Greece's central bank is likely to step in to smooth funding for the country's banks after an earlier-than-expected downgrade of the nation's credit rating prevented them from borrowing against Greek government bonds.

Rating agency Standard & Poor's cut Greece's long-term credit ratings to 'selective default' after Athens launched a bond swap to lighten its debt burden as part of its second bailout.

While such downgrades were expected, S&P moved before the euro zone could activate a deal to offset the impact of the ECB's obligation to temporarily suspend the use of Greek bonds as collateral in its funding operations.

The plan is for Greece to receive 35 billion euros ($47 billion) worth of support from the EFSF, the euro bloc's rescue fund, to back central bank lending against Greek government bonds and other assets underwritten by Athens.

But with this arrangement not yet in place, the ECB said on Tuesday national central banks would have to help banks through emergency liquidity assistance (ELA) until the 35 billion collateral enhancement scheme is activated, at which point Greek bonds would again be eligible in principle.

This is expected to take place by mid-March 2012, the ECB said in a statement.

That the euro zone's deal makers and the ECB did not foresee the potential risk of the EFSF support scheme not being activated in time is likely to leave some with red faces.

The issue is vital because Greek banks would almost certainly go bust if their central bank funding was withdrawn. Other banks in countries like France also own large chunks of Greek debt, though they have other assets to use as collateral.

The timing is particularly awkward for the ECB, coming just a day before its eagerly-awaited second, and expected to be final, offering of 3-year loans - a major crisis-fighting policy tool.

The ELA is effectively underwritten by the states in which it is extended, putting more pressure on the finances of euro zone countries whose budgets are already strained.

The ECB requires guarantees in the form of eligible collateral from all banks that seek central bank funds in its lending operations.

RISKS AHEAD

S&P's downgrading of Greece could well be short but there is a risk Athens falls back into default later, S&P analyst Moritz Kraemer told Reuters Insider television.

It's a distinct possibility that this will be a short default which will be cured, Kraemer told Reuters Insider in London. The more interesting question is not when it will be cured but whether it will be the last one.

I think the rating coming out of default of the Hellenic Republic will give some indication of what the likelihood of another restructuring down the road would be, he added.

When assessing what rating to give Greece in the future, S&P would look at the political environment, the growth outlook and the remaining debt stock.

We think that on all three fronts there are huge question marks, said Kraemer.

Commerzbank economist Michael Schubert said the collateral enhancement plan was implemented too slowly.

We do not know what they'll accept as collateral, but the spirit of emergency liquidity assistance is to bridge a short-term liquidity squeeze, so in principle it is the ideal instrument, he added.

($1 = 0.7466 euros)

(Additional reporting by Marc Jones and Sakari Suoninen; Editing by Ruth Pitchford)

European central bank