Standard & Poor's stripped Ireland of its last 'A' rating on Friday, citing future risks to bondholders, but the one notch cut was less severe than feared and gave the thumbs up to the state's bank bill.

Ireland's new government has said it will recapitalize its banking system to the tune of a further 24 billion euros to try and draw a line under a legacy of reckless lending that has forced it into an EU-IMF bailout.

S&P, whose rubbishing of a previous final bill for Ireland's banking sector sent the country's debt crisis into overdrive last year, said the assumptions underlying the latest round of stress tests were robust.

They changed their outlook to stable, meaning no further downgrades in the pipeline.

It's as positive as a downgrade can be, said Eoin Fahy, economist at Kleinwort Benson Investors.

I would take that as distinctly positive. The fact that they moved us to stable is significant and the language they have used is encouraging. I was worried we would see two or even three notches (cut).

The premium investors demand to hold Irish debt over benchmark German paper narrowed by 12 basis points to 6.72 percent.

That contrasted with a muted reaction to Dublin's big bang bank announcement on Thursday when it ratcheted up estimates for the total bill for bailing out its banks to 70 billion euros and pledged a radical shake-up of the sector.

S&P now rates Ireland BBB+, above fellow euro zone strugglers Portugal and Greece, in line with rival agency Fitch, which also has a stable outlook. Moody's rates Ireland Baa1 with a negative outlook.

The rationale for the cut was the risk that bond investors could be hit if Ireland needs to borrow from a new European bailout fund, set to be up and running in 2013.

Ireland is already borrowing off the euro zone's temporary rescue fund and some analysts think Dublin will need to tap the permanent bailout fund despite government ambitions to return to the debt markets, possibly in the second half of 2012.

GROWTH KEY

S&P said it expected the Irish economy would gradually recover after a three year contraction and its reliance on external trade meant that it had better growth prospects than Portugal and Greece.

But analysts in Dublin are less optimistic about the domestic economy and this weak outlook coupled with the European Central Bank's failure to provide a formal medium-term liquidity facility for Irish banks means that investors still doubt the state can shoulder its debt burden.

If our economy goes well, if we get back to growth, get to full employment, then we can pay this easily, central bank governor Patrick Honohan told a TV interview. If economic growth is weak, then it won't be so easy.

The ECB said it would give Irish banks continued access to liquidity and said it had suspended collateral requirements for Irish sovereign and Irish guaranteed debt.

But Standard & Poor's downgrade means that Frankfurt will still apply an extra discount of 5 percent on Irish debt.

European clearing house LCH.Clearnet also raised the margin requirement it charges on Irish bonds to 45 percent from 35 percent on Friday making it more expensive to trade Irish debt.

The ECB assurance means that the Irish banks are still accessing short-term loans, totaling 89 billion euros at the end of last month, and are exposed to future rate hikes.

Analysts said Europe would need to come up with a longer-term liquidity facility for struggling euro zone banks.

If that is everything the ECB does then it would turn into a significant issue, said Holger Schmieding, economist at Berenberg, arguing the result is that the ECB would not be able to withdraw its overall emergency support for banks.

The ECB should really go toward targeted support for specific banks or banking systems, under conditions, he said.

Finance Minister Michael Noonan hopes he can cap the state's part of the 24 billion euros bill at around 16 billion euros, which can be funded out of the 17.5 billion euros Irish government contribution to the 85 billion euros EU-IMF bailout.

The rest would be paid by imposing losses on banks' subordinated bonds, which Noonan said could raise between 5 billion and 6 billion euros, and asset sales.

If Ireland has to pump the full 24 billion euros into the banks its debt to GDP ratio would rise to 111 percent by 2013 from around 100 percent currently, a finance official said.

Shares in Bank of Ireland rose on the government's commitment to make it one of the pillars of a new two-bank system, while the government's retreat on a threat to impose losses on some bondholders pushed senior bank debt higher.

(Additional reporting by Padraic Halpin and Steve Slater)

Portugal European union European central bank