Britain blocks Royal Bank of Scotland bonus plan

* RBS (LSE: RBS.L - news) had planned to pay bonuses worth double salary

* UK government told bank it opposed the move

* Government says would back similar proposal from Lloyds

* Lawmaker Tyrie questions independence of UKFI

* RBS CEO Ross McEwan awarded 5.4 mln stg package (Adds lawmaker comment on UKFI)

By Matt Scuffham and Chris Vellacott

LONDON, April 25 (Reuters) - Britain has blocked plans by state-controlled Royal Bank of Scotland to pay bonuses worth double an employee's fixed salary, adding to the pressure on banks to rein in pay.

Banks across Europe have come under fire from the public, shareholders and politicians for extravagantly rewarding staff at a time of austerity that was brought on in part by the reckless lending of some financial groups.

British Business Secretary Vince Cable this week wrote to banks and other big companies warning them to cut out excessive rewards or face tighter rules. He said banks needed to address "dangerous levels" of pay.

Banks, however, argue they need to compete for talent with overseas rivals, particularly those in the United States.

The European Union has introduced a rule, which will apply to awards handed out from early 2015, that bankers' bonuses can be no higher than fixed pay, or twice that level with shareholder approval.

Britain has launched a legal challenge against the rule, saying it could make banks riskier if they respond by increasing employees' base salaries, which cannot be clawed back later if the future of the bank is under threat.

However the UK government, which owns an 81-percent stake in the Royal Bank of Scotland (RBS) after bailing it out at the height of the financial crisis, said on Friday the loss-making bank was not performing well enough to justify higher bonuses.

"RBS is heading in the right direction, but it has not yet completed its restructuring and remains a majority publicly-owned bank. So an increase to the bonus cap cannot be justified and the government made clear it would not have supported such a proposal," a finance ministry spokesman said.

With the prospect of losing a vote on its bonus proposal at its annual shareholder meeting in June, RBS said it was withdrawing it.

On Thursday, more than a third of Barclays (LSE: BARC.L - news) ' investors declined to back its pay policy, showing it is not just state-backed companies whose shareholders are unhappy at what they see as rewards for failure.

"We want banks to be run for the shareholders and not for the staff. It's a difficult balance but it's certainly not right at the moment," a major institutional shareholder in Barclays (Berlin: BCY.BE - news) and RBS told Reuters on Friday on condition of anonymity.

"Think what a miserable experience being a bank shareholder has been over the last few years whereas the staff have made out like bandits. Maybe the climate is such at the moment that people are prepared to wear a bit more political intervention," the shareholder added.

"TERRIBLE MUDDLE"

Britain's opposition Labour Party said on Friday the government had got itself in a "terrible muddle" over banker pay and called on Finance Minister George Osborne to drop his legal action to block the EU cap on bonuses.

"He is spending taxpayer's money on a legal fight in Brussels against the bonus cap and yet imposing the minimum cap at RBS," said Cathy Jamieson, Labour's spokeswoman for financial affairs.

Sources familiar with the matter said that UK Financial Investments (UKFI), which manages the government's stake in RBS, had initially been supportive of the RBS proposal but that the finance ministry chose not to back its recommendation.

The finance ministry's intervention raised questions over the independence of UKFI, which is meant to act like a commercial shareholder, operating at arm's length from the government and preventing political interference in the way RBS and state-backed rival Lloyds Banking Group are run.

"It is difficult to argue that RBS is operating on an arms length, commercial basis, free from government interference," said Andrew Tyrie, chairman of parliament's Banking Standards Commission, which last year called for UKFI to be scrapped.

The finance ministry said that, unlike with RBS, it would support a proposal by Lloyds to pay bonuses worth up to 200 percent of fixed pay.

Lloyds has returned to profit and the government has begun selling shares in the bank, leaving it with a 25 percent stake.

RBS in February posted an 8.2 billion pound ($13.8 billion) pretax loss for 2013 due to restructuring costs and misconduct charges.

The bank is shrinking its investment bank and selling off its U.S. business Citizens (NYSE: CIA - news) to appease lawmakers who want it to focus on lending to British households and businesses.

RBS said on Friday that the change in strategy had led to an "exodus of talented staff".

The bank said in March it was paying out 576 million pounds in staff bonuses for 2013, down 15 percent on the previous year.

Its annual report, published on Friday, showed RBS paid one unnamed person more than 5.5 million pounds last year and another two were paid more than 4 million. The bank said it paid 75 people 1 million pounds or more in 2013. Chief Executive Ross McEwan, who took up the role last October, could be paid 5.4 million pounds a year under a new pay plan.

Shares in RBS were down 0.4 percent at 1520 GMT, compared with a 3.7 percent decline in the European banking index . Shares in Lloyds were down 1 percent.

($1 = 0.5953 British Pounds) (Additional reporting by Steve Slater, Clare Hutchison and Andrew Osborn; Editing by Erica Billingham and Mark Potter)