By Sumeet Desai

LONDON (Reuters) - The government plans to raise the maximum compensation for victims of bank failures to 50,000 pounds but banks will not have to pay money upfront into the deposit protection scheme, the Treasury said on Tuesday.

In a consultation document on reforming the banking system in the wake of last year's run on mortgage lender Northern Rock, the Treasury concluded it would be wrong for banks to pay more money when they are rebuilding their capital positions.

The paper proposed as the lead option an increase in the compensation limit for protected deposits to 50,000 pounds, on a per person per bank basis.

"The Financial Services Authority (FSA) will explore with the financial sector ways for customers to cover amounts above the compensation limit and the appropriate coverage for client accounts and similar arrangements," the Treasury said.

The 50,000 pound limit was expected but banks, who have been worried by the prospect they might have to pay billions of pounds into the scheme when their balance sheets are under strain because of the global credit crunch, will be relieved to hear there are no upfront costs.

The Treasury is keeping open the option of a pre-funded scheme in the future. The United States requires its industry to have such a compensation scheme.

The British Bankers' Association said no pre-funding was needed. "What we want is a system that works, that intervenes quickly, that frees deposits when necessary and has the ability to top up as and when required. None of that requires a pre-fund," said Angela Knight, chief executive of the lobby group.

Under the plans which could come into effect later this year, savers will have up to 50,000 pounds of their deposits protected in the event of a bank failing.