LONDON (Reuters) - Britain is closer to selling part of its stake in Royal Bank of Scotland (>> Royal Bank of Scotland Group plc) after seeing growing appetite for the bank's shares from financial institutions and it could offer some of the stock to private retail investors.

A sale would allow the British government to start shedding its 80 percent holding in RBS, which was rescued through a 45 billion pound bail-out during the 2007-2009 financial crisis.

Oliver Holborn, head of capital markets at UK Financial Investments (UKFI), a government agency which manages the stake, said he had been contacted by institutions interested in buying RBS shares and the prospect of the bank returning to private ownership had accelerated this year.

"We are definitely seeing more interest from institutions about investing in RBS. If you speak to institutional investors they will tell you that (RBS Chief Executive) Ross McEwan has made very good progress this year in terms of trying to make RBS a simpler, better bank," Holborn told parliament's Treasury Select Committee on Tuesday.

Reuters reported earlier this month that the chances of the government selling shares in RBS had risen this year and that it saw a first sale as being possible in the next two years.

Holborn said he had met with the agency's advisor JP Morgan (>> JPMorgan Chase & Co.) more than 5 times to discuss the issue in the past month.

Shares in RBS are currently trading at 358.5 pence, well below the government's 502 pence a share buy-in price, leaving taxpayers sitting on a paper loss of nearly 13 billion pounds.

UKFI Chairman James Leigh-Pemberton told the committee that it would consider offering RBS shares to private retail investors as well as financial institutions when it comes to sell, partly because it would enable them to sell off more of the government's stake.

"The inclusion of retail has the benefit of enabling a larger size (of sale) than would otherwise be achievable," he said.

A planned sale of part of the government's remaining 25 percent stake in Lloyds Banking Group (>> Lloyds Banking Group PLC) to retail investors was cancelled this year because the shares were not trading at a high enough level.

Holborn said UKFI would need more clarity on future litigation issues potentially affecting RBS before any sale.

"There are a number of outstanding issues that need to be dealt with in particular on the conduct and litigation side where the sizes of some of those issues are at this stage unknown," he said.

RBS is one of six banks in talks with Britain's financial regulator to settle allegations its staff were involved in the rigging of the global $5 trillion-a-day currency market. It is also being investigated by regulators looking into its treatment of struggling small British firms and its selling of bonds backed by residential mortgages in the United States.

Leigh-Pemberton said the government over-ruled plans by RBS to pay some staff bonuses worth twice their basic pay earlier this year to avoid a backlash from Britons unhappy about pay levels at the bank.

Leigh-Pemberton said UKFI had recommended RBS be allowed to pay that level of bonus to help it retain staff and attract top talent. But after the Treasury intervened, RBS was told it could pay bonuses worth only the same as staff's basic pay.

"In order to avoid a major public controversy at that time it was considered that it would be more appropriate not to put that resolution to shareholders," he said.

(Reporting by Matt Scuffham, editing by Simon Jessop and Jane Merriman)

By Matt Scuffham