Cypriot banks could take a hit of more than 1 bln euros ($1.4 bln) to shoulder their Greek bailout obligations, forcing them to raise capital and potentially deepening concerns over the island's own sovereign debt.
Bank of Cyprus and Marfin Popular Bank have not yet committed to join a voluntary private sector plan to rescue Greece, whereby investors will take a 21% loss on the country's bonds.
Marfin held 3.4 bln euros of Greek bonds at the end of last year, and is the biggest overseas creditor not yet to pledge to join. It faces a loss of more than 700 mln euros. Bank of Cyprus held 1.7 bln euros at the end of May.
"It's potentially a big hit and they would probably need to raise capital if they took a 21% haircut," said one analyst, who asked not to be named.
The banks are waiting for more details to emerge on the offer. These are due to come in mid-August and investors are expected to sign up in early September, sources have said.
The central bank and Bank of Cyprus have warned Cyprus could need a bailout if it does not take urgent action to repair its finances. It would become the fourth state in the euro zone to request a rescue after Greece, Ireland and Portugal.
A new finance minister said on Friday that Cyprus does not need a bailout for the moment and must do all it can to avoid one.
Cyprus, which accounts for only about 0.2% of the 17-nation euro zone's economy, would not strain Europe's resources but it would show how the crisis can spread and how intertwined banks are with sovereign borrowers.
"We see three risks for Cypriot banks — there is the high exposure to Greek sovereign debt, there is their exposure to Greece through their lending into the country, and thirdly, given the high uncertainty in the region banks may face a challenge to sustain their current funding and liquidity profiles," said Christos Theofilou, analyst at ratings agency Moody's.
"There is a risk the banks will need some state support over the medium term, although it's not our base case scenario," he added.
ENERGY CRISIS
All three major credit rating agencies have downgraded Cyprus in recent months because of the Greek sovereign debt its banks hold and the exposure to Greece through trade and loans.
Marfin had 18.7 bln euros of loans to Greece at the end of 2010 and Bank of Cyprus had 11.2 bln euros. The risk is that those loans will sour as Greece's austerity plan bites.
The domestic economy is in better health, but an explosion a month ago at the island's main power plant has sparked an energy crisis and may derail growth and increase losses on loans.
Other threats are that losses on Greek bonds may exceed the 21% earmarked, and if Cyprus needs to support its banks it will hurt sovereign debt, creating a negative circular loop, analysts said.
A bailout could also damage Cyprus's reputation and see the withdrawal of some of the 27 bln euros it has in overseas deposits, with much historically coming from Russia.
Those overseas deposits leave its banks well funded, with 71 bln euros in deposits at the end of June, more than the 65 bln they lend, according to central bank data.
Cyprus offers tax breaks to international businesses. The risk is it might not be able to continue providing all of them under the terms of an international rescue, or depositors could retreat to other safe havens.
Cyprus's banks are seen as profitable and well regulated and have successfully raised capital in the past, so the risk of a full-blown crisis was low, analysts said.
Marfin raised 488 mln euros in a rights issue in February, which lifted its core Tier 1 capital ratio to 9.4%. But under a stress test of Europe's bank, which assumed a two-year recession, that core capital ratio would drop to 5.3% at the end of 2012.
Under the test, conducted last month by the European Banking Authority (EBA), banks had to raise funds if capital fell below 5% under the adverse scenario. The EBA said banks just above the pass mark who had significant exposure to strained sovereign debt should also strengthen capital.
Marfin said the sale of its Australian subsidiary, the issuance and exchange of securities into equity and a plan to trim its assets will increase its capital cushion . It declined to comment further.
Bank of Cyprus said it successfully passed the EBA stress test and its Greek bonds were held at a 13% discount based on end-March prices. It declined to comment on its participation in the Greek rescue plan or the possible impact.
Bank of Cyprus's core Tier 1 capital was 8.2% at the end of March but would fall to 6.2% under the 2-year adverse scenario.
