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CBSL flags sovereign exposure and gold lending risks

Sovereign risk linked to financial sector stability
Rapid vehicle and gold-backed lending growth prompts tighter lending limits
Emerging borrower risks warrant vigilance despite adequate capital and liquidity buffers

Sri Lanka’s financial recovery is carrying fresh lending risks alongside a long-standing vulnerability: the financial institutions remain heavily exposed to the government, while the rapid growth in vehicle and gold-backed loans is adding to the household indebtedness, the Central Bank warned.

Its Financial Stability Review 2026, released yesterday, found that stronger economic activity, improved fiscal performance and adequate capital and liquidity had kept the financial system stable during the first half. However, the composition and pace of lending required continued scrutiny.

“Although the financial sector exposure to the public sector reduced, it remained significant, underscoring the considerable sovereign-financial sector nexus,” the Central Bank said.The assessment highlights the continuing connection between the government finances and financial sector stability, even as the banks channel more funds towards the private borrowers.

The banking sector credit grew by 23.6 percent year-on-year at end-June, compared with 11.4 percent a year earlier, with consumption, trade, financial services, construction and offshore-related lending contributing to the expansion.

The banks shifted part of their asset allocation from high-quality liquid assets, particularly government securities, towards private sector lending. This contributed to a moderation in the liquidity ratios, although they remained well above the regulatory thresholds.

The Central Bank also identified the widening short-term maturity mismatches, which increased the potential refinancing and liquidity risks under unexpected stress conditions.Alongside the continuing sovereign exposure, the rapid growth in collateral-backed lending emerged as a concern.

The review said vehicle financing and gold-backed lending continued to widen the private sector credit gap, signalling a potential build-up of systemic vulnerabilities. The rising household indebtedness, volatility in collateral values and increasing real estate prices added to those risks.

Household credit expanded by 25.4 percent year-on-year at end-June, compared with 14.8 percent a year earlier. The banks accounted for 62.5 percent of household lending, while the share provided by the non-bank financial institutions increased to 37.5 percent.

Although the household credit growth moderated marginally towards the latter part of the first half, it remained elevated. The borrowers’ overall credit scores nevertheless remained broadly stable during the period.

The finance companies recorded a sharper lending expansion, driven by the demand for vehicle financing and gold-backed loans. Their credit grew by 45 percent year-on-year at end-June, compared with 35.1 percent a year earlier.

The vehicle-backed loans represented 63.8 percent of finance company credit, while the gold-backed loans accounted for 21.4 percent, highlighting the sector’s substantial exposure to these forms of secured lending.

The Central Bank responded by simplifying and tightening the maximum loan-to-value limits on motor vehicle financing and introducing maximum limits for gold-backed lending. It also tightened the applicable risk weights on the gold-backed loans.

These measures sought to contain excessive leverage, promote prudent lending and limit the build-up of financial vulnerabilities. The Central Bank also raised its overnight policy interest rate in May 2026.The review identified the emerging borrower risks despite the improvements in headline loan-quality indicators.

The banking sector Stage 2 loans, which indicate a significant increase in credit risk, rose by 7.8 percent year-on-year at end-June, reversing an 18 percent decline a year earlier. Meanwhile, the gross Stage 3 loan ratio improved to 9.1 percent, from 11.9 percent.

The finance companies also recorded a sharp increase in Stage 2 loans, partly reflecting the adverse effects of Cyclone Ditwah and the Middle East conflict on the affected borrowers.Their gross Stage 3 loan ratio improved to 5.1 percent, from 8.3 percent. However, the declining impairment coverage indicated a weaker loss absorption capacity, underscoring the need to monitor the asset quality closely.The capital and liquidity buffers also moderated as lending expanded.

The banking sector capital adequacy declined to 18.2 percent, from 19.4 percent a year earlier, as the growth in risk-weighted assets exceeded capital accumulation. The finance companies’ capital adequacy fell to 19.3 percent, from 22 percent.

Both sectors retained capital above the regulatory requirements. However, the finance company borrowings increased by 124 percent year-on-year, substantially faster than the deposit growth of 22.9 percent, strengthening their interconnectedness with the banks.The external pressures could compound these domestic vulnerabilities. The Central Bank warned that the prolonged geopolitical tensions and energy price shocks could weaken the external balances, increase inflation and affect the borrowers’ repayment capacity.

Such pressures could amplify the risks associated with expanding collateral-backed household lending, rising Stage 2 exposures and declining capital and liquidity buffers.The financial stability outlook remained broadly positive, provided economic recovery continued, fiscal consolidation progressed and policy implementation remained prudent.

The Central Bank called for credit expansion consistent with the underlying economic activity and risk conditions, alongside the preservation of strong capital and liquidity buffers and better management of climate and cyber risks.