The Government has backed away in the face of speculation that it will impose a windfall tax on banks to punish them for paying excessive bonuses.

The move came yesterday as City lawyers warned that rushing through legislation to crack down on bonuses would be unworkable and a legal minefield. Downing Street distanced itself from a controversial one-off windfall tax, telling banks that it was up to them to ensure that they were acting appropriately, but the Conservatives have said that they may impose a one-off levy.

Even if a windfall tax — as was levied on banks in 1981 and on utilities in 1997 — is abandoned, other forms of legislation could be considered. Lord Myners, the City Minister, and other senior politicians have turned up the heat on bankers’ bonuses, which are set to explode again as a political issue as banks are nearing the end of the year. Several are preparing to pay bumper rewards despite having almost collapsed in the past year because of the global financial crisis.

The Government could introduce a law that caps bonuses at a fixed amount or imposes greater restraint through new guidelines. This would mark a U-turn for the Treasury and the Financial Services Authority (FSA), the City regulator, which have said that it was for the private sector to set remuneration.

The Government is running out of time to make such a bold move, lawyers said. Alistair Woodland, a Clifford Chance partner, said: “It would be very difficult for the Government to get through primary legislation to limit or cap bonuses before they are paid out for 2009.”

Bringing in a law after the 2009 payouts would be even harder. “It is just not practical to try and recover money from individuals once it has been paid out,” Mr Woodland said.

David Berman, a partner with Macfarlanes, warned that it would be hard to draft the legislation: “If the litmus test were to centre around a concept such as ‘excessive remuneration’ — as it well might — how do you define or quantify excessiveness? If a proprietary trader has earned £50 million for his bank, is it excessive to pay him 5 per cent, 10 per cent or 15 per cent of that?”

Attempts to ban mega-payouts for this year would be far more difficult than setting policy for the future because of a clash with contracts. Mr Berman said: “Some banks could end up in the unenviable position of having to comply with new rules which may well be inconsistent with existing employee contracts. Ironically, this would be likely to lead to a compensatory payment to the employee.”

Any new legislation would be on top of the pay guidelines set out by the FSA in August and the G20 pledges of last month. Under both, banks must pay a substantial amount of bonuses in shares rather than in cash, and bonuses must be deferred over several years. There is to be a “clawback” feature, such that if a deal caused a bank to lose money, the bonus to which it was linked could be retracted.

To avoid the charge of creating an unfair playing field, the Government would be under pressure to treat Royal Bank of Scotland and Lloyds, which received £37 billion in taxpayers’ help, the same as banks that benefited from systemic support but did not take direct capital injections, such as Barclays.

Downing Street would probably want to include foreign banks operating in London as well as native lenders in any new crackdown on bonuses. Large American-based investment banks, such as Goldman Sachs, signed up to the G20 pledges and come under the remit of the FSA, but may fight any new legislation in the UK over bonuses.

Lawyers said that the Government could have leverage over bonuses granted by foreign banks by getting the FSA to withhold the “approved person” status of anyone deemed to have been paid an excessive sum.

• Seven months after President Obama vowed to use “every single legal avenue” to prevent the payment of bonuses at AIG, the insurance giant, a new White House approach to Wall Street bonuses has emerged along with the early signs of recovery — indignation, but no compulsion. Talk of legal redress was absent even against groups that have survived thanks to tax-funded bailouts, as White House advisers urged banks to stop resisting regulatory reform.

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