* Greek sovereign debt rallies
* Greek bank shares extend gains
* New ECB collateral rules take effect Dec. 21 (Adds economist quote)
By Thomas Atkins
FRANKFURT, Dec 19 (Reuters) - The European Central Bank re-opened the path to cheap financing for Greek banks on Wednesday, allowing the country's sovereign debt to be used as collateral in ECB funding operations in a big confidence boost for markets.
Lifting a ban in place since July, the ECB said it was making Greek debt eligible again in light of the country's progress with reform measures, budget-cutting and privatisations.
Greek bonds rallied sharply in response to the change, which makes the debt more attractive for domestic banks, with 10-year sovereign yields falling by almost 1.5 percentage points to 11.42 percent.
The ECB move followed last week's decision by the euro zone to provide nearly 50 billion euros ($64 billion) in long-delayed aid to Athens, which averted a catastrophic default and secured Greece's continued membership of the single currency club after months of doubt and political turmoil.
"Together with the rating (upgrade, this) is another step suggesting that the chance of Greece leaving (the euro zone) has diminished," said Alan McQuaid, chief economist at Merrion Stockbrokers in Dublin.
"Going back to (President Mario) Draghi's comments that (the ECB) will do whatever it takes to save the euro, there seem to be more and more people believing that's going to be the case."
Wednesday's decision by the central bank, which takes effect on Dec. 21, came a day after a ratings upgrade on Greece to B-minus from selective default by credit agency Standard & Poor's.
In November, euro zone finance ministers and the International Monetary Fund clinched an agreement on reducing Greece's debt in a breakthrough to release urgently needed loans to keep the near-bankrupt economy afloat.
Greek banks are among the biggest holders of the country's debt, meaning the ECB decision would potentially allow them to tap cheap financing and expand lending to Greek businesses. Greek bank shares extended gains on the news, some trading up more than 10 percent on the day.
Unable to tap the wholesale market, Greek banks have been dependent on so-called Emergency Liquidity Assistance (ELA) during the collateral ban. The Bank of Greece has, in turn, been dependent on the ECB for approval to provide the ELA.
In August, the ECB agreed to raise the ceiling on the amount of T-bills the Bank of Greece could accept as collateral in exchange for ELA to keep the country afloat until the international lenders granted Athens its next tranche of aid.
For the complete ECB statement:
Additional reporting by William James and Marius Zaharia in London; Editing by Stephen Nisbet and John Stonestreet