The scheme should leave banks with more money to lend
The Treasury is to announce an insurance scheme for banks next week to try to revive confidence in the industry, the BBC has learned.
It would allow banks who pay a fee to have their bad loans underwritten by the taxpayer up to a certain level.
BBC business editor Robert Peston says the move is designed to avert a further loss of confidence ahead of gloomy results expected from the big banks.
Treasury officials and bank executives have spent the weekend in talks.
The BBC's business editor said: "It'll be designed to give banks and their investors a bit more certainty about the losses they'd face as the recession undermines the ability of many borrowers to repay their debts.
"Our biggest banks would identify their bad loans and foolish investments, then pay a fee to a new state-backed insurer to protect themselves from the losses over a certain level."
He added the government wants to prevent another "alarming" loss of confidence in the banking system weeks before HBOS and the Royal Bank of Scotland announce "unprecedented" losses.
Britain's largest banks suffered sharp share price falls last week.
Under the proposals, banks would examine both corporate and private customers looking for potential defaulters.
They would then approach the new state-controlled insurance company, which in return for a premium would provide cover in the event of those customers not paying their bills.
Having insured themselves against potential losses, the banks would have more money to lend because they would not have to set aside vast sums in anticipation of bad debts.
Earlier, Prime Minister Gordon Brown said talks with international leaders were ongoing to tackle the global financial crisis caused by the failure of banking systems.
He said in Britain he would adopt measure to help families feel secure about their savings so mortgages can be provided and businesses can get loans.
He also demanded that banks admit how many "toxic assets" they have on their balance sheets.
Mr Brown told the Financial Times the banks had to "come clean" about these bad debts so people could trust them again.
He said: "One of the necessary elements for the next stage is for people to have a clear understanding that bad assets have been written off.
"We have got to be clear that where we have got clearly bad assets, I expect them to be dealt with."
In the FT interview, Mr Brown refused to rule out further bank nationalisation plans.
Liberal Democrat Treasury spokesman Vince Cable said an insurance scheme may have to be tried.
But he said: "We do need to establish first of all what happened to the £37bn worth of taxpayers' money that's already gone into the banking system.
"Where did it go? Why isn't it coming out in the form of new lending?
"There is a real crisis at the moment that very large numbers of very good British companies, completely solvent companies, cannot raise credit from the bank.
"They cannot be allowed to go down in large numbers taking large numbers of jobs with them, simply because the banks aren't functioning properly."
BBC business correspondent Joe Lynam said amid a deepening downturn the prospect of more taxpayer support to banks may be unpalatable for those facing redundancies in industries which have been starved of credit.