wealth manager St. James's Place toboost its capital by about 600 million pounds and its corecapital ratio by around 20 basis points.
Prime Minister David Cameron last month called on RBS, whichis 82 percent-owned by the taxpayer, to speed up itsrestructuring, despite the fact that CEO Stephen Hester hasalready shrunk its assets by 900 billion pounds.
The government is keen to start selling shares in RBS in2014, a year before the next general election, but the bank'sshares are still more than a third below the price thegovernment paid for them under its 45 billion-pound ($67billion) rescue during the banking crisis.
Hester last month said he planned to partially sell the U.S.business Citizens, saying he had "accommodated" concerns held bythe regulator.
The lender will also further shrink its investment bank,which should improve its capital ratio by reducing its assets, and will sell or float a portfolio of 315 UK branches.
The sale of the branches and Direct Line are required by theEuropean Commission as the EU's competition regulator in returnfor allowing the bank's bailout by the UK government followingthe 2008 financial crisis.
RBS had to sell at least half of Direct Line by the end ofthis year, and the latest sale cuts its holding to 48.5 percent.
It has to sell the remainder by the end of 2014.
RBS had agreed to a 180-day "lock-up" not to sell moreshares at the time of last year's IPO until April 9, but thatwas waived by the bookrunners. It said it will not sell any moreshares for 180 days unless it gets consent again from thebookrunners. The sale was handled by Goldman Sachs, MorganStanley and UBS.
Direct Line shares were down 3.3 percent at 203 pence by1315 GMT, when RBS shares were down 2.3 percent at 299 pence,and the Stoxx 600 Europe banking sector index was down0.9 percent.
The RBS sale comes just before Direct Line's younger rivalesure, is due to make its own London market debut on March 22. ($1=0.6718 British pounds) (Editing by Kylie MacLellan and Greg Mahlich)
Lloyds (LLOY)