Banking credit-to-deposit ratio breaches 70% as rapid lending sparks systemic risk warnings

• Banking sector credit grew by a massive 24.4% year-on-year, while the finance companies sector saw an alarming 52.4% surge in lending
• Central Bank introduced strict Loan-to-Value limits on gold and vehicle loans to ensure financial system stability amid asset-price volatilities

Sri Lanka’s banking sector witnessed its credit-to-deposit ratio surge to 71.2 percent by the end of the first quarter of 2026. This marks a significant milestone, with financial intermediation improving as the ratio surpassed 70 percent for the first time in the last three years, indicating a continued recovery in lending. 

However, this rapid credit expansion, while reflecting broadly supportive domestic conditions, prompted the monetary authority to issue warnings regarding emerging vulnerabilities and the potential build-up of systemic risk.

The sheer volume of this credit expansion is starkly visible in the latest performance metrics. Credit granted by the banking sector grew by a massive 24.4 percent year-on-year at the end of the first quarter of 2026, a sharp acceleration compared to the 7.9 percent growth reported at the end of the first quarter of 2025. While this signals robust economic activity, the regulator explicitly warned that the credit-to-GDP gap widened further into the positive territory, underscoring the potential build-up of systemic risk within the financial sector. 

This aggressive lending trajectory naturally impacted liquidity, with the Rupee liquidity coverage ratio declining to 267.9 percent from 342.4 percent a year earlier, though it remains well above the minimum regulatory requirement. In addition, the recent depreciation of the Rupee, together with increased secondary market yields, could further moderate the sector’s capital buffers through the revaluation impact on assets. This rapid expansion is occurring against a backdrop of complex headwinds. The Central Bank noted that the financial system remained resilient amidst challenging global and domestic conditions arising from heightening tension in the Middle East and global uncertainties. Despite these external pressures, the domestic appetite for credit continued unabated, forcing a shift in how regulators approach the growing debt burden.

The credit momentum is even more pronounced within the finance companies sector, which emerged as a primary driver of collateral-based lending. Credit granted by this sector surged by an alarming 52.4 percent year-on-year at the end of the first quarter of 2026. This growth was heavily concentrated in specific consumer segments, with vehicle-backed lending increasing by 52.8 percent year-on-year, while gold-backed lending demonstrated a robust year-on-year growth of 69.2 percent.

Reacting to this highly concentrated credit inflation and the associated vulnerabilities, the monetary authority pivoted towards strict macroprudential tightening. Stating its rationale, the regulator noted that considering the recent significant expansion in collateral-based lending and asset-price volatilities stemming from geopolitical uncertainties and exchange rate fluctuations in the domestic forex market, the Central Bank of Sri Lanka introduced several measures to ensure financial system stability. Effective from May 25, 2026, a maximum Loan-to-Value ratio of 70 percent has been introduced for credit facilities secured by gold, while the existing maximum limits applicable on credit facilities granted for motor vehicles have been tightened by 10 percentage points.

Beyond the lending space, these overlapping domestic and global pressures distinctly impacted Sri Lanka’s broader financial markets during the first five months of 2026. The Colombo Stock Exchange exhibited increased volatility and weaker market sentiment, with the All Share Price Index declining marginally by 1.4 percent by the end of May. Driven by rising domestic inflation expectations and external shocks, continued foreign investor withdrawals pushed net foreign outflows from the share market to US$ 103.4 million.

Concurrently, the government securities market experienced upward pressure on yields from March 2026 onwards, which increased further following a policy interest rate hike in late May. Adding to the complexities, the domestic foreign exchange market saw the Rupee continue to record volatility, reflecting increased external sector pressures.

Market analysts and regulators anticipate that the targeted lending interventions will effectively moderate the runaway credit momentum. The Central Bank highlighted that the increase in vehicle prices, driven by higher import duties and the exchange rate depreciation, together with tightened monetary policy and macroprudential measures, could moderate the future credit growth momentum of the finance companies sector. (NF)