Finance Minister Brian Lenihan said on Tuesday that guarantee would be extended until the end of the year for short-term liabilities.
With Ireland once again at the centre of European debt fears amid concerns over the escalating cost of bailing out Anglo Irish, there were fears corporate depositors would pull funds out of Irish banks if the guarantee were allowed to expire at the end of this month.
"We don't want to see the Irish financial system on a cliff on Sept. 30," Lenihan told reporters after a meeting of euro zone finance ministers in Brussels.
Analysts said while the guarantee kept Ireland on the hook for its struggling banks, it at least gave them breathing space ahead of a crucial month in which they need to refinance around 26 billion euros of funding.
"Irish bond spreads hit a historic high in the lifetime of the euro zone today and really I don't think this is the time to be removing any support for the financial system," said Eoin Fahy, chief economist at KBC Asset Management.
The extension of the guarantee was announced after the main stock market had closed. But the move will likely help its main lenders, Allied Irish Banks and particularly Bank of Ireland test debt markets in the coming weeks.
"Now that the uncertainty over short-term corporate deposits and inter-bank funding is cleared up, it allows the Irish banks to proceed with the needed terming out of their wholesale funding," said Stephen Lyons, analyst at Davy Stockbrokers.
Irish Prime Minister Brian Cowen insisted the economic situation was manageable. "It is clear that we have to deal with the situation, which we believe is manageable. There has been turbulence generally in the international bond markets for some time and you have seen ebbs and flows in terms of sentiment," he told reporters.
Spreads between German debt and peripheral euro zone states generally widened but the jump was most dramatic for 10-year Irish paper. Investors demanded a 389-basis-point premium over bunds, a new euro lifetime high, and yields rose more than 30 basis points to top 6 percent.
The spike in Irish borrowing costs will make it more costly for Irish banks to refinance this month's debt and wean themselves off a government guarantee of their funding. Analysts said the jump appeared to be an over-reaction, but such an extreme move puts further pressure on Lenihan and the European Commission to put a final price on Anglo's bailout.
It looks increasingly likely that the government, conscious of its wafer-thin parliamentary majority, will try to eventually wind down the troubled lender.
Asked about any restructuring of Anglo's debt, Lenihan noted the Sept. 30 expiration of the guarantee on its subordinated debt, and added: "At that stage, it is open to government to review where we go. Already there have been debt management exercises in relation to part of that subordinated debt."
Although Ireland is holding an auction for short-term paper on Thursday, its own funding needs for this year have largely been secured in a series of monthly auctions that give Lenihan some breathing space while he negotiates with Brussels.
"It is certainly important that the Anglo situation is resolved over the balance of the year and on top of that that we have a credible budget on December 7 so that the funding program for next year does not meet difficulties," said Oliver Mangan, chief bond economist at AIB Global Treasury.