Royal Bank of Scotland expects difficult market conditions in the fourth quarter, with banks around the world hit by Europe's debt crisis, and the part-nationalised lender added it had cut its exposure to Greece and Italy.

RBS, which is 83 percent owned by the British government following a state bailout during the 2008 credit crisis, said on Friday that it had made a third-quarter net profit of around 1.2 billion pounds.

RBS followed the likes of Barclays and Morgan Stanley in benefiting from a debt accounting gain, which boosted its earnings by 2.36 billion pounds and helped offset lower profits at its GBM investment banking division.

Its third quarter net profit was up from a second-quarter loss of 897 million pounds, although the operating profit at its core division fell to 1.3 billion pounds from 1.7 billion in the previous quarter.

RBS added that it had taken a further impairment loss of 142 million pounds on its exposure to Greece during the third quarter.

RBS's third-quarter results show the improved strength and resilience we have built up since 2008, Chief Executive Stephen Hester said in a statement.

They also highlight the external pressures facing banks, and economies more broadly, which are making the road to recovery longer and bumpier than hoped for, he added.

CUTTING EUROZONE EXPOSURE

RBS shares, which have fallen nearly 50 percent over the last year, rose sharply in early morning trade as analysts and investors said they were reassured by the bank's underlying business performance and capital position.

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

RBS shares were up 4.6 percent at 23.85 pence, making it the top gainer on Britain's benchmark FTSE 100 index, which rose by 0.6 percent. The stock however remains well below the average 49.9 pence price at which the British taxpayer acquired its stake in the bank.

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 some 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 added it sold 2.5 billion pounds of Italian bonds in the third quarter, leaving it with just 294 million pounds worth, following rivals including BNP Paribas, ING and Barclays in selling down sovereign debt in the face of euro zone turmoil.

RBS had cut its holdings of sovereign debt from Portugal, Italy, Ireland, Greece and Spain to 772 million pounds at the end of September, from 4 billion at the start of the year, with most sales in the third quarter.

CUTTING BACK ON INVESTMENT BANKING ARM

Britain acquired stakes of around 83 percent in RBS and 40 percent in rival Lloyds after having to bail out both banks during the 2008 credit crisis.

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 Sir Fred Goodwin.

Since then, RBS has been steadily restructuring its business. It aims to dispose of its insurance arm, possibly via a stock market flotation, in the second half of 2012 and has also pared back on some of its investment banking businesses.

CEO Hester said RBS planned to shrink its GBM investment bank division further. The unit has already more than halved in size in the last three years and Hester has said that some 2,000 jobs could be cut at 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. Therefore its weight within the group will decline still further, he told reporters.

Hester is half-way through a five-year turnaround plan and said he expects to achieve the turnaround issues it 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.

(Reporting by Sudip Kar-Gupta and Steve Slater; Editing by Mike Nesbit and Hans-Juergen Peters)