* 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 on Wednesday to water down EU legislation to cap banker bonuses as Brussels edged towards agreement on pay curbs officials hope will address public anger at financial sector greed.
Limits to bankers' pay are popular on a continent struggling to emerge from the ruins of a 2008 financial crisis. Lavish bonuses are blamed for encouraging bankers to take excessive risks, 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 to keep staff, making wage bills less flexible.
Britain in particular is wary of any measure that might hurt the City of London, the continent's financial capital, with 144,000 banking staff and many more in related jobs.
In a document seen by Reuters spelling out Britain's concerns, British officials warned a cap would encourage a "sharp increase in fixed salaries" and "undo much of the positive benefit" of rules allowing bonuses to be clawed back.
Britain, anxious to protect a sector that accounts for one tenth of its economy, wants to dilute the impact of the cap by allowing higher bonuses if they were paid in share options. It accepts there should be a cap on cash bonuses.
But European lawmakers see a total cap - possibly limiting bonuses to no more than a banker's base pay or double that level if 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," said Arlene McCarthy, the British member of the European Parliament who pushed for pay reform. "The parliament is not prepared to budge. Legislators have got fed up because they don't see any restraint in the bonus culture."
Although tougher rules now seem certain, it is unclear whether a final deal can be struck at a meeting of EU country diplomats and the European Parliament to finalise the draft legislation on Wednesday.
Officials said those talks could last until midnight local time (1100 GMT), with the possibility that the row may not be resolved until a later date.
Britain could yet be outvoted as a majority of states in the 27-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 professional services in London. About 27 billion pounds ($41 billion) of bonuses have been spent over the last decade on real estate in the British capital, according to data compiled for Reuters by property firm Savills.
"This could push British political opinion and opinion in the City of London several notches more hostile to the EU than it is already," said Charles Grant of the Centre for European Reform, a think tank.
Writing in the Daily Telegraph, Norman Lamont, a former finance minister from Britain's ruling Conservative party, described the bonus cap as "economic lunacy."
Many in banking argue that such reform will do little to lower pay in finance, where head-hunters say some annual packages in London approach 5 million pounds ($7.6 million).
"This will only change the way that pay is structured," said Andrew Breach, a head-hunter at Michael Page, which recruits traders and other bankers. "This is not the civil service. This is a market-driven industry. If you want people to make profit, then you need to reward them."
An earlier attempt to limit bankers' pay with an EU law forcing financiers to defer bonus payments over up to five years merely prompted lenders to increase base salaries.
However McCarthy, the European lawmaker, said it would be harder for banks to raise base pay this time around. The bonus rules will come as part of wider legislation setting higher capital standards for banks, increasing their costs and curbing freedom to hike salaries.
Hedge funds and private equity firms will be excluded from such curbs although they face restrictions on pay later this year under another EU law.
Bankers who spoke to Reuters are worried about the law but reluctant, like many of their employers, to speak openly about the reform.
The restrictions planned by Brussels, which could come into force from the beginning of next year, may, however, be overtaken by events in an industry where slack activity has already driven down most bonuses to twice salary or lower.
Having peaked in 2008 at 11.5 billion pounds ($17.4 billion), the bonus pool in London fell to 4.4 billion pounds last year, according to research by the Centre for Economics and Business Research. It predicts that pool will be just 1.5 billion pounds this year and fall further in the future.
On Wall Street, by contrast, the securities industry's bonus pool was expected to total $20 billion last year with the average cash bonus rising an estimated nine percent to almost $121,900, New York state's comptroller said this week.