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* Banks could absorb impact of a 50% Greek haircut *
Fitch ratings cut Cyprus's sovereign rating by three notches to A- on Tuesday, saying it was concerned about its banks' exposure to Greek debt and the impact this could have on the island's finances.
The outlook was negative, the agency said. Its sharp downgrade, from AA-, makes it the third agency to cut the ratings because of the banking exposure to Greece.
Fitch said that it believed Cypriot banks were "relatively well placed" to absorb the impact of an assumed 50% haircut on Greek bonds, but that worse-case scenarios could have a knock-on effect on Cyprus's own debt profile.
The downgrade "reflects the severity of the crisis in neighbouring Greece and the risk this poses for the Cypriot banking system and consequently the public finances of Cyprus," said Chris Pryce, Director in Fitch's Sovereign Group.
The European Union is racing to draft a second bailout package for Greece to release vital loans next month and avert the risk of the euro zone country defaulting on its debt.
The Fitch downgrade brings the Cyprus rating into line with Standard and Poor's and is one notch below Moody's A2 rating.
Recapitalising banks after a 50% haircut on Greek debt could cost 2 bln euros ($2.9 bln), only part of which may have to be assumed by the state, the agency said.
Exposure to Greece was a significant source of vulnerability which had intensified with successive downgrades of the Greek sovereign since January 2011, Fitch said.
It said that holdings of Greek government bonds by Cypriot and Greek banks which had subsidiaries based on the island totalled 14 bln euros.
Bank of Cyprus held 1.8 bln in Greek bonds, Marfin Popular 3.1 bln and Hellenic Bank 110 mln, officials from the three banks told Reuters.
"Fitch believes that these (Cypriot) banks are relatively well placed to absorb the impact of a sovereign debt crisis in Greece that entailed an assumed 50% haircut to face value of Greek government bonds," it said.
In that scenario the cost of recapitalising the banks to a tier 1 ratio of 10% would be 2 bln euros, or 11% of Cyprus's GDP.
But in a more severe stress test where a Greek default was associated with significant deterioration in asset quality, the cost could rise to 25% of GDP — placing strain on Cyprus's debt profile.
The Central Bank of Cyprus said it disagreed with the Fitch analysis. "The Central Bank is adopting stringent supervision which demands, among others, the maintenance of high liquidity and capital ratios to cover any possible risks which may be assumed," it said.
To allay concerns of ratings agencies healthy public finances were also required, the bank said.
The island itself, one of the smallest economies in the euro zone, is struggling to keep a lid on its public deficit, a high public payroll and anaemic growth which has sapped tax revenues.
