The directors of The Royal Bank of Scotland are reportedly threatening to quit if the Treasury blocks plans to pay out an estimated £1.5 billion in bonuses to staff in its investment arm.
He told GMTV: "I think this confrontation has been a long time coming. The bank is still operating as if it is a private bank in the good old days before it had to be rescued, before Fred Goodwin ruined it and imposed vast costs on the taxpayer.
"The government said to Parliament a few weeks ago that there wouldn't be any bonuses paid to senior executives. It later emerged that in fact they would be getting cash bonuses.
"I think the government has just got to be very firm here and say, 'Well, if you want to go, you go, and we will install a team of management that is willing to run the bank in the national interest as long as it remains under public ownership'."
RBS board members were reportedly advised to resign if they lose the power to run the largely state-owned bank for the benefit of shareholders.
Chancellor Alistair Darling signalled he is prepared to veto the size of the RBS bonus pool, which is around 50 per cent bigger than last year.
Business Secretary Lord Mandelson said he "understood" the point of view of the RBS directors, but the government was entitled to demand "restraint" on bonuses.
"The government does not run RBS, it is run by its management and its board," he told BBC Radio 4's Today programme. "Equally we own a very large part of it and we are entitled to express our views as we see the public's interest, and we are entitled to represent and reflect public opinion on this equally.
"My own view and the government's view is that restraint has to be exercised by RBS and other banks.
"But I understand the point of view that RBS directors are expressing.
"They say they have to remain competitive in the market for recruiting senior executives, and that is why it is important that all the banks are equally restrained and that RBS is not singled out.
"But nobody is suggesting that will happen."
News of the row came as City Minister Lord Myners warned that at least 5,000 UK bankers will earn more than £1 million this year unless action is taken.
He called on major shareholding institutions to tackle the issue immediately before it was too late.
As part of the terms of its latest deal to insure bad debts, the Government wants to dictate both the "quantum and shape" of the payouts at RBS for 2009.
The bank, which will be 84 per cent state-owned under the terms of the Asset Protection Scheme (APS), will now 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 last night: "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."
An RBS spokesman said: "Our agreed business plan requires us to operate commercially in competitive markets and this plan underpins the prospects of recovering value for taxpayers and other shareholders alike.
"UKFI, as with our other shareholders, has to date engaged with us positively in reiterating this goal and we expect that to continue.
"At the same time we understand and embrace the need to ensure pay meets the new G20 and FSA requirements and will continue to advocate this and other ways to address public concerns relating to banks and always pay on the principle of no rewards for failure."
Lord Myners said at question time yesterday that there was "precious little evidence" that people at the top of banks appreciated "the concern about these extraordinary levels of income".
He told the Lords: "I would estimate that at least 5,000 people working in the banking industry in the UK will receive, if nothing is done, remuneration in excess of £1 million this year.
"I think the real responsibility here must lie with the shareholders. Accordingly I have written to the National Association of Pension Funds, the CBI and the TUC urging them to use their influence to persuade trustees to ask their fund mangers: 'What are you doing to stop these quite unreasonable and unjustified levels of remuneration?"'
He added: "The decisions about bonuses are going to be made over the next six to eight weeks and it is important our major institutions engage now with the companies and say that 'we will not support grotesque payments and if you persist in paying them we will exercise our votes to remove from the board the people who authorised them'."
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.
"Lord Myners is absolutely right to challenge fund managers as the representatives of the banks' owners to get tough on top bank remuneration. Surely there must be a limit to the amount of champagne that even a banker can consume in a year?"
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