Moody's Investors Service on Tuesday cut the credit ratings on two Cypriot banks and put another on review for a downgrade, citing the increased risks of a possible Greek exit from the euro zone.
Bank of Cyprus (BOC), the largest lender on the Mediterranean island, had its deposit and senior unsecured debt ratings cut by one notch to B2 from B1 and the stand-alone credit assessment lowered to B3 from B2.
Moody's also cut Hellenic Bank Ltd's deposit ratings by one notch to B1 from Ba3 and the stand-alone credit assessment lowered to B2 from B1.
Both banks were also put on review for a possible further downgrade.
Cyprus Popular Bank, the country's second-largest lender, was also put on review for a downgrade.
"Although a Greek exit is not Moody's central scenario, the rating agency says that it considers the risk of a euro exit by Greece as substantial and recognises that the probability of such an outcome may increase further following the Greek parliamentary elections on 17 June," Moody's said in a statement.
Cyprus, most of whose population is Greek Cypriot, has close cultural, business and political links with Greece, but that relationship has not been without difficulties as Greece's economy has crumbled.
Cyprus is a member of the European Union and the third smallest economy in the euro zone.
Cypriot Finance Minister Vassos Shiarly last week said Cyprus could not rule out an EU bailout to prop up its Greece-exposed banks.
Popular Bank (CPB) requires 1.8 billion euros ($2.90 billion) in fresh capital to meet European regulators' conditions by June 30. If the bank cannot raise the funds privately, the government - itself cash-strapped by its exclusion from international capital markets - will have to step in.
CPB was hit by a 76-per cent writedown on its holdings of Greek sovereign bonds in its 2011 results, with an impairment loss of 2.3 billion euros, depleting its capital buffers.
"The rated Cypriot banks maintain extensive branch operations in Greece, with exposures to Greek borrowers amounting to 42 per cent of net loans for CPB, to 34 percent of gross loans for BoC, and 17 per cent of gross loans for Hellenic. As such, their capital positions remain susceptible to the direct and indirect consequences of a Greek exit," Moody's said.
A bigger risk of a euro exit by Greece could lead to faster withdrawals of deposits from Cypriot banks' Greek branches, thereby straining liquidity. If there were to be an exit, a redenominated Greek currency would likely trigger a default in Greece that "would materially weaken" the solvency of Cyprus' banks, Moody's said.
In his interview with Reuters last week, Shiarly said there was a worry in the Nicosia government that its EU partners would impose prohibitive conditions on any offer of aid.
There is precedent for Cyprus to go back to individual countries for funding help. It received a 2.5 billion euro bilateral loan from Russia last year and is in talks with another country - rumored to be China - to come to its rescue this time around.
Cyprus has traditionally had strong ties with Moscow, with many Russians holding cash on the island. So far, the numbers show that foreign investors are not worried.
Central bank data for April show a 0.5 per cent year-on-year increase in total deposits in Cyprus to 71.6 billion euros. Within that figure, there was a 29-per cent increase in deposits by other euro zone residents.