* Job cuts include planned Citizens sale, UK branch sales
* Investment bank may be folded into corporate arm
* Government has pressed for investment bank retreat
* Analysts say it will take 5 years to restore RBS to health
* RBS shares up 2 percent
By Matt Scuffham
LONDON, Feb 21 (Reuters) - Royal Bank of Scotland is to shrink its investment banking and international operations as part of a revamp in which the group could shed up to a quarter of its 120,000 workforce, sources familiar with the matter said on Friday.
The part-nationalised bank has given in to demands from politicians that it focuses on lending to British households and businesses and maintains only a downsized investment banking business to service corporate clients, one source said.
Ross McEwan, who replaced Stephen Hester as CEO last October, will unveil the outcome of a strategic review of the business alongside the bank's full-year results on Thursday.
Shares in RBS - 81 percent-owned by the government after a 45-billion-pound ($75-billion) bailout in 2008 - were up 2 percent by 1300 GMT, outperforming a flat European banking sector.
Numis analyst Mike Trippitt said the plans were a positive development subject to restructuring costs and the impact on the bank's capital position.
"It has been clear for some time that the government has wanted RBS to retrench to a UK focused retail and commercial bank," he said.
RBS is under pressure to improve its capital position after Moody's placed its credit ratings on review for downgrade last week and Trippitt noted that a quarter of the group's assets, when adjusted for risk, are housed within the investment bank.
The bank said in January it expected to report a core Tier I ratio - a gauge of a bank's financial strength - of between 8.1 and 8.5 percent at the end of 2013 under full Basel III capital rules, below most rivals.
RBS could reduce its headcount by up to 30,000 as part of the reorganisation, according to the sources who did not want to be quoted directly, a figure that includes previously announced plans to sell its U.S. retail business Citizens, which accounts for 18,300 jobs, and a UK retail business, Williams & Glyn, which employs 4,500.
Finance Minister George Osborne has said he wants RBS to be more like state-backed rival Lloyds Banking Group, which has minimal investment banking operations and concentrates on domestic lending. Lloyds is expected to return fully to private ownership in the next 12 months while RBS is three to five years away.
Hester clashed with politicians over their desire to see RBS's investment bank scaled back and for the bank to sell off its U.S. retail business Citizens and this contributed to his departure. He warned that pursuing a strategy of focusing on the UK could result in the bank becoming a "second-best Lloyds".
Sources close to McEwan say he is determined to focus attention on the bank's future, following a rocky start to his tenure during which RBS has set aside 3 billion pounds to deal with past misconduct, experienced an IT problem that affected millions of customers and faced accusations about its treatment of some small businesses.
Analysts say the 56-year-old New Zealander needs to strike a balance between keeping the government happy and establishing a plan to reignite growth and return the bank to profit.
RBS said last November it would create an internal "bad bank" to fence off its riskiest assets, part of a raft of measures designed to heal its relationship with the British government and speed up its eventual privatisation.
The bank's remaining investment banking activities could be incorporated into its corporate business, one source said, and the bank is considering the future of its U.S. and Asian investment banking businesses.
Analysts at Citi said on Friday that it could take more than five years to restore RBS to health and said McEwan had yet to provide a credible business plan on the future direction and strategy of the remaining "good bank".
"While we believe RBS can be repaired, one should not underestimate the time the time frame over which this will be achieved: probably 5+years. In the near-term we expect it will be extremely difficult for new CEO McEwan to turn around the profitability of the bank," they said in a research note.