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George Osborne on Thursday night abandoned his bid to overturn the EU banker bonus cap, saying he would focus on reforming global rules on pay rather than wasting more money on a hopeless lawsuit.

The chancellor’s decision to raise the white flag came after an adviser to Europe’s highest court rejected London’s case, saying the restrictions on bonuses as a ratio of salary were legally sound.

In response to the setback, Mr Osborne has written to Mark Carney, the governor of the Bank of England, urging him to press the case for tougher global standards with penalties for bankers who break rules that put their salaries at risk as well as their bonuses.

The move effectively endorses a speech by Mr Carney this week that called for new pay structures to reduce risk-taking and short-term thinking, including through senior staff taking some salary as “performance bonds”.

The withdrawal of the suit is Mr Osborne’s third such defeat at the European Court of Justice. His legal action over the short-selling curbs and the proposed financial transaction tax found little sympathy in Luxembourg.

Britain last year ordered legal action against the bonus curbs on the grounds that they would hurt financial stability by creating “perverse incentives” to raise fixed pay.

While his legal arguments were dismissed, Mr Osborne said the opinion of Niilo Jääskinen, the court’s advocate general, vindicated his prudential concerns because he made clear that the cap did not represent a limit on overall pay.

“Fixing the ratio of variable remuneration to basic salaries does not equate to a ‘cap on banker bonuses’, or fixing the level of pay, because there is no limit imposed on the basic salaries that the bonuses are pegged against,” Mr Jääskinen concluded, according to a summary of the opinion.

Mr Jääskinen also rejected the UK’s argument that the measures were disproportionate, breached privacy rights, overstepped the regulatory authority of the European Banking Authority and impaired employment contracts signed before the legislation was passed.

Mr 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.”

Writing to Mr Carney in his capacity as chairman of the Financial Stability Board, Mr Osborne said he “strongly supported” efforts to set global standards on pay to encourage “sound risk taking by financial institutions” and address the shift towards fixed pay in Europe.

The chancellor specifically mentioned the idea of performance bonds, first floated by Bill Dudley, president of the New York Federal Reserve, which would increase accountability by putting more of senior bankers’ remuneration at risk.

London is home to the vast majority of high-earning EU bankers, and the Prudential Regulation Authority has the responsibility of enforcing a bonus cap from next year, even though the UK argues it is unlawful and misconceived.

Last month, the EBA challenged the PRA for permitting the widespread use of allowances that were circumventing the bonus cap. It called on national authorities to take “all necessary measures” to ensure allowances were adjusted to comply with the law, but the PRA has taken no steps to force banks to revise their plans for the 2014 pay year.

The defeat at court is likely to lead to the PRA gradually enforcing a stricter interpretation of the bonus cap, which will in turn increase fixed pay at many banks, according to pay consultants.

The most recent EU capital requirements directive limits bonuses to no more than 100 per cent of salary – or 200 per cent with shareholder approval. Mr Osborne spent £46,000 in outside legal fees in his bid to overturn it.

In most ECJ cases, the judges follow the advice of the advocate general, but in a minority of rulings there can be significant differences. In its challenge to curbs against short-selling, for instance, the UK was backed by Mr Jääskinen only for that advice to be ignored in the final judgment.

Before the withdrawal of the case, the British Bankers’ Association said it continued to support the Treasury’s challenge. “We believe that shareholders should be given powers to determine staff pay – not politicians,” said the BBA.

“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.”

Ed Balls, Labour’s shadow chancellor, accused Mr Osborne of trying to sneak out “a humiliating climbdown” under the cover of the Rochester and Strood by-election.

“The chancellor revealed his true priorities when he decided a year ago to spend taxpayers’ money fighting a bank bonus cap while working families face a cost-of-living crisis. He should tell taxpayers how much money he has now wasted on this challenge, which we warned him against.”

Additional reporting by Claer Barrett and George Parker in London

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