UPDATE 2-BOJ targets municipal bonds to help small banks

* BOJ to lend against wider range of municipal bonds

* Policy rate kept on hold at 0.1 percent

* Governor Shirakawa to hold news conference

TOKYO, April 7 - The Bank of Japan said on Tuesday it would start lending against a wider range of municipal debt in a move that would support regional banks reeling from a domestic credit crunch and the worst recession since World War Two.

The central bank left interest rates on hold at 0.1 percent after a two-day policy review that ended on Tuesday and focused on relatively minor moves to ease a credit squeeze on smaller banks and businesses.

Tuesday's announcement amounted to merely tinkering on the margins while the BOJ waits for the government to flesh out a $100 billion economic stimulus plan, analysts said.

"The BOJ appears to be standing still for the time being to see how measures it has taken so far will play out," said Kyohei Morita, chief economist at Barclays Capital.

The BOJ said it would accept privately placed municipal bonds as collateral. It has previously shunned the bonds, held mostly by small regional banks, because of poor liquidity and accepted only municipal bonds sold in public auctions.

"The BOJ's move to widen the collateral it accepts is a preemptive action to help get credit flowing through regional banks," said Mari Iwashita, chief market economist at Daiwa Securities SMBC.

"These banks are expected to support growing bond issuance up to May by regional public institutions, which face fiscal difficulties."

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, allowing banks to sell bonds to cover losses on their shareholdings without taking a hit on the debt market.

It also helps keep down the cost of government borrowing for the stimulus plan that Prime Minister Taro Aso is expected to announce on Friday.

"The problem is not the BOJ, the problem is that the politicians have not pushed reform," said Jesper Koll, CEO of investment consultancy Tantallon Research Japan.

"This (the planned stimulus package) is the first time that they are actively doing something."

Bond yields have risen on worries over bond oversupply as the government announced 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 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 of corporate sentiment said funding in the market was at its tightest ever.

The BOJ repeated that Japan's economy is worsening but said exports and output were likely to pull out of a steep dive.

Governor Masaaki Shirakawa will hold an embargoed news conference later on Tuesday, 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)