Image caption Europe's Advocate General has upheld limits on London bankers' bonuses

In a surprise move, the UK government has withdrawn its legal challenge to EU legislation that caps the level of bankers' bonuses.

Chancellor George Osborne said he had recognised the challenge was "now unlikely to succeed".

The move comes after an adviser to the European Court of Justice rejected the UK's legal arguments against the plan.

The cap restricts bonuses to 100% of banker's pay or 200% with shareholder approval.

The Treasury had argued that the cap would drive talent out of Europe and inflate basic pay, making it harder for banks to trim costs in lean years.

"I'm not going to spend taxpayers' money on a legal challenge now unlikely to succeed," Mr Osborne said.

But he added: "The fact remains these are badly designed rules that are pushing up bankers' pay not reducing it. These rules may be legal but they are entirely self-defeating, so we need to find another way to end rewards for failure in our banks."

The cap on the ratio is designed to reduce incentives for bankers to take excessive risks, but critics say it will push up basic pay and banks' costs.

'Restoring trust'

Labour's Shadow Chancellor, Ed Balls said: "This is a humiliating climb down by George Osborne.

"He should tell taxpayers how much money he has now wasted on this challenge, which we warned him against.

"It shouldn't have taken the EU to act to rein in excessive bonuses, but George Osborne has totally failed to act here in Britain."

Mr Osborne also wrote a letter to Bank of England governor Mark Carney, in which he said that although the Treasury was abandoning its challenge, it "should not stop us from pursuing our objective of ensuring a system of remuneration that encourages responsibility instead of undermining it".

"Ensuring that firms incentivise employees to behave in the right way is essential to restoring public trust in financial markets," he added.

Mr Carney had himself voiced concerns about the EU measure, saying it had the "undesirable side-effect of limiting the scope for remuneration to be cut back".

Image copyright PA Image caption Mr Osborne had strongly opposed the EU measures

The UK government had challenged the legislation, asking the EU Court of Justice (ECJ) in Luxembourg to consider six arguments against both the scope and legal basis for the new rules.

EU legal blow

Earlier on Thursday, ECJ Advocate General Niilo Jääskinen gave an opinion that the EU legislation limiting the ratio was valid.

Mr Jääskinen, one of nine advocates-general who advise the ECJ, rejected all the UK government's legal and technical arguments against the EU legislation.

He said: "Fixing the ratio of variable remuneration to basic salaries does not equate to a 'cap on bankers bonuses', or fixing the level of pay, because there is no limit imposed on the basic salaries that the bonuses are pegged against."

Non-binding

A spokesman for the British Bankers' Association said: "We believe that shareholders should be given powers to determine staff pay - not politicians. That's why banks consult with investors before setting staff pay and shareholders also have the power to vote on the pay of senior bankers.

"We believe this law runs counter to recent reforms and will make the system less robust by incentivising firms to increase fixed pay. It also puts European banks at a disadvantage when competing with firms in other parts of the world."

The Luxembourg court would have considered Advocate General Jääskinen's reasoning in reaching its verdict.

Historically, around three quarters of the opinions of Advocate Generals have been adopted by the Court.

A final ruling was not expected until next year.

UK and EU banking regulators have also clashed over attempts by British banks to sidestep the bonus cap by awarding banking executives "allowances", paid alongside salaries to bolster their pay.

Analysis: Theo Leggett, Business Correspondent

The advocate general's opinion may not be legally binding, but it still amounted to a slap in the face for the UK government.

The new rules were introduced to prevent senior bankers from taking excessive risks in the hope of gaining big short term rewards. EU policymakers think this kind of behaviour was one of the factors which led to the financial crisis.

But the UK government thinks there's no evidence to suggest a bonus cap will make the banking system any safer. In fact, it believes it could make matters more precarious - because large fixed salaries aren't as easy to cut during a downturn.

The government put forward six legal arguments to support its case; the advocate general decided none of them held water.

However, he did make one rather interesting point. He said that because the level of bonus is linked to annual salary, and there is no cap on salaries, there is not really a bonus cap at all.

That is a point the Treasury agrees with wholeheartedly - and which it claims undermines the whole rationale of the new rules.