Royal Bank of Scotland may halve the size of its already shrunken investment bank after its majority shareholder, the government, took a more assertive stance and told it to focus on its core rump of UK clients.

Stricter banking regulations and low profitability across the industry had already prompted RBS to sharpen its knife on an investment bank that has halved in size in the last three years.

RBS needs to go further and the management agrees, Chancellor George Osborne told politicians on Monday.

It needed to make further significant reductions and cut back riskier businesses that are heavy users of capital or funding, Osborne said, capping a set of far-reaching reforms for Britain's banks.

RBS confirmed last month that we would adjust the size of our investment bank in line with changing market conditions. We will update on final decisions in the new year following consultation with our major shareholders, a spokesman for the bank said in response.

RBS's global banking and markets (GBM) arm is strong globally in bond trading, foreign exchange, U.S. mortgage financing and other financing.

But it is outside the global top tier and is expected to scale back in equities -- potentially selling UK advisory and broking business Hoare Govett -- as part of retreat that could again cut its size in half, bankers and analysts said.

There is already a big question mark over the sustainability of return on equity in investment banks. The (UK banking) ring fence means that funding costs go up even further ... and it's even more difficult to get that sustainable return, said Shailesh Raikundlia, analyst at Espirito Santo.

RBS shares fell 3 percent to 19.7 pence, leaving the UK taxpayer sitting on a paper loss of 27 billion pounds. The government pumped in 45 billion pounds in one of the biggest rescues of the financial crisis, and shares need to reach 50p for the taxpayer to breakeven.

BONUS HEADACHE

Paying big bonuses at a bank 83 percent owned by the state has also sat badly with taxpayers.

RBS has argued it would lead on reducing bonuses, but needed to pay top bankers to prevent an exodus to rivals.

Another headache for CEO Stephen Hester, himself a former investment banker at Credit Suisse , is that GBM contributes most of RBS's profits, and shrinking the division could push back the return of RBS shares to private hands.

GBM has produced more than 10 billion pounds of profits since the financial crisis, and even its depressed profit of 1.7 billion pounds in the first nine months of this year accounted for 77 percent of the group total.

But its return on equity was just 2.3 percent in the third quarter and it slumped to an operating profit of 112 million pounds as the euro zone debt crisis ravaged trading activity.

GBM had already targeted fewer, deeper relationships. It had more than 26,000 relationships in the past but has slashed these to about 5,000, a number that could now shrink further, RBS insiders have said.

GBM, which is led by John Hourican and has 18,900 employees in 39 countries, has also come under fire this year for arranging a bond issue for the government of Belarus, after a campaign by human rights groups, and had to pledge to drop this kind of work, at least for now.

(Editing by Mark Potter)