(Reuters) - The Federal Reserve is expected to soon allow some healthy banks with strong capital levels to increase dividend payments, according to people familiar with the decision.

The Fed's updated guidance is likely a few weeks away. It is expected to take a conservative approach in deciding which banks can increase dividends and assess each bank individually, according to a person familiar with the matter.

Banks have been pushing to boost dividends. But regulators have balked at giving them the green light, citing uncertainty about the economic outlook and new capital rules.

With global capital rules and the U.S. financial regulatory system retooling farther down the track, the environment is more conducive to letting strong banks increase dividend payments.

The Fed does not want to prevent banks that are viewed as particularly strong from boosting dividends, a source said.

The news of the Fed move was first reported by the Wall Street Journal. The KBW Bank Index closed up 3.6 percent on Thursday. The Dow Jones industrial average ended 1.96 percent higher.

Industry officials welcomed the news.

"The economy and many older Americans rely on dividends and, if a bank is strong enough, it should be allowed to resume paying dividends," said Scott Talbott, an executive at The Financial Services Roundtable.

Banks are better capitalized than they have been for some time, and the largest ones have the highest capital levels in years, according to analysts.

"If you've seen the numbers that the banks are producing, things are getting a lot better," said Greg Donaldson, founder of Donaldson Capital Management in Evansville, Indiana.

Retail investors are still significantly invested in banks and have been hankering for dividends, he said. Investors are saying, "We want action. You're sweet talking us, you're telling us things are getting better -- well, show us!... If things are really getting better, show me the cash!" he said.

Uncertainty over how much more capital banks would have to keep on hand to satisfy new domestic and international bank rules had been an obstacle to allowing banks to raise dividends.

That obstacle has been partially cleared after international regulators last month struck a deal on so-called Basel III capital rules. The accord is expected to be endorsed by leaders from the Group of 20 developed and emerging nations later this month in Seoul.

The new Basel rules will force banks to hold top-quality capital equal to 7 percent of risk-bearing assets, more than triple current standards, to better withstand economic downturns and financial shocks.

Banks will have until 2015 to meet the minimum core Tier 1 capital requirement, which consists of shares and retained earnings worth at least 4.5 percent of assets. An additional 2.5 percent "capital conservation buffer" will have to be in place by 2019.

In order to be allowed to boost their dividend, banks will not necessarily have to be able to meet this standard now but they will have to have a detailed plan for doing so, according to a source. They also will have to include in their plans any capital standards they have to meet under the new Dodd-Frank financial reform law.

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