UPDATE 3-British bank Lloyds takes $1.2 billion mis-selling hit

* Q3 underlying profit up 83 percent year on year

* CEO says bank will become high-dividend stock

* Expects significant sale of government shares in 2014

* Shares down 1.9 percent

By Matt Scuffham

LONDON, Oct 29 (Reuters) - Lloyds Banking Group onTuesday set aside a further 750 million pounds ($1.2 billion) tocompensate customers mis-sold loan insurance, overshadowing anear-doubling of third-quarter underlying profit.

Britain's biggest retail bank, which is 33 percent owned bythe government, now expects to pay out more than 8 billionpounds to deal with the UK's most expensive consumer financescandal. That is more than double the 3.95 billion poundsBarclays expects to pay out.

However, Lloyds' 83 percent rise in quarterly profit, notincluding the mis-selling provisions, lifts its hopes ofresuming dividend payments and hastening its exit fromgovernment ownership.

The bank, now Europe's fourth-largest, is in talks withBritain's financial regulator about dividends and will set outits dividend policy alongside its 2013 results in February.

Finance Director George Culmer told reporters the bank hadentered those discussions in a good position.

"We are in a stronger capital position than some of ourpeers who are paying dividends, so hopefully we'll get the rightoutcome," he said.

Lloyds reported underlying profit of 1.5 billion pounds, upfrom 831 million a year earlier and in line with analysts'forecasts. The bank said the rise was driven by increasedlending, an improved interest margin and a reduction in costsand bad-loan charges.

"The bank is back to profitability. We are back to being anormal company," Chief Executive Antonio Horta-Osorio toldreporters, adding that Lloyds will be a high-dividend stock inthe future.

Shares in Lloyds, which last week climbed close to afour-year high, were down by 1.9 percent at 1158 GMT.

STATE EXIT TO CONTINUE

The shares have more than doubled in value over the pastyear, enabling the government to start offloading the shares itacquired in a 20.5 billion pound bailout of the bank during the2008 financial crisis.

The government began that process with the sale of a 6percent stake in September and Horta-Osorio said he expectedanother significant disposal next year.

"I think it is very likely that there will be a significantother tranche (sold) in 2014," Horta-Osorio said, adding that hewas sympathetic to the idea of private retail investors beingincluded in future sales.

David Lis, head of equities at Aviva, one of Lloyds' top 20investors, highlighted the bank's improving margins, reducedloan impairments and the increase in lending.

"Lloyds remains on track in its financial rehabilitation andwe continue to expect a return to the dividend list in the nottoo distant future," he told Reuters.

The bank said that its net interest margin had increased by13 basis points to 2.06 percent in the year to date and isexpected to reach 2.11 percent by the year end. It has cut costsby 6 percent during the year and achieved a 44 percent reductionin charges for loans that have turned sour.

Rival British banks Barclays and Royal Bank of Scotland report third-quarter results this week, with HSBC reporting next week.

Numis analyst Mike Trippitt, noting that the strongunderlying performance was offset by additional mis-sellingprovisions and losses on asset sales, downgraded the stock to"hold" from "add" on valuation grounds.

More than 17 billion pounds has been set aside by Britishbanks to compensate customers mis-sold payment protectioninsurance (PPI). The policies were meant to protect borrowers inthe event of sickness or unemployment but were often sold topeople ineligible to claim.