Moody's blamed Government unwillingness to support failing banks for its downgrade of Royal Bank of Scotland, Lloyds Banking Group and 10 other British financial institutions.
The ratings agency said yesterday that its downgrades of senior debt and deposit ratings, which also included Nationwide and Santander UK, reflected an increased risk that the holders of bank bonds would share the pain if a lender got in trouble in future.
The cuts came as RBS vehemently denied that it might need a fresh bailout amid fears about banks' potential losses from the eurozone debt crisis. RBS said it had passed earlier tests of financial resilience easily and that it was one of Europe's best capitalised banks.
Moody's said the actions taken by the UK and statements about getting taxpayers off the hook for failures had reduced the predictability for bondholders. The agency's downgrades followed recommendations from Sir John Vickers' banking commission, which included a separation of retail and investment banking and for senior bondholders to suffer losses ahead of taxpayers.
Elisabeth Rudman, an analyst at Moody's, said: "There is a gradual move towards trying to ensure that taxpayers don't put in the money to support banks in future and that bondholders are somewhat more likely to share the pain if there were to be a problem."
Moody's stressed that its decision did not reflect weaker finances either for the banks or the Government.
RBS said it was disappointed that Moody's had not acknowledged its improved standalone credit profile. Lloyds said Moody's decision would have minimal impact on funding costs.
However, amid widespread jitters about banks' financial strength, RBS shares dropped 3 per cent and Lloyds declined 3.4 per cent, making them the biggest fallers in the FTSE 100 index.
Barclays and HSBC, which did not receive direct cash injections from the Government, escaped downgrades because they were already assumed to have less Government support. The Chancellor, George Osborne, defended the Government against the downgrades of RBS and Lloyds, which are 41 per cent and 83 per cent state-owned. He said the downgrades showed that the Vickers commission and other reforms were freeing taxpayers from the need to rescue failing banks.
Mr Osborne said: ""People ask me, 'How are you going to avoid Britain and the British taxpayer bailing out banks in the future?' This government is taking steps to do that. And, therefore, credit-rating agencies and others will say these banks have got to show they can pay their way in the world."
The Chancellor also argued that the banks were financially strong after speculation that RBS might need more capital on top of the £45bn pumped in by the Government. He said: "I'm confident that British banks are well capitalised, they are liquid [and] they are not experiencing the kind of problems that some of the banks in the eurozone are experiencing at the moment."
RBS took the unusual step of issuing a statement rebutting reports that it could need more capital. Some analysts estimate that Europe's banks may need hundreds of billions of pounds in new capital to cope with the eurozone debt crisis. The European Banking Authority is also working on new stress tests after RBS passed the previous round in July, but not by much.
RBS said the original tests were flawed and took no account of its successful efforts to offload assets from its balance sheet and that trading losses were assessed based on the bank's extraordinary write-offs in 2008.
On exposure to the eurozone, RBS said: "Our peripheral sovereign exposures outside of Greece, which we have already written down to 50 per cent, are circa £1bn, which are modest relative to core tier-one capital of [about] £50bn. Any haircut on a new test by the EBA would therefore not change our result materially."
Lord Oakeshott, a close ally of the Business Secretary, Vince Cable, called for RBS to be fully nationalised. He said: "RBS is starving viable small businesses of the credit they need to grow. They can't wait for the Treasury to dream up fancy new financial structures – they just want the Treasury to pull the stuck lending levers now."