UPDATE 3-UK regulators say won't apply EU bonus cap to all banks

* UK plans to exempt bankers working for smaller lenders

* UK regulators believe there is flexibility in rules

* EU authorities to hold off from legal challenge for now (Adds European Commission reaction)

By Huw Jones

LONDON, Feb 29 (Reuters) - British financial regulators havesaid they won't apply the European Union's cap on banker bonusesto smaller lenders because they pose fewer risks to thefinancial system.

Under EU rules, all bonuses should be no bigger than fixedpay but can rise to twice that amount with shareholder approval.London has the largest number of bankers hit by the cap, whichextends to asset managers in a banking group.

The reform was aimed at quelling public anger over largebonuses at a time of austerity in many EU states following thefinancial crisis.

National regulators must explain if they diverge from therules as set out by the bloc's European Banking Authority (EBA).

The Bank of England's Prudential Regulation Authority, andthe Financial Conduct Authority said in a joint statement theyhave told the EBA that they disagree with a blanket applicationof the bonus cap rule on all firms.

The PRA and FCA said they interpreted EU law as allowing forflexibility in relation to the size and complexity of a lender.

"The PRA attaches a great deal of importance to theprinciple of applying policies in a proportionate mannerconsistent with the legal provisions," Bank of England DeputyGovernor and PRA Chief Executive Andrew Bailey said in astatement.

More flexibility in applying financial regulation fromBrussels was at the core of Britain's "new settlement" negotiated 10 days ago by Prime Minister David Cameron before aBritish vote in June on whether to stay in the EU.

London's banking sector is among the industries with most tolose if Britain leaves the EU, according to many economists whosay an exit could hamper its ability to operate in the singleEuropean market and lead to thousands of jobs being shifted tothe euro zone.

"The PRA and FDA's announcement will come as a big relief tosmaller banks and asset managers in the UK who had beenconcerned that the cap would apply to them from 2017. It remainsto be seen whether any other EU regulators will take a similarapproach," said Alexandra Bedims, an employment lawyer atLinkages.

Britain was outvoted on the EU law capping bonuses, sayingit would prompt banks to raise fixed pay and make them lessnimble in cutting costs in a market downturn.

The EBA noted on Monday an announcement it made last yearthat the cap should be applied without exemptions.

The bloc's executive European Commission has powers to takea member state to court for not complying with EU rules. It isalready assessing an EBA recommendation to give smaller lendersmore flexibility on some aspects of banker pay rules.

"At this stage it is too early to talk about whether or notto launch infringment proceedings. The Commission needs to firstcarefully look into and assess the detailed information providedby EBA," a Commission spokeswoman said.

The UK regulators said that all large and systemicallyimportant banks, which would include RBS, Lloyds, HSBC andBarclays, must continue to apply the bonus cap.

(Editing by Adrian Croft and Keith Weir)