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UPDATE 3-Australia's CBA vows reputational rebuild as scandal taints record profit

profit@

* Cash profit A$9.88 bln vs A$9.83 bln analyst f'cast

* Flags sale of life insurance business

* Board sub-committee to handle money-laundering case (Adds CEO saying no knowledge of overseas regulators' involvement, closing share price)

SYDNEY, Aug 9 (Reuters) - Commonwealth Bank of Australia acknowledged on Wednesday its reputation is on the line over money-laundering and terror financing allegations, as it posted its eighth straight record cash profit under the shadow of massive potential penalties.

Australia's mortgage leader flagged the sale of its life insurance business and hiked dividends, sending its shares sharply higher, but any good news was eclipsed by the fallout of bombshell criminal allegations.

Chairman Catherine Livingstone said four directors had been tasked with overseeing the bank's response to a Federal Court lawsuit alleging criminal syndicates had laundered millions of dollars through CBA accounts over several years.

The claims, leveled last week by the government's financial intelligence agency AUSTRAC, have wiped billions of dollars from CBA's market value and overshadowed its better-than-expected 4.6 percent rise in annual profit to A$9.88 billion ($7.82 billion).

"The board acknowledges the significance of the allegations ... and that this issue impacts the reputation not only of the bank but of the industry more broadly," Livingstone said in a statement accompanying the earnings release.

The comments from the chairwoman of Australia's second-biggest lender struck a different tone to those of CEO Ian Narev, who has blamed most of the breaches on a software glitch.

CBA's board said on Tuesday it had cut short-term bonuses to zero for Narev and other top executives for the year to June 30, 2017, citing the "collective accountability of senior management for the overall reputation of the group."

But Livingstone went further on Wednesday amid mounting calls for a sweeping judicial inquiry into misconduct by Australia's banking sector, naming the board sub-committee and promising to rebuild public trust.

The board would "take an active role in addressing any further management accountability," she said, noting that there was "no reason to believe that the allegations arose from deliberate or unethical behavior, or any commercial motive."

CBA said it was not possible to reliably estimate the potential financial impact on the group, although technically it could face billions of dollars in penalties.

The regulator accused CBA of "systemic" failings to spot thousands of illegal transactions, some of which allegedly involved drug syndicates sending money abroad to centers like Hong Kong.

Narev told reporters he was not aware that any foreign government had made inquiries in relation to the transactions.

The AUSTRAC allegations are the latest headache for Australia's major lenders, which have been embroiled in a series of scandals that have fueled calls for the industry's dirty laundry to be aired in a judicial inquiry known as a Royal Commission.

SILVER LININGS

CBA shares closed 0.57 percent higher at A$81.11 on the day, outpacing the broader market's 0.36 percent rise.

The result was "slightly ahead of expectations with very few surprises, likely just as CBA would like it," UBS banking analyst Jonathan Mott said.

CBA said it was in talks to sell its life insurance business, although it did not name any potential buyer and added that the outcome of the negotiations was uncertain.

Growth in home lending and a drop in expenses related to bad debts helped CBA pip average analyst forecasts for a A$9.83 billion profit for the 12 months to June 30.

Net interest margin, the difference between interest costs and interest earned, was unchanged in the second half at 2.11 percent, while loan impairment expenses dropped about 13 percent.

CBA declared a fully-franked dividend of A$2.30 per share, for a yearly final dividend of $4.29 per share, up 2.1 percent.

Corporate operating expenses jumped 20 percent due to higher costs of technology and safeguarding information, reporting requirements and anti-money laundering measures. The bank said it had spent A$3.64 billion on risk and compliance.

Livingstone said the bank had made progress in beefing up its anti-money-laundering programs since late 2015, including recruiting more than 50 compliance staff.

($1=1.2642 Australian dollars) (Reporting by Paulina Duran and Byron Kaye in Sydney, Rushil Dutta in Bengaluru; Editing by Stephen Coates & Shri Navaratnam)