Fitch took negative rating actions on two Cypriot covered bond issuers on Thursday, downgrading Bank of Cyprus from BBB+ to BBB-, on negative outlook, and revising the outlook on Marfin Popular Bank’s BBB- rating from stable to negative.

Cyprus’s sovereign rating was downgraded by Fitch from A- to BBB, with a negative outlook, on Wednesday.

Fitch said the rating action reflects serious concerns about the Greek sovereign and economy, to which Cypriot banks are “highly exposed”. Fitch said there will be increasing pressure on Cypriot banks’ capital, credit risk profiles and profitability due to this exposure.

Exposure to Greek government securities (GGS) and banking operations in Greece make these banks vulnerable to negative developments for its neighbour, said Fitch. The rating agency said Marfin Popular Bank had the largest such exposure, with 46% of group loans at the end of Q1 11 and 99% of Tier 1 capital in GGS. Bank of Cyprus had levels of 35% and 55%, respectively, at the end of May 2011.

“Marfin Popular Bank also has a comparatively weaker funding profile than its peers with a higher reliance on ECB funding,” said Fitch.

The rating agency noted that the banks have made efforts to improve capital levels since 2010 and viewed this positively. Yet, in anticipation of restructuring of Greek sovereign debt and given Cypriot banks’ exposure to GGS, Fitch expected that capital levels would be affected, particularly for Marfin Popular Bank.

“In conjunction with escalating credit quality issues due to Greece’s distressed macroeconomic environment and, to a lesser extent, weaker economic prospects in Cyprus, this may require further capital raising at banks,” said Fitch.

Despite Cypriot banks’ funding profiles having generally benefited from deposit inflows since the onset of the Greek crisis, Cypriot banks continue to focus on increasing liquidity buffers, largely through self-retained covered bond issues, which are eligible for ECB refinancing, said Fitch. The rating agency nevertheless believes banks are vulnerable to potentially significant deposit outflows – with a high proportion of corporate deposits – if market confidence towards the Cypriot sovereign and/or banks weakens.

The rating agency said Cypriot banks will face a more challenging domestic operating environment due to the need to adopt austerity measures to address fiscal slippage and the negative consequences of these measures as well as from an explosion in July that took out half of Cyprus’s electricity generating capacity.

The banks’ issuer default ratings are at their Support Rating Floors (SRF), “reflecting Fitch’s view that potential support could be made available by the Cypriot authorities and ultimately by international authorities in the case of need”.

Fitch added that if Cyprus’s sovereign rating is further downgraded, the banks’ ratings, support ratings and SRFs could also be downgraded.