By Leika Kihara
TOKYO, April 7 (Reuters) - The Bank of Japan may start lending against a wider range of municipal bonds to support regional banks, reeling in 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 type 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 move would come as central banks continue working together to foster financial stability. The Federal Reserve on Monday opened swap lines with the BOJ and three other central banks in Europe to provide foreign currency to U.S. financial institutions if needed.
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."
By expanding the list of collateral, 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.
While these steps 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 an April 30 meeting.
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 likely hold an embargoed news conference with his comments 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. (Editing by Dayan Candappa)