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Thu Feb 24, 2011 3:08am EST

* Improvement in finances likely "short-lived"

* Bank exposure to Greece substantial

NICOSIA, Feb 24 (Reuters) - Moody's Investors' Service downgraded Cyprus's sovereign bond ratings two notches to A2 on Thursday, citing exposure of its banks to indebted Greece, and concerns a recent improvement in finances was unsustainable.

The outlook for the Mediterranean island was stable, Moody's said in a statement. However, it warned that if problems in the Cypriot banking sector from its Greek exposure were to "materially increase" from its current level a further sovereign downgrade could be expected.

Moody's said that Cypriot bank's exposure to macroeconomic stress in Greece was substantial. Prolonged exposure increased the probability that those liabilities could manifest on the state's balance sheet, it said.

It also questioned whether a recent improvement in government finances could be sustained, given the rigid structure of government spending on the state payroll and social transfers.

Two of Cyprus's largest banks, Marfin (MRBr.AT) CPBC.CY and Bank of Cyprus BOC.CY (BOCr.AT) have a substantial presence in Greece. The island's three largest domestic banks have over 40 percent of their total lending in Greece, Moody's said.

Bank assets total around 650 percent of Cyprus's GDP. If foreign banks and their subsidiaries are included the figure reaches 925 percent, Moody's said.

Standard and Poor's cut Cyprus's sovereign ratings in November to A, with a negative outlook. Fitch, which rates Cyprus AA-, placed the island on a review for a possible downgrade last month.

(Writing by Michele Kambas, editing by Toby Chopra)

http://www.reuters.com/article/2011/02/ ... CL20110224