The ECB's threat to cut off liquidity comes as Cypriot authorities imposed controls to stop money being transferred out of the island country once banks reopen after this week's shutdown.
The withdrawal of the ECB's financial lifeline could cause Cyprus banks to collapse and raises the prospect the nation will be forced to leave the single euro currency to stem damage to other eurozone members.
Banks have been closed in Cyprus since the weekend and are not scheduled to re-open until Tuesday, while ATMs remain the only source of cash.
The initial plan for a bank deposits levy to fund the Cypriot contribution, was rejected this week by the nation's parliament amid outrage from depositors who stood to be slugged.
"If the financial sector collapses, then they simply have to face a very significant devaluation and, faced with that situation, they would have no other way but to start having their own currency," the EU official said.
Cash economy, run on banks
In the meantime, Cypriots have turned to cash for everyday transactions, with facilities such as electronic payments out of action.
"You know, petrol stations are no longer taking credit cards, I think a lot of supermarkets and, meanwhile, you've got all sorts of businesses which obviously can't conduct transactions anymore because they can't use electronic banking, they can't get money out of the island, they can't get money in."
Some banks are limiting the amount of cash depositors can withdraw from ATMs each day and Dr Lindsay says its clear most of the tiny nation's financial institutions will collapse if a bailout is not forthcoming by the end of the weekend.
"In terms of the big banks there, we've already seen the viability of one of them now - it's become clear it can't possibly survive," he said.
"The key question is whether this can be an orderly restructuring of some sort which will protect depositors or whether it's go down in flames and all the mess that goes with it."
Dr Ker-Lindsay says, even if there is some bailout deal struck over the weekend, it may be difficult to restore the confidence of Cypriot depositors, many of whom are likely to try and pull their remaining cash out as soon as the banks reopen.
"I think that this is the big worry now, that a lot of depositors, not just foreign depositors but Cypriots themselves, will just simply say look, I just don't have the confidence anymore in the Cyprus banks. I'm going to get my cash out of here," Dr Ker-Lindsay added.
"Absolutely, I think the real fear is a run and okay, there are restrictions that can be imposed but you know, they're very, very problematic and they bring all sorts of other problems with them."
However, Dr Ker-Lindsay believes the European authorities will ultimately have to step in and do whatever it takes to save the Cypriot financial system and keep the tiny island in the euro.
"Having fought so hard for Greece, now for it all to come crashing down over Cyprus, I think they're wedded to the euro as a political concept and so really have to find a way of saving Cyprus and keeping it in," he concluded.