* Q2 net profit 40 percent higher than expected
* Stronger fees, lower loan-loss charges help earnings
* CEO Mustier confirms targets despite profit beat
* To pay first cash-only dividend in 5 years (Adds details, CEO comments)
MILAN, Aug 3 (Reuters) - UniCredit, Italy's largest bank, reported its biggest quarterly profit in almost a decade on Thursday, outstripping market expectations and restoring cash dividends after a radical balance sheet overhaul.
The result will add to a general sense that the worst is over for Italy's banks, long seen as the euro zone's weakest financial link. The strong earnings also confirmed that Chief Executive Jean-Pierre Mustier's turnaround plan had begun to pay off barely a year since he took up the job.
Mustier, appointed in July 2016 to reinvigorate the then weakly capitalised bank, has been selling businesses, cutting jobs and shutting branches to strengthen UniCredit's balance sheet.
He also pulled off a 13 billion euro ($15.43 billion) share issue, Italy's biggest cash call, in February to bolster the bank's financial strength.
The restructuring helped drive the Milan-based bank's net profit up 3 percent to 945 million euros. The bank confirmed this was its best quarter since June 2008, even though it highlighted that the scope of its activities had changed since then. The result was 40 percent higher than a consensus forecast distributed by the bank.
UniCredit shares were up about 6 percent in afternoon trade.
Mustier said Europe's more benign economic environment had helped the results, along with lower costs and stable net-interest income, a measure of how much a bank makes from its core retail business.
"These are the early, encouraging signs of our turnaround plan. The engine is working very well," he told reporters, confirming that the bank would pay an all-cash dividend on this year's accounts, the first time in five years.
Italy had failed for years to tackle the problems of its banking industry, saddled with 350 billion euros of bad loans. But this year the government, with European Union approval, committed more than 20 billion euros to rescue three banks, removing systemic risks.
Monte dei Paschi di Siena, the world's oldest bank, is being bailed out by the state, while two Veneto banks were liquidated, with their healthiest assets handed over to UniCredit's rival, Intesa Sanpaolo.
"The government action has significantly reduced the risk premium for Italian banks," Mustier said. Italian banking shares have outperformed those of European peers by nearly 15 percent since the start of the year.
He was still cautious about the outlook, despite strong profits and a core capital base that is ahead of his "Transform 2019" plan. He did not revise up any goals for this year, except for loan provisioning costs, now expected to be a bit lower.
The bank boosted its core capital ratio to 12.8 percent at end-June, making it one of Europe's strongest, through the sale of Polish division Pekao. It will add another 84 basis points in the next quarter with the sale of asset manager Pioneer.
A year ago, the ratio, a key measure of financial strength, stood at a lowly 10.3 percent.
"It's better to manage expectations, because not all quarters are the same and there is still a lot of work to do," Mustier said, adding stricter accounting standards and other regulatory requirements would eat into the bank's capital base in the second half of the year and beyond.
Several analysts said UniCredit now had excess capital after years of lagging behind rivals.
"Things are going much, much better than expected," one trader said. "Yet, at 18-19 euros a share, the restructuring story starts to be priced in and UniCredit could need a revamp in its investment case."
Under a plan dubbed FINO (Failure Is Not An Option), the bank last month closed a deal to sell 17.7 billion euros of "sofferenze", the worst kind of bad loans, to a vehicle majority-owned by U.S. funds Pimco and Fortress.
Loan-loss charges in the three months to June totalled 564 million euros, compared with analyst forecasts of around 700 million euros. Net fees and commissions rose 7.6 percent from a year earlier, helped by a distribution agreement UniCredit struck with fund manager Amundi after selling it Pioneer. ($1 = 0.8422 euros)
(Addiitonal reporting by Gianluca Semeraro and Danilo Masoni; Editing by Mark Bendeich and Jane Merriman)