By Francesco Canepa

FRANKFURT (Reuters) - The European Central Bank is looking for ways to lend out more of its huge pile of government debt to avert a freeze in the 5.5 trillion-euro short-term funding market that underpins the financial system, central bank sources told Reuters.

The ECB has bought more than a trillion euros ($1.06 trillion) of euro zone government bonds in a bid to shore up economic growth and inflation in the euro zone. For the most part the bank is holding these bonds.

By doing so, it has taken away the key ingredient for repurchase agreements, or repos, whereby financial firms lend to each other against collateral, typically high-rated government bonds such as Germany's.

Repo is used by investment funds to finance trading and is regarded by the ECB as a key avenue to transmit its own monetary stimulus to the economy.

A freeze in repo activity risks undoing some of the ECB's stimulus by hampering lending between financial companies and leaving bond markets vulnerable to sharp sell offs.

To avert this, the ECB wants to make it easier for banks to borrow the bonds that it has bought so that they can be used as collateral for repo loans, the sources said.

Possible changes include reducing charges for firms which fail to return on time the bonds they have borrowed, accepting new types of collateral and extending the duration of loans.

"If liquidity dries up there are more fails and banks are more cautious when it comes to making the market," one of the sources said.

The sources added the issue will be discussed at the ECB's Dec. 8 meeting, when rate setters will decide on whether to continue purchases beyond March and ensure they can still find enough bonds to buy.

Any decision on bond lending might not be finalised in December and will depend on what other changes the ECB makes to its asset-purchase program.

"The ECB’s securities lending is proving valuable for smooth market functioning, and it is being reviewed on an ongoing basis," an ECB spokesman said.

GERMANY

Germany, the only large euro zone country with a top-notch credit rating, is where the problem is at its most severe.

With the ECB now owning more than a quarter of all outstanding German bonds, funds pay up to 1.5 percent to borrow a 10-year Bund, up from some 0.40 percent a year ago, according to Icap data.

This is putting a strain on investors as they face increasingly frequent demands to put up cash or liquid collateral against their derivative positions due to new regulation.

"If a pension fund can’t borrow a bond in time, it may have to sell its own cash bond, foregoing a potential return in the future to fulfill a short-term obligation," Godfried DeVidts of the International Capital Market Association industry body said.

"So basically the pension funds are getting poorer and the pensioners too."

But any decision would then have to be implemented by national central banks, which own the bulk of the debt bought by the ECB and bear the risk for their own bond-lending schemes.

This means the most radical proposals may run into resistance, the sources said.

The Bundesbank declined to comment

Both the Bundesbank and the ECB have already taken some steps toward making their bonds easier to borrow.

In late September, the Bundesbank started to lend out German government debt directly to dealers, rather than only via its agent.

But for the moment such loans are only extended in exchange for other German debt, limited to a week and subject to a number of constraints.

Last week the ECB said it would give borrowers more flexibility in deciding when they settle their loans, in a bid to limit the number of fails.

"(The change) can help prevent settlement fails in the market, as counterparties can borrow to cover short positions that they only know about on the value date," an ECB spokesman said.

($1 = 0.9446 euros)

(Editing by Jeremy Gaunt, Larry King.)