* Year-end drought worries policy makers
* Chart on collateral squeeze since QE:
By Francesco Canepa
FRANKFURT, Feb 16 (Reuters) - The European Central Bank is ready to make new changes to the way it lends bonds for collateral after a drought of such paper at the turn of the year threatened the functioning of financial markets, minutes of the ECB's latest meeting showed on Thursday.
The worst scarcity of German and French bonds on record just before New Year saw investors pay record rates to borrow that paper, used as collateral for guaranteeing trading positions, and avoid the risk of being put into default.
The ECB and the other euro zone's central banks are lending out part the 1.3 trillion euros ($1.38 trillion) of government debt they have bought since 2015. Since December, some of them have been accepting cash as collateral against some of that paper.
But their efforts have proven insufficient, particularly at the end of the year, when the market normally dries up because banks are reluctant to take on risk before reporting results.
"Against this background, the Governing Council should carefully monitor market developments and the use of the securities lending facilities, and stand ready to make further adaptations, if needed," the ECB said in the minutes of its Jan 19 meeting.
Aggressive ECB bond buying, higher collateral requirements and stricter rules on bank dealing have all contributed to a squeeze in the availability of government bonds.
With the end of the first quarter just over a month away, industry group the International Capital Market Association (ICMA) urged the ECB to make new changes earlier this week.
These include centralising all bond lending, currently largely left to national central banks, at the ECB, which already has agreements in place with dealers across the bloc, thereby removing a hurdle for borrowers.
The ECB had just 5 billion euros worth of bonds out on loan against cash at the height of the bond drought on Dec. 31, its annual accounts showed on Thursday.
This compares to 112 billion euros worth of government bonds bought directly by Frankfurt since the start of the programme in March 2015.
$1 = 0.9399 euros Editing by Jeremy Gaunt