The Government is working on a plan to use Northern Rock's own funds to buy back debt from the stricken bank's bondholders in a move that could release billions of pounds of capital for the nationalised group.

The deal could mean that the Government would not have to inject all the £3 billion in extra capital that it promised the bank last year.

The bondholders include insurance groups, fund managers and hedge funds. The Government and its advisers have not yet started negotiations with Northern Rock's bondholders, and the bank's debt deal is one of several options being considered as a way to bolster the bank's capital and secure its future as a mortgage lender.

A deal with Northern Rock's bondholders could also ease negotiations between the Treasury and the European Commission. Europe is due to rule on whether the Treasury's plan to inject £3 billion into Northern Rock so that the publicly owned bank can increase mortgage lending by offering £14 billion in new loans constitutes state aid.

The Commission's initial ruling may come as early as this week and it will publish its final verdict after a month of public consultation. The Government may find it easier to obtain a final sign-off on its plans for the Newcastle-based lender if it is able to show that it is working on a bondholder deal that would reduce the amount of state aid.

Sources said that investment bankers were working on a scheme that may devise offers for holders of different types of Northern Rock debt, including subordinated debt, covered bonds and the securities within Granite, the bank's off-balance sheet funding programme.

Northern Rock has about £2 billion in subordinated debt, Granite has about £30 billion in outstanding loans and the bank owes about £9 billion through its covered bonds programme.

The subordinated debt is trading at about 25p in the pound. Northern Rock could offer to pay debt holders 50p, incentivising them to take the offer as they would see a 25p uplift. If Northern Rock bought back all its subordinated debt for £1 billion, when it is carrying the debt at £2 billion on its books, it could recognise a £1 billion capital uplift. If the bank extends the offer to holders of different types of debt, the capital uplift would be greater.

Northern Rock would have to find a way to pay the bondholders and would probably use some of the money it has on deposit with the Bank of England. That money is not counted in its current loan from the Government, which stands at £9.8billion. The effect of using the money on deposit with the Bank would be that the Government's loan, which has been gradually falling, would rise again.

Any deal with Northern Rock's bondholders would be crucial to its future. The Government is proposing the bank be split to create a new company that takes on the deposits and branches and provides new lending. Separately, Northern Rock's existing book of mortgages would be put into an asset company to be run off over time. The Government is expected to split the £3billion in new capital between the two companies so that it can support new mortgage lending and serve as a capital buffer against fresh bad debts.

The bondholders are set to be put into the asset company by the Government in a move that has caused consternation among them because they fear that they will be stuck with all the bank's toxic loans. However, they are likely to jump at a deal that would allow them to recognise an improvement in the value of their bonds.

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