Moody's downgraded Spain's sovereign debt rating by one notch on Thursday and warned of further cuts to come due to fears that bank restructuring will cost more than twice what the government expects.
"(Moody's) believes there is a meaningful risk that the eventual cost of the recapitalisation effort could considerably exceed the government's current projections," the ratings agency said in a statement.
The cut in the rating -- to Aa2 from Aa1 -- drove the euro to session lows against the dollar and the premium investors charge for Spanish 10-year debt instead of German Bunds expanded to its widest point in two months at 232 basis points before narrowing again to 226.
The Bank of Spain will release its own report on banks' capital needs after markets close on Thursday.
The government and central bank have forecast no more than 20 billion euros would be needed to recapitalise weak banks.
But Moody's said the overall cost was likely to be nearer 40-50 billion euros. In a more stressed scenario recapitalisation needs could even rise to around 110-120 billion euros, it said.
Moody's still rates Spain as a high grade investment proposition. By way of comparison, the agency rates Portugal two notches lower and Greece far down with junk status.
Spanish sovereign debt prices had stabilised recently after months of volatility, as investors became less concerned that Spain could follow Greece and Ireland in needing a financial bailout from the European Union.
A bank bill at the higher end of forecasts could change that.
"I think there are a lot of uncertainties about the bank shortfall, but given the cost of bailouts in countries like Ireland, the forecast given by the government looks low," said Ben May, economist at Capital Economics.
European shares slid as the downgrade raised concerns about the health of peripheral euro zone economies. The FTSEurofirst 300 index of top European shares was down 0.65% at 1,137.3 points.
"We are surprised that Moody's has taken this decision before knowing the details of the (Bank of Spain's) report on the recapitalisation of the Spanish financial sector," Spanish Treasury Director Soledad Nunez told Reuters.
She said Moody's had had until March 15 to take its final decision after putting Spain on credit watch on Dec 15.
The Moody's rating is now in line with the Standard & Poor's rating of AA. The other major ratings agency, Fitch, has a rating one notch higher, AA+, but last Friday revised its outlook on Spain to negative.
Fitch and S&P declined to comment on the Moody's downgrade. A Fitch spokesman said the agency does not specify a deadline to act on its revision on Spain's outlook but said it is a "relatively short period".
Moody's also noted that nine of Spain's 17 autonomous regions have breached budget deficit targets.
"This casts doubts over the ability of the central government to exercise sufficient control over the regions to ensure compliance with deficit targets," it said.
But it said it still believed Spain's debt was sustainable and its baseline assumptions did not anticipate a need for the Spanish government to ask for an EU bailout.
The European Central Bank has signalled it will raise interest rates in April to combat inflation in the euro zone.
Spain is vulnerable to the tightening cycle because of its high percentage of floating rate mortgages, low economic growth and fragile banking sectors.
Many of its banks have been blighted by huge loans to property developers, many of whom went bust after Spain's real estate bubble burst.
Measures taken by the government to force savings banks, known as cajas, to seek private capital have helped calm market fears, and funding costs for the sovereign have shrunk since the beginning of the year.