Credit rating agency Moody's cut the debt ratings for Cyprus and three Cypriot banks Monday, saying it expected the government to have to rescue the troubled banks with outside support.
Moody's chopped Cyprus's sovereign rating by three notches to B3, deep in junk bond territory, citing the impact of the meltdown in the country's banks following Greece's financial crisis.
"The profound difficulties in the Cypriot banking sector, which are the result of deteriorating conditions in Greece and Cyprus, are the key driver of today's rating action," Moody's said.
In a parallel action, Moody's cut Bank of Cyprus and Cyprus Popular Bank to "caa3" and Hellenic Bank to "caa2."
"Moody's believes that the banks' capital shortfalls will be severe, given their currently thin capital buffers and the rating agency's expectation that very large credit losses will emerge from the bank's lending exposures in Greece and Cyprus."
Moody's said that it expected the Nicosia government, already facing financial challenges itself, to have to lead a rescue of the banks.
However, it said, "the government's capacity to provide support to the banks is very limited."
"Moody's expects that support would be forthcoming from external parties, specifically the Troika (European Commission, European Central Bank and the International Monetary Fund) via the Cypriot government."
Troika representatives have visited Cyprus twice since June, when the country called for help after both the Bank of Cyprus and Cyprus Popular Bank said they could not meet recapitalization requirements.
A third visit to sign a memorandum has been postponed, as the EU is awaiting the government's counter-proposals for austerity under the terms of an eventual loan deal.
The troika reportedly wants to slash the Cypriot state payroll by 15 percent, shave 10 percent off welfare benefits, scrap the inflation-linked, cost-of-living allowance and roll back government-subsidized housing finance.
But the government has been resisting austerity moves that it says would undermine an economy already in recession and expected to shrink by 1.5 percent this year.