UPDATE 1-BOJ may target municipal bonds to help small banks

* BOJ may lend against wider range of municipal bonds

* Policy rate likely kept on hold at 0.1 percent

* Meeting result due sometime between 0300-0500 GMT

TOKYO, April 7 - The Bank of Japan may start lending against a wider range of municipal bonds to support regional banks that have been left reeling by a domestic credit crunch and the country's worst recession since World War Two.

The central bank's board will probably keep interest rates unchanged at 0.1 percent on Tuesday after a two-day policy review, analysts said. It will focus instead on easing a credit squeeze gripping smaller banks and businesses.

The BOJ may expand the range of municipal bonds it accepts as collateral for loans to include those sold to banks in private placements, the Nikkei business daily reported on Monday without citing sources.

The BOJ now accepts only municipal bonds sold in public auctions. Privately placed municipal bonds, held mostly by small regional banks, are excluded from market operations because of poor liquidity.

"This is a policy designed to improve liquidity at smaller banks," said Hirokata Kusaba, senior economist at Mizuho Research Institute.

"It could be seen as a pre-emptive measure the BOJ is considering just in case credit markets start to tighten again around earnings season."

Nearly 40 percent of municipal bonds issued in Japan are placed privately, mainly to regional banks. Outstanding issuance of municipal bonds, at 66 trillion yen ($653.4 billion) as of the end of last year, is less than 10 percent the size of the government bond market, BOJ data shows.

TINKERING ON MARGINS

By expanding the list of collateral, however, the BOJ would be tinkering on the margins rather than making a drastic move to flood the banking system with liquidity.

"I can appreciate the BOJ's efforts, but I can't imagine that would drastically help improve financing at financial institutions," said Junko Nishioka, chief Japan economist at Royal Bank of Scotland.

The BOJ has cut rates twice since October to cushion the economy from the shock of the global financial crisis triggered by the collapse of the U.S. mortgage market in 2007.

It has also moved to prevent credit to companies from drying up after Western bank failures spooked Japanese lenders and bankruptcies in the country soared as an export slump slashed sales and profits.

The BOJ has bought corporate debt from banks, offered subordinated loans to them and increased its purchases of government bonds. The last move effectively caps long-term interest rates, keeping the cost of financing public debt low for the government and allowing banks to sell bonds to cover stock losses without taking a hit on the debt market.

Bond yields have risen on worries over bond oversupply as the government unveiled on Monday its plan for a new stimulus package worth more than 2 percent of GDP.

The benchmark 10-year government bond yield stood at 1.465 percent on Tuesday after touching a 4-½ month high of 1.475 percent on the previous day.

While the BOJ moves have allowed funding to flow to big firms, many smaller firms remain strapped for cash as banks hesitate to take on risk. Companies surveyed in the BOJ's March tankan survey said funding in the market was at its tightest ever.

BOJ policymakers will probably hold back on any major shift in policy ahead of an expected downgrade in its economic growth forecast at a meeting on April 30.

The central bank is expected to announce its rate decision sometime between noon and 2 p.m. (0300-0500 GMT) and Governor Masaaki Shirakawa will hold an embargoed news conference with his comments expected to be released around 4:15 p.m. (0715 GMT).

Japan's economy shrank 3.2 percent in October-December, the fastest pace since the 1974 oil crisis. It is likely to keep shrinking in the first half of this year, economists say, running up a record five quarters of contraction. ($1=101.00 Yen)