Chancellor George Osborne is just weeks away from launching a 20 billion pound scheme to boost the flow of credit to cash-starved small businesses, a Treasury source said, following the failure of a previous scheme to encourage lending.

The credit easing scheme announced in November is a cornerstone of the government's drive to help small businesses invest and create jobs.

Osborne is counting on a burst of hiring by private firms to make up for the hundreds of thousands of jobs set to be shed in the public sector as part of his deficit cutting plan.

However, banks have clamped down on credit since the 2007/08 financial crisis, crippling firms too small to raise funds on capital markets and posing a major obstacle to growth.

The government was forced to admit this week that its Project Merlin deal with the UK's five biggest lenders failed to do enough to alleviate tight lending conditions for small businesses and has ditched the plan, stoking public anger at a time when banks are paying out massive bonuses.

The government is now pinning its hopes on the National Loan Guarantee scheme, which it hopes will kickstart investment by reducing firms' borrowing costs by up to 1 percentage point, though the scheme will not address the problem of tough lending criteria.

Treasury officials are locked in talks with lenders on the finer details of how the scheme will work, and Britain is also waiting for the EU Commission to finish poring over the state aid implications of the plan.

We're doing detailed work with the banks to negotiate how we allocate the 20 billion pounds over time, the Treasury source said.

We want to make sure it (the money) gets to SMEs. We also need to get state aid clearance: that's on track and we aim to have it operational by the Budget, the source said. Osborne will present his annual Budget on March 21.

An industry source familiar with the talks said one of the most complex aspects of the scheme was resolving the issue of state aid, but that discussions were on track.

It's not a simple mechanism to put into place, given the detailed discussion with parties outside this country. The discussions are progressing well and we know the Budget is coming up relatively shortly.

Another of the difficulties facing officials is how to ensure that banks actually pass on the cheaper money in loans to small firms instead of hoarding it.

One option that officials are looking at involves charging banks a fee to access the funds, which is reimbursed once loans are made.

The process of agreeing the system is what's holding things up, according to the Treasury source.

A third source familiar with the talks said the discussions were going on, but there were still some points to be hammered out.

INVESTMENT BOOST?

The government is relying on the private sector to fill a gaping hole in demand that will be left as it swings the axe on state jobs. The Office for Budget Responsibility nearly doubled its forecast for public sector job losses in November, and now expects 710,000 public jobs to be culled by early 2017.

But worries about economic prospects and concerns that euro zone policymakers are still some way from resolving the debt crisis in Britain's biggest trading partner, has discouraged many firms from ploughing money into their operations.

The industry source said they expected the credit easing scheme to be rolled out in a series of tranches. The government would likely decide the scale of the first tranche and agree the allocation of funds with individual banks. The timing and allotment of funds would be subject to state aid and market conditions.

Business groups complain that banks have also tightened their lending terms, making it virtually impossible for small companies to get credit. And the credit easing scheme will not change that.

If you're an SME or a business that doesn't have a long track record, then you're considered too risky, said British Chambers of Commerce Director General John Longworth.

(Reporting by Fiona Shaikh; Editing by Toby Chopra)