The European Central Bank said on Tuesday it was temporarily suspending the eligibility of Greek bonds for use as collateral in its funding operations and that national central banks would have to provide banks with liquidity using an emergency measure.

The move came after ratings agency Standard & Poor's cut Greece's long-term ratings to 'selective default' after Athens launched a bond swap to lighten its debt burden.

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

In anticipation of such downgrades following a second Greek bailout, the euro zone and ECB had struck a deal whereby Greece would receive 35 billion euros worth of support from the EFSF, the bloc's rescue fund, which it would pass to the ECB as a contingency payment so that the central bank could keep accepting Greek bonds and other assets underwritten by Athens in its lending operations.

However, this support measure has not yet been activated. 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 ECB said national central banks could provide liquidity using so-called emergency liquidity assistance (ELA) until the 35-billion-euro 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.

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The issue is vital because Greek and Cypriot banks would almost certainly go bust if their central bank funding was withdrawn.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, meaning they too would face major financing issues if their Greek assets suddenly become unusable at the ECB.

Via ELA, the Greek central bank is allowed to accept collateral that is not eligible in normal ECB operations, said Commerzbank economist Michael Schubert.

That the euro zone's deal makers and the ECB did not foresee the potential flaw in the collateral plan brought about by the 35-billion-euro support scheme not being activated in time is nonetheless likely to leave some with red faces.

The central bank estimates that there is roughly 40 billion euros of sovereign and other types of bonds underwritten by Greece being used to get ECB funding.

Greek banks account for a large portion of that but those in Cyprus and other parts of the euro zone such as France also have sizeable Greek holdings meaning their governments will also come with the use of the emergency liquidity assistance.

The implementation of collateral enhancement was too slow, they should do it quicker, but that did not happen, said Schubert. We do not know what they'll accept as collateral, but the spirit of emergency liquidity assistance is to bridge short-term liquidity squeeze, so in principle it is the ideal instrument.

(Reporting by Paul Carrel, Marc Jones and Sakari Suoninen, editing by Mike Peacock)

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