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* Sources cite political, technical, legal hurdles
* Squeeze looms at end of March
By Francesco Canepa
FRANKFURT, March 6 (Reuters) - The European Central Bank is unlikely to beef up its lending of government bonds when it meets on Thursday, sources have told Reuters, raising the spectre of a painful new squeeze in a vital market for investors.
Sources at euro zone central banks said political, legal and technical hurdles were still standing in the way of industry calls for them to lend out more of the 1.4 trillion euros ($1.48 trillion) of sovereign debt they have bought to boost inflation.
ECB policymakers opened the door to changes at their January meeting after a bond shortage late last year saw investors pay record rates to borrow government paper, for example to post as collateral at the clearing houses which settle their trades.
Failure to come up with collateral when asked can lead to a firm being put into default, with potentially destabilising consequences for the financial system as a whole.
Huge debt purchases by the ECB and stricter European Union rules for investment banks in the wake of the financial crisis have siphoned off large amounts of highly rated sovereign debt such as Germany's, the most prized form of collateral.
After the New Year squeeze, investors fear another, smaller, drought at the end of March, when banks close their books for the first quarter of the year and are reluctant to lend.
But the chances of an announcement at Thursday's meeting, when the ECB is expected to keep policy on hold despite a recent rebound in euro zone inflation, are slim, the sources said.
The ECB declined to comment.
Imminent help from the European Commission, which is responsible for financial regulation, is also unlikely.
A Brussels official told Reuters more time was needed before deciding on any easing of the rules on repurchase agreements -- through which cash is swapped for collateral -- to give banks an incentive to continue lending at quarter-ends.
The ECB's decision in December to accept up to 50 billion euros worth of cash, not just bonds, as collateral for lending out sovereign debt has meanwhile fallen short of the mark.
That threshold was not even reached during the New Year's squeeze, indicating the channel was simply not working.
Even though it is sitting on 270 billion euros of public sector debt, the Bundesbank had made loans against just 4.3 billion euros worth of collateral on Dec. 31. That is less than the ECB's own bond lending on that day, even though the ECB owns fewer than half as many bonds as the German central bank.
Industry body the International Capital Market Association has called, among other proposals, for bond-lending to be centralised at the ECB, taking it away from national central banks.
It hopes that would expand the pool of dealers which can borrow those bonds and pass them on to investors, given that the ECB has agreements in place with all banks across the bloc.
But this raises a number of issues, the central bank sources said.
First, national central banks own 90 percent of the bonds bought as part of the ECB's quantitative easing scheme.
This is a deliberate feature of the programme and is designed to limit the sharing of risk between euro zone countries, so resistance to changing it is high.
Second, the ECB delegates all its government bond lending to a single dealer, Germany's Deutsche Bank, and this could present a bottleneck if Frankfurt were to take the bulk of the lending upon itself.
Third, with previous changes to the scheme falling short of expectations, some on the ECB's rate-setting body argue the problem should be tackled at its root by further reducing the volume of purchases.
The ECB is already scheduled to cut its monthly bond buys by 25 percent to 60 billion euros from April and further reductions appear unlikely before elections in the Netherlands, France and Germany due later this year.
This means the ECB may eventually have few other choices than relaxing its bond-lending facility if it is to keep the purchases going until the end of the year as promised.
Other industry suggestions include setting a floor on the rate charged for lending out bonds or raising the cap on the cash-for-bonds scheme.
"We find it more likely that the ECB raises the maximum limit of 50 billion euros for cash collateral in the facility than changes in pricing," analysts at Nordea said.
"More attractive pricing, however, would be what probably affected repo market conditions more."
$1 = 0.9465 euros Editing by Catherine Evans