Bahrain's financial problems from political unrest are being made worse by investment links to embattled Libya, a widely known issue in the financial industry that came to the fore as Moody's downgraded Arab Banking Corp., the kingdom's banking giant.

Earlier this year Bahrain suffered downgrades of its sovereign debt ratings by in response to the government's violent crackdown on political activists.

The ABC downgrades could be more far-reaching, however, because of very large Libyan stake in the bank, analysts said.

Moody's said it downgraded ABC to speculative grade because of the bank's continued reliance on Libyan deposits and the potential constraints on its franchise given that its 59 percent majority shareholder, the Central Bank of Libya, remains subject to sanctions imposed by United Nations, the United States and the European Union against the Libyan regime.

European authorities froze unspecified Libyan state funds, believed to be tens of billions of dollars, in response to Libyan leader Moammar Gadhafi's war on dissidents and then armed rebel groups, now grouped together in an interim Transitional National Council and poised to wrest power from Gadhafi.

The Moody's downgrade had the dual impact of hitting an already nervous Bahraini banking sector harder and raising new questions about the status of Libyan assets abroad.

There are no signs of an early resolution of the Libyan crisis that could re-inject liquidity into the North African's state's blocked billions and provide a breather to dependent entities such as Bahrain's ABC. Conflicting signals Monday suggested contacts between involving Gadhafi, French President Nicolas Sarkozy and the rebels, aimed at breaking the military deadlock.

George Chrysaphinis, a Moody's vice president and lead analyst for Bahraini banks, said the ratings service downgraded ABC's deposit ratings by one notch to Ba1/Not-Prime, from Baa3/Prime-3.

Moody's also downgraded ABC's standalone bank financial strength rating to D -- mapping to Ba2 on the long-term scale -- from D-plus.

"All the aforementioned ratings now carry a negative outlook," Chrysaphinis said.

A significant proportion -- 27 percent -- of ABC's highly concentrated deposit base is sourced from the Central Bank of Libya and other Libyan state institutions.

"Although Libyan deposits are currently frozen and cannot be withdrawn, there is uncertainty about what will happen to these deposits once the situation in Libya is resolved."

The United States froze Iranian government deposits in the 1970s hostage crisis but ties between the former allies went downhill afterward, with the result that the freeze remains in place.

Deeper uncertainty surrounds the current status of the Central Bank of Libya, still under Gadhafi's thumb, its financial standing a matter of pure conjecture.

Moody's said ABC's Ba1 deposit rating continues to incorporate one notch of parental support uplift from the Kuwait Investment Authority, the bank's minority shareholder with 30 percent, behind the CBL with 59 percent. The Ba1 rating is based on Moody's assumptions of a moderate of support from the KIA.

"The negative outlook on ABC's ratings reflects residual uncertainty about the ownership of the bank, once the conflict in Libya is resolved and the possible impact on the franchise and funding base," Moody's said.

Analysts said, whatever the outcome, the frozen Libyan assets would most likely be redistributed with compensation claims from the rebels as well as coalition forces deployed in the military missions to support the rebels.

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