George Osborne has conceded defeat in his attempt to overturn the EU cap on bonuses after a senior legal advisor at the European court of justice rejected his arguments.

Instead the chancellor raised the prospect of forcing changes to the way bankers are paid, by having their salaries – not just their bonuses – clawed back when errors are made.

He took his decision after one of the ECJ’s advocate generals, recommended upholding the EU law on bankers’ bonuses that restricts payouts to 100% of a bankers’ salary, or 200% if shareholders grant their approval.

The opinion – although not binding – was seen as a blow to the chancellor who gave his backing to ideas floated by Mark Carney and other central bankers to force change in the way bankers are paid.

Osborne wrote to Carney – in his capacity as head of the financial stability board – on Friday night to set out his views on the need for further reform. The FSB was set up after the banking crisis to create global standards for banks.

Osborne said: “I’m not going to spend taxpayers’ money on a legal challenge now unlikely to succeed. 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.”

Osborne and officials at the Bank of England have warned that bankers’ fixed pay will rise to compensate for the lower bonus potential. As it is, bankers were being handed “allowances” alongside their salaries and bonuses – a move which the European Banking Authority had concluded was circumventing the bonus cap.

The Treasury said the advocate general of the European Court of Justice confirmed that argument, highlighting that the legislation provides no restriction on fixed pay, which is already increasing because of the limit on bonuses. “But it has also made it very clear that the government’s legal challenge is unlikely to succeed.

A spokesman said: “We will therefore withdraw the challenge, and instead look at other ways of building a system of pay in global banking that encourages rather than undermines responsibility. For example, it may be necessary to develop standards that ensure non-bonus or fixed pay is put at risk, maximise claw back, or pay senior staff in performance-related bond.”

Such an idea was floated by Carney this week when he said fines were not enough to change behaviour. It is based on ideas put forward by US regulators.

The Treasury had argued that the EU overstepped its remit by legislating on bankers’ bonuses and imposed the law in a rushed way without any assessment of its impact. But the advocate general dismissed all the UK’s arguments in an opinion that said European regulators had the legal authority to introduce the cap and had not infringed UK sovereignty. He also argued that it was wrong to characterise the bonus restrictions as a cap on pay, because basic salaries were not fixed.

A final judgment from the court is expected by early February, just as thousands of bankers in the City are waiting to hear how much their bonus cheques will be worth.

Many legal experts think the court will follow this latest opinion, leaving the bonus cap in place.

“It seems unlikely now that the court will overturn the advocate general’s opinion, so banks should continue planning on the basis that the bonus cap will still be in force next year,” said Tom Gosling, head of PwC’s reward practice.

Jake Green, a senior associate at Ashurst, said although the advocate general’s conclusion was expected, the forcefulness of his arguments came as a surprise. “It seems so thoroughly reasoned and absolute in its conclusions and perhaps that is the surprise. There is no fence-sitting on any of the issues.”