* Japan wants to manage vast reserves better
* Government to propose changes to law to remove hurdles
* Govt will tread carefully to avoid big market impact -analyst
TOKYO, Oct 13 (Reuters) - Japan is looking to allow private sector funds and trust banks to manage a part of its $1.27-trillion pool of foreign exchange reserves in a drive to manage them better, a government source told Reuters on Sunday.
Until now the government has managed the foreign exchange reserves itself, but its ability to do so has been stretched as the reserve roughly doubled over the past decade, thanks to massive yen-selling interventions to weaken Japan's currency.
The government needs to clear legal hurdles on its use of foreign exchange assets if it wants to draft in the services of private financial institutions and will propose amending the law during a parliamentary session that begins on Tuesday.
The government is now restricted to lending its foreign securities only to banks, but the new law will also permit brokerages to borrow securities, the source said, with the fees borrowers pay going to replenish government coffers.
"Although we do not think the Japanese government will outsource all of the foreign exchange reserve to the private sector, even just a 10 percent outsourcing will become a $120 billion business," Tohru Sasaki, head of Japan rates and FX research at JP Morgan Tokyo, told clients in a note.
The government will not alter its stance of investing the bulk of its foreign exchange reserves in U.S. Treasuries and other high-grade investment bonds, and it will allow private sector institutions to manage only a few percent of the reserves, the Nikkei business daily reported on Sunday.
"While there is no detail about the plan, we do not think it will have an impact on the FX market, because the government knows that it will have a significant market impact if they change the currency composition significantly," Sasaki added.
Japan is the world's second largest holder of foreign currency reserves after China, which held about $3 trillion by August, according to IMF data.