UPDATE 1-Britain seeks to water down EU cap on banker bonuses

* European Union seen capping banker bonuses

* Britain argues cap would see "sharp increase" in salaries

* Lawmaker McCarthy says European Parliament will not budge

* Talks could last until 1100 GMT, row may not be resolved

By John O'Donnell and Claire Davenport

BRUSSELS, Feb 27 (Reuters) - Britain was fighting onWednesday to water down EU legislation to cap banker bonuses asBrussels edged towards agreement on pay curbs officials hopewill address public anger at financial sector greed.

Limits to bankers' pay are popular on a continent strugglingto emerge from the ruins of a 2008 financial crisis. Lavishbonuses are blamed for encouraging bankers to take excessiverisks, destabilising banks that then needed to be bailed out.

Industry lobbyists have strongly resisted bonus caps,arguing such limits would only force banks to hike base pay tokeep staff, making wage bills less flexible.

Britain in particular is wary of any measure that might hurtthe City of London, the continent's financial capital, with144,000 banking staff and many more in related jobs.

In a document seen by Reuters spelling out Britain'sconcerns, British officials warned a cap would encourage a"sharp increase in fixed salaries" and "undo much of thepositive benefit" of rules allowing bonuses to be clawed back.

Britain, anxious to protect a sector that accounts for onetenth of its economy, wants to dilute the impact of the cap byallowing higher bonuses if they were paid in share options. Itaccepts there should be a cap on cash bonuses.

But European lawmakers see a total cap - possibly limitingbonuses to no more than a banker's base pay or double that levelif bank shareholders agree - as the only way to rein in pay,reduce incentives for risk and make banks safer.

"A cap is the only way we will see bonus restraint," saidArlene McCarthy, the British member of the European Parliamentwho pushed for pay reform. "The parliament is not prepared tobudge. Legislators have got fed up because they don't see anyrestraint in the bonus culture."

Although tougher rules now seem certain, it is unclearwhether a final deal can be struck at a meeting of EU countrydiplomats and the European Parliament to finalise the draftlegislation on Wednesday.

Officials said those talks could last until midnight localtime (1100 GMT), with the possibility that the row may not beresolved until a later date.

Britain could yet be outvoted as a majority of states in the27-member bloc would be sufficient to introduce the measure,pushed for by the European Parliament.

"There will definitely be a bonus cap," said one official."It's just a question of how much."

Nearly 700,000 people work in financial and professionalservices in London. About 27 billion pounds ($41 billion) ofbonuses have been spent over the last decade on real estate inthe British capital, according to data compiled for Reuters byproperty firm Savills.

"This could push British political opinion and opinion inthe City of London several notches more hostile to the EU thanit is already," said Charles Grant of the Centre for EuropeanReform, a think tank.

Writing in the Daily Telegraph, Norman Lamont, a formerfinance minister from Britain's ruling Conservative party,described the bonus cap as "economic lunacy."

Many in banking argue that such reform will do little tolower pay in finance, where head-hunters say some annualpackages in London approach 5 million pounds ($7.6 million).

"This will only change the way that pay is structured," saidAndrew Breach, a head-hunter at Michael Page, which recruitstraders and other bankers. "This is not the civil service. Thisis a market-driven industry. If you want people to make profit,then you need to reward them."

MARKET-DRIVEN

An earlier attempt to limit bankers' pay with an EU lawforcing financiers to defer bonus payments over up to five yearsmerely prompted lenders to increase base salaries.

However McCarthy, the European lawmaker, said it would beharder for banks to raise base pay this time around. The bonusrules will come as part of wider legislation setting highercapital standards for banks, increasing their costs and curbingfreedom to hike salaries.

Hedge funds and private equity firms will be excluded fromsuch curbs although they face restrictions on pay later thisyear under another EU law.

Bankers who spoke to Reuters are worried about the law butreluctant, like many of their employers, to speak openly aboutthe reform.

The restrictions planned by Brussels, which could come intoforce from the beginning of next year, may, however, beovertaken by events in an industry where slack activity hasalready driven down most bonuses to twice salary or lower.

Having peaked in 2008 at 11.5 billion pounds ($17.4billion), the bonus pool in London fell to 4.4 billion poundslast year, according to research by the Centre for Economics andBusiness Research. It predicts that pool will be just 1.5billion pounds this year and fall further in the future.

On Wall Street, by contrast, the securities industry's bonuspool was expected to total $20 billion last year with theaverage cash bonus rising an estimated nine percent to almost$121,900, New York state's comptroller said this week.