Sri Lanka’s financial system remained stable in the first half of 2026, supported by economic recovery, stronger bank profitability and adequate capital buffers, but rapid household lending and external uncertainties pose emerging risks, the Central Bank of Sri Lanka (CBSL) has warned.
In its Financial Stability Review 2026, released under the Central Bank of Sri Lanka Act, No. 16 of 2023, the Central Bank highlighted growing vulnerabilities arising from vehicle financing, gold-backed lending, rising household indebtedness and increased exposure to collateral-backed credit.
The report, which generally covers developments up to end-June 2026, said the continued economic recovery and improved fiscal performance had helped cushion the financial system against multiple domestic and external shocks. Nevertheless, geopolitical tensions, elevated energy and commodity prices, renewed global inflationary pressures, tighter international financial conditions and climate-related risks continued to threaten financial stability.
Sri Lanka’s exposure through trade, tourism, workers’ remittances, capital flows and exchange rate movements made the economy particularly vulnerable to adverse external developments.
The Central Bank also noted that rapid private sector credit expansion had widened the credit gap, signalling a potential build-up of systemic vulnerabilities. In response, it raised the overnight policy interest rate in May 2026 and tightened macroprudential regulations, including loan-to-value (LTV) limits on vehicle financing and gold-backed lending.
The banking sector continued to demonstrate resilience, supported by improved profitability, adequate capital and liquidity buffers, and stronger economic activity. Credit expanded significantly, driven by demand from consumption, trade, financial services, construction and offshore-related activities.
The ratio of Stage 3 loans, which represent loans that are credit-impaired, declined, while impairment coverage improved, indicating better asset quality and loss-absorption capacity.
However, an increase in Stage 2 loans during the second quarter of 2026 pointed to emerging credit risks among borrowers amid rapid lending growth.
Although banks maintained liquidity ratios well above regulatory requirements, these ratios moderated as institutions shifted assets from highly liquid investments, particularly government securities, towards private sector lending. Short-term maturity mismatches also widened, potentially increasing refinancing and liquidity risks under stressed conditions.
Bank profitability continued to improve, although at a slower pace than in the first half of 2025. Capital adequacy ratios declined as risk-weighted assets expanded faster than capital accumulation, but remained comfortably above regulatory thresholds.
Licensed finance companies recorded significant credit expansion, largely driven by vehicle financing and gold-backed lending. While Stage 3 loan ratios improved, the sharp increase in Stage 2 loans indicated rising credit risks.
The Central Bank attributed part of the pressure to the effects of Cyclone Ditwah and the conflict in the Middle East on affected borrowers. The impairment coverage ratio also declined, pointing to a weakening capacity to absorb potential credit losses
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Liquidity buffers remained above regulatory requirements but declined amid rapid lending growth. Borrowings also grew faster than deposits, highlighting increasing financial interconnections between finance companies and banks
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Profitability in the sector continued to rise on the back of net interest income, although profit growth moderated in the first quarter of the 2026/27 financial year. Capital buffers also declined as risk-weighted assets increased
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The insurance sector remained adequately capitalised, but profitability moderated. Significant claims arising from Cyclone Ditwah increased reinsurance receivables and heightened underwriting, liquidity and counterparty risks.
Credit extended to households and businesses increased during the first half of 2026. Although household credit growth moderated marginally towards the latter part of the period, non-bank financial institutions accounted for a growing share of household lending, with banks remaining the principal source of formal financing.
Household borrowers’ overall credit scores remained broadly stable, but the Central Bank cautioned that increasing indebtedness and the expansion of collateral-backed lending warranted close monitoring.
Listed non-financial companies recorded stronger revenue growth during the period, but aggregate profitability weakened as higher costs of sales and operating expenses eroded earnings. The resulting slowdown in profitability and debt-servicing capacity pointed to some moderation in corporate creditworthiness.
Domestic financial markets remained broadly stable, with the Financial Stress Index at relatively low levels. However, subdued investor sentiment moderated equity market performance, while market liquidity weakened and volatility increased.
Government securities yields rose across maturities amid changing market expectations and subsequent monetary policy tightening. Secondary market liquidity remained subdued, while foreign investor participation continued to be low despite a modest recovery towards the latter part of the review period.
The foreign exchange market experienced periods of pressure, particularly following escalating tensions in the Middle East. Higher import expenditure and energy prices, together with shifts in investor sentiment, contributed to depreciation of the rupee against the US dollar.
Conditions subsequently improved, supported by policy measures and inflows from workers’ remittances, tourism and exports, as well as intermittent declines in oil prices.
The Central Bank also highlighted the growing importance of cyber resilience as digital financial services expand. While digitalisation has improved payment efficiency and financial inclusion, it has increased exposure to cyberattacks, operational disruptions and third-party risks.
During the review period, the Central Bank tightened maximum LTV limits for motor vehicle financing, introduced LTV limits for gold-backed lending and strengthened the applicable risk weights for such exposures.
It also directed banks and finance companies to provide relief to individuals and businesses affected by Cyclone Ditwah, issued recovery-planning requirements for financial institutions and pursued consolidation initiatives to strengthen sectoral resilience.
Additional measures targeted digital payment fraud, financial consumer protection, anti-money laundering and counter-terrorism financing safeguards, alongside efforts to strengthen crisis-resolution arrangements and financial inclusion.
The Central Bank maintained a broadly positive outlook for financial stability, conditional on the continuation of economic recovery, fiscal consolidation and prudent policy implementation.
However, it warned that prolonged geopolitical tensions and energy price shocks could weaken external balances, fuel inflation and undermine borrowers’ repayment capacity. These pressures could compound rising Stage 2 exposures, household indebtedness and potential declines in capital and liquidity buffers.
The report stressed the importance of preserving strong capital and liquidity positions, improving domestic capital market depth and investor confidence, strengthening climate and cyber risk management, and ensuring that credit expansion remains consistent with underlying economic activity and borrowers’ repayment capacity.
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