Quoting from a one-month-old FT Alphaville blog post dated February 24th, 2011:

[BEGIN QUOTE] A two-notch Moody’s downgrade of Cyprus on Thursday (Aa3 to A2). Long-term fiscal factors were involved, but then there was this:

Moody’s decision to downgrade Cyprus was also informed by its concerns about the country’s banking sector. “Cypriot banks’ exposure to macroeconomic stress in Greece is substantial, and prolonged macroeconomic stress increases the probability that these contingent liabilities will crystallise on the sovereign’s balance sheet,” says the rating agency. Although current capital and liquidity levels are not a source of concern, the country’s credit profile is affected by the banking sector’s large size relative to the size of the economy; bank assets total around 650% of GDP if we exclude foreign banks’ subsidiaries/ branches and 925% of GDP if these are included. Its exposures to Greece are significant, as in aggregate the three largest domestic banks have over 40% of their total lending in Greece.

If anything is a sign that Europe isn’t facing fiscal crisis, but a sovereign-banking one — then this Cyprus downgrade is it. [END QUOTE]

The FT Alphaville blog entry continued by drawing parallels between Cyprus and Ireland due to the high bank-assets-to-GDP situation, and with notes of concern about the Greek housing market. You can read the rest of the blog entry here on their site.

About a week after that FT Alphaville report, a Cypriot banker was quoted saying Cypriot Banks are Strong Because their Main Source of Funding is Deposits, not Capital Markets. However, on the same day, the Financial Mirror in Cyprus reported that the island’s two major banks were embarking on roadshows and efforts to raise nearly 3.34 bln euros in bond issues this year. Is EUR 3.34 billion a lot? Well, as a proportion to GDP (about 19%), the analogy for the USA would be if Citigroup and Bank of America had suddenly embarked on a roadshow to China with hopes to raise $2.7 trillion. So yeah, it is a big number, and it shows that the island’s banks are actively working at maintaining liquidity.

And yesterday, S&P downgraded Cyprus’ sovereign credit rating for the second time in five months, citing contagion from an expected debt restructuring in Greece:

The move [to A-] came a day after S&P chopped Greece’s debt deeper into junk status, by two notches to BB-. It said that a bailout scheme agreed by euro zone leaders last week increased the likelihood of debt restructuring.

Once seen as spurring growth of Cyprus’s banking system, the Greek exposure is now increasingly regarded as an achilles heel for the island’s 17.4 billion euro economy.

In a previous assessment, S&P said the Cypriot banking system’s exposure to Greek customers and securities of the Greek government and corporations had grown to more than double Cyprus’s GDP over the past decade.

On Wednesday, it said the Cyprus ratings could stabilise at present levels if the Cypriot banking sector showed strong resilience, and further strengthened its capital levels. That must be sufficient to support its Greek exposure without resorting to government resources, the agency said.

Overall the picture is one of increasing tension and nerves as it becomes increasingly clear that an eventual restructuring of Greek debt is in the cards (but not before all the French and German banks manage to retire their Greek paper and pass it on to European taxpayers). If it is true that the Cypriot banks are strong thanks to their deposit base, then retaining the confidence of the depositors if or when the Greek debt gets restructured will be paramount to what happens next in Cyprus.

Any contagion from Greece affecting the balance sheets of major Cypriot banks is bound to cause contagion to the real economy in Cyprus via a renewed domestic credit crunch, which will in turn come back and further contaminate the balance sheets of Cypriot banks. At the same time, any rescue or assistance to Cypriot banks from the government of Cyprus will not make those banks willing to open the lending spigots, but it will result in a massive increase in the debt to GDP ratio, resulting in pressures for austerity and a further blow to the economy.