The German constitutional court ruled that parliament may not delegate most decisions on disbursing bailout funds to a special committee meeting in secret, as Merkel had planned after a previous ruling bolstered lawmakers' oversight powers.

But financial markets, buoyed by the prospect of another bumper injection of cheap, three-year European Central Bank funds to banks on Wednesday, shrugged off the setbacks for Europe's main paymaster.

Italy's 10-year borrowing costs fell to the lowest since last August at an auction in another sign that the ECB's three-year cash bonanza, combined with Rome's fiscal and economic reforms, have steadied bond markets and eased the euro zone's debt crisis.

The court ruling came a day after Merkel won parliamentary backing for a second aid program for debt-stricken Greece without securing an absolute majority of her own centre-right deputies, in a sign of growing public hostility to bailouts.

Seventeen of her 330 lawmakers rebelled against the Greek package, up from 13 who defied her in a vote on the euro zone rescue fund last September.

That could make it harder for her to agree to an increase in the currency bloc's financial firewall as major economies are demanding as a condition for giving the IMF more money to fight the fallout from Europe's debt crisis.

Former chancellor Helmut Kohl, one of the architects of the euro, warned in the popular daily Bild that Germany was in danger of "losing sight of the goal of a united Europe."

In a case brought by two opposition lawmakers, the court said a nine-member sub-committee created to approve urgent action by the bailout fund was "in large part" unconstitutional because it infringed on the rights of other deputies.

The judges said the panel may approve price-sensitive debt purchases on the secondary market by the EFSF bailout fund, since confidentiality was essential in such operations.

But they denied it the power to authorize loans or preventive credit lines to troubled states or for the recapitalization of banks.

While not a show-stopper, the decision means parliamentary deliberations on future rescue operations could be slower and more cumbersome, since the full 41-member budget committee or the entire 620-member lower house will have to decide.

EXCEPTION?

Euro zone leaders have insisted that Greece is an exception and after bailouts for Portugal and Ireland, they do not expect other members of the 17-nation single currency area to require assistance from their rescue fund.

Portugal said on Tuesday it has passed a third compliance review by international lenders of its bailout program.

However, many economists say Lisbon is likely to need increased emergency funds, and the chairman of euro zone finance ministers, Jean-Claude Juncker, has acknowledged that Greece may also need further assistance at a later stage.

There are some concerns too about Spain, which announced on Monday that its 2011 public deficit was 8.51 percent of gross domestic product, far higher than the 6 percent target set by the European Union and above a preliminary estimate of 8.2 percent from the new centre-right government.

That made it even less likely that Madrid will be able to reduce the deficit to 4.4 percent of FDP this year, as promised to the EU, against a backdrop of recession.

None of that dented financial markets. The euro rose close to a three-month high against the dollar.

The ECB temporarily suspended the eligibility of Greek bonds for use as collateral in its funding operations and said national central banks would have to provide banks with liquidity using an emergency measure.

The move, which was expected but not so soon, was triggered by ratings agency Standard & Poor's cutting Greece's long-term ratings to 'selective default' after Athens launched a bond swap to lighten its debt burden.

The swap is intended to wipe some 100 billion euros off Greece's 350 billion euro debt pile, reducing it to 120 percent of GDP by 2020, and forcing private debt holders to take a 53.5 percent loss on the face value of their bonds.

Anticipating such temporary downgrades, the euro zone and ECB had struck a deal whereby Greece would receive 35 billion euros in support from the EFSF rescue fund to enable the central bank to continue accepting Greek bonds and other assets underwritten by Athens in its lending operations. But the ECB action came before the EFSF funds have been activated.

S&P's head of European sovereign ratings, Moritz Kraemer, said the downgrading of Greece's long-term ratings to 'selective default' could well be short-lived but there was a risk Athens could fall back into default later.

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

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.

(Additional reporting by Stephen Brown in Berlin, Alexandra Za in Milan, Axel Threlfall in London, Paul Carrel in Frankfurt and Axel Bugge in Lisbon. Writing by Paul Taylor, editing by Mike Peacock)

• A Permanent Economic Emergency