Royal Bank of Scotland Group Plc warned it could struggle to hire and retain key staff after the UK government demanded control of bonuses as a condition for insuring its bad debts.

Bailed-out RBS, set to become 84 percent state-owned after the latest aid package, detailed the unprecedented direct intervention ahead of a shareholder meeting later this month to vote on its participation in the state-backed Asset Protection Scheme (APS) for toxic loans.

RBS said it had been forced to agree to restrictive terms in order to join the scheme, including a clause that hands the Treasury -- through UK Financial Investments (UKFI), which manages government holdings in rescued banks -- the right to consent to the quantum and shape of the 2009 bonus pool.

Chief Executive Stephen Hester said the risks to the bank's recovery were real, warning lawmakers on Wednesday of the tension between short-term political pressures on the government and the longer-term aim of turning around the bank.

There is a tightrope to be walked on this issue, he said. If RBS is unable to retain and motivate staff it will be very difficult to fulfill our goal of making the bank safe, serving customers or of having the taxpayer get their money back.

But Hester said he was confident the Treasury would not abuse its right to interfere in the bank's commercial business.

I believe the intent is not to misuse the rights ... so we may get through all this in a sensible way, he said.

A Sky News report late on Wednesday, citing undisclosed sources, said the RBS board has threatened to resign en masse if the government vetoes bonus payments approved by its directors or was asked to do anything that was not in the interest of its shareholders.

An RBS spokesman declined to comment on any future intentions of the board when contacted by Reuters about the report.

The government is facing public anger over the return of fat cat bonuses and hefty pay packages at rescued banks such as RBS, whose problems put it at the center of the crisis.

But RBS and its investors fear a state veto on pay will hinder its efforts to rebuild its battered Global Banking and Markets investment banking arm.

Depending on UKFI's approach to recommendations made by the board in respect of that bonus pool, this requirement may adversely impact RBS's ability to attract and retain senior managers and other key employees and thereby place RBS at a significant competitive disadvantage, the bank said in the circular.

The move could also increase the risks facing RBS and weaken management's ability to deal with them, it said.

RBS already faced negotiations with the government over 2008 bonuses after it was rescued from near collapse, but news of an explicit veto demand for this year's compensation added to pressure on RBS shares in a weak market on Wednesday.

The stock fell almost 8 percent during the day, though it recovered to close down 2.1 percent at 33.6 pence, not far from a seven-month low of 29.62p hit last week.

INVESTORS FRET

The precondition, which emerged on Wednesday, worried institutional investors. Led by the Association of British Insurers, they cautioned short-term pressures on the bank's largest shareholder, the government, should not be allowed to damage the long term.

Mindful of their fiduciary obligations to their beneficiaries, shareholders will look for an approach which protects the long-term value of their investments, said Peter Montagnon, director of investment affairs at the ABI.

This means the bank must not overpay, but it must also be able to pay commercial rates. The ABI is expected to put an amber top warning for shareholders on the issue on Thursday.

Global Banking and Markets, a key profit driver before the crisis, has been hit by poaching from rivals and has abandoned some business areas, with headcount falling by 1,500 staff, or 8 percent, in the first half. It employs around 20,000.

RBS has repeatedly said there may be a damaging but not yet destructive exodus, but its far tougher comments in the circular indicate risks could increase, particularly as profit and compensation begin to recover across the sector.

The bank said no proposals on bonuses had been made or would be until after the end of the year.

RBS, along with bailed-out Lloyds Banking Group Plc , already agreed last month to ban cash bonuses this year for staff earning over 39,000 pounds ($64,600) a year.

It can take some comfort, however, from comments made by UKFI's outgoing boss, who has said the body is aware of the balance between changing a culture and losing value.

RBS shareholders meet on December 15 to decide whether to back a decision to join the APS.

The Treasury did not have any immediate comment.

(Reporting by Clara Ferreira-Marques and Steve Slater; Additional reporting by Stefano Ambrogi; Editing by David Holmes, Will Waterman and Richard Chang)

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