The directors of the Royal Bank of Scotland are threatening to resign if the Treasury stops them paying bonuses of £1.5bn to staff in its investment arm.
RBS board members sought legal advice after the Chancellor, Alistair Darling, said the government would have the right to veto excessive bonuses.
They have been advised to resign if the bank, which is 70 per cent state-owned, loses the power to raise bonus levels.
Under the terms of the latest deal to insure bad debts, RBS will have to agree the size of this year's payouts with UK Financial Investments (UKFI), the body set up to manage the public stakes in banks.
A Treasury spokesman said: "As a major shareholder, UKFI needs to be satisfied that RBS's approach to remuneration is in keeping with the FSA's code of practice. We expect other institutional shareholders will be equally concerned to ensure remuneration practices do not pose a risk to the stability of the organisation."
"We expect other institutional shareholders will be equally concerned to ensure remuneration practices do not pose a risk to the stability of the organisation," the Treasury added.
RBS reportedly wants to pay £2bn in bonuses across the group for 2009.
"Our agreed business plan requires us to operate commercially in competitive markets and this plan underpins the prospects of recovering value for taxpayers and shareholders alike," the bank said.
News of the dispute came as City minister Lord Myners warned that at least 5,000 UK bankers will earn more than £1 million this year unless the government intervenes. He called on shareholders to act before it was too late.
He said there was "precious little evidence" that bank executives appreciated "the concern about these extraordinary levels of income".
The TUC general secretary, Brendan Barber, said: "The banks nearly brought down the whole economy only a year ago. Few would have survived without Government or Bank of England help. Yet now we learn that they are back to the bad old days when they confused their telephone numbers with what they were paid."
