In terms of Section 70(1) of the Central Bank of Sri Lanka Act, No. 16 of 2023, the Central Bank of Sri Lanka released its annual Financial Stability Review (FSR) for 2026. This statutory report provides an assessment of the stability of the financial system, identifies and evaluates the associated risks and vulnerabilities, and outlines the policy measures implemented by the Central Bank and other regulatory authorities. The report generally covers data up to end June 2026. The electronic version of the publication can be accessed through the Central Bank website. (https://www.cbsl.gov.lk/en/publications/economic-and-financial-reports/financial-system-stability-review )

Summary of the FSR 2026 is given below:

Amidst multiple shocks, Sri Lanka’s financial system remained stable during the first half of 2026, supported by the continued economic recovery, sustained adequacy of capital and liquidity buffers across banks and finance companies (FCs), and improved fiscal performance. While domestic macrofinancial conditions remained stable, intensifying uncertainties in the global environment increased the risk of adverse spillovers to the domestic economy. Stability during the review period was supported by the continued recovery in economic activity, improved fiscal conditions and stronger financial sector performance. These developments provided an important cushion against heightened external uncertainties and supported the overall stability of the financial system. Nevertheless, the external environment remained challenging. Heightened geopolitical tensions, resurgent global inflationary pressures, elevated energy and commodity prices, tighter global financial conditions, growing trade fragmentation and increasing climate-related risks continued to pose potential spillovers to the domestic economy. Sri Lanka remained particularly exposed to adverse external developments, given its significant exposure through trade, tourism receipts, workers’ remittances, capital flows, external financing conditions and exchange rate dynamics. On the domestic front, credit growth, particularly in household lending including vehicle financing and gold-backed lending, continued to widen the private sector Credit Gap, signaling a potential build-up of systemic vulnerabilities. Moreover, although financial sector exposure to the public sector reduced, it remained significant, underscoring the considerable sovereign-financial sector nexus. Rising household indebtedness, volatility in collateral values with increased exposure to collateral-backed lending, the continued rise in real estate prices and inflationary pressures further highlighted emerging risks. In response to these developments, the Central Bank increased the overnight policy interest rate in May 2026 and introduced macroprudential measures, including loan-to-value (LTV) limits on vehicle and gold-backed lending, aimed at containing the build-up of vulnerabilities within the economy.

Domestic financial markets remained largely stable during the period, with the Financial Stress Index remaining at relatively low levels. Financial market conditions were shaped by heightened global uncertainty, domestic inflation concerns, and tighter monetary conditions. Equity market performance moderated amid subdued investor sentiment, while market liquidity weakened and volatility increased. Yields of Government securities increased across maturities during the review period with evolving market expectations and subsequently due to monetary policy tightening. Secondary market liquidity remained relatively subdued pointing to limited depth and trading activity in the domestic debt market. Meanwhile, foreign investor participation continued to be low despite a modest recovery towards the latter part of the reference period. The domestic foreign exchange market experienced periods of heightened pressure particularly with the escalation of tensions in the Middle East, reflecting increased demand for foreign currency arising from higher import expenditure, rising energy prices, and shifts in investor sentiment. These developments contributed to the depreciation of the Sri Lanka rupee against the US dollar. Market conditions subsequently improved, supported by policy measures and continued inflows from workers’ remittances, tourism, exports and intermittent fall in oil prices. Money market activity strengthened during the period, while overall liquidity remained in surplus and interest rates remained broadly aligned with the monetary policy stance. Payment and settlement systems continued to demonstrate operational resilience, supported by further digitalisation and improvements in settlement infrastructure. The continued expansion of digital financial services enhanced efficiency and financial inclusion, albeit increasing the financial system’s exposure to cyber, operational, and third-party risks. As digital connectivity deepens and technology evolves rapidly, ensuring adequate cyber resilience and operational preparedness remains critical to safeguarding financial stability.

Financial institutions continued to demonstrate overall resilience during the period under review, supported by the recovery in economic activity, stronger profitability and adequate capital and liquidity buffers. The banking sector credit expanded significantly amid robust private sector demand, with notable growth in consumption, trade, financial services, construction, and offshore-related lending. The decline in the Stage 3 loans ratio along with the improvement in the Stage 3 impairment coverage ratio depicted improved resilience of the banking sector. However, Stage 2 loans increased during Q2 of 2026, indicating a potential build-up of credit risk among borrowers amid elevated credit expansion. While liquidity ratios in the banking sector moderated during the review period, they remained well above regulatory thresholds. This decline primarily reflected a shift in asset allocation from high-quality liquid assets, particularly Government securities, to private sector lending. Meanwhile, short-term maturity mismatches widened, increasing potential refinancing and liquidity risks within the sector under unexpected stress conditions. Further, banking sector profitability continued to improve, although the pace of growth moderated somewhat from the levels recorded during the first half of 2025. Despite continued buildup of capital, driven by stronger profitability, the banking sector’s capital adequacy ratios declined as the growth of risk-weighted assets exceeded the pace of capital accumulation. Notwithstanding this moderation, capital buffers remained well above regulatory thresholds, providing adequate capacity to absorb potential shocks.

FCs sector witnessed a significant credit expansion driven by heightened demand for vehicle financing and gold-backed lending. Despite the improvement in the Stage 3 loans ratio, the sharp increase in Stage 2 loans indicated rising credit risks within the FCs sector. This was partly attributable to the adverse effects of Cyclone Ditwah and the Middle East conflict on affected borrowers and underscored the need for continuous monitoring of asset quality developments and the potential buildup of sectoral vulnerabilities. Moreover, the impairment coverage ratio declined, indicating a deterioration in loss absorption capacity within the sector. While liquidity buffers in the FCs sector remained adequate and well above regulatory thresholds, liquidity ratios declined amid strong credit expansion. Meanwhile, faster growth in borrowings compared to deposits highlighted the increasing interconnectedness between FCs and banks. Profits in the FCs sector continued to increase, supported by net interest income, although the rate of profit growth moderated during the first quarter of the financial year 2026/27. Capital buffers of the sector declined alongside the increase in risk-weighted assets driven by the expansion in credit. The insurance sector remained adequately capitalised, although profitability moderated. Significant claims arising from Cyclone Ditwah increased reinsurance receivables and heightened underwriting, liquidity, and counterparty risks.

Lending to both the Household and Institutional sectors increased during the first half of 2026. Although household credit growth remained elevated, a marginal moderation was observed towards the latter part of the period. The share of credit extended by Non-Bank Financial Institutions to the Household sector increased further during the first half of 2026, although the banking sector remained the primary source of formal financing for households. Moreover, risk profiles of Household borrowers, as reflected by overall credit scores, remained broadly stable during the first half of 2026. Credit to the Institutional sector also expanded at a rapid pace, with the banking sector accounting for the vast majority of lending to the sector. Meanwhile, the listed non-financial corporate (NFC) sector recorded stronger revenue growth during the first half of 2026, although aggregate profitability weakened. The decline in aggregate profits was largely attributable to higher costs of sales and operating expenses. Against this backdrop, creditworthiness of the listed NFC sector showed some signs of moderation, reflecting a slowdown in aggregate profitability and debt-servicing capacity.

In response to developments and emerging risks within the financial sector, a range of policy measures were implemented during the review period. Against the backdrop of rapid credit expansion in vehicle financing and gold-backed lending, borrower-based macroprudential measures were tightened to contain excessive leverage and mitigate emerging risks. These measures included simplification and tightening of maximum LTV limits on motor vehicle financing and the introduction of maximum LTV limits on gold-backed lending, aimed at promoting prudent lending practices and containing the buildup of systemic vulnerabilities. In addition to the LTV limits on gold-backed lending, applicable risk weights were also tightened during the review period. In response to the adverse effects of Cyclone Ditwah, the Central Bank issued circulars to both banks and FCs, requiring relief measures to be provided to affected individuals and businesses. The Directions on recovery planning for both banks and FCs were issued, alongside consolidation initiatives aimed at strengthening the resilience of the banking and FCs sectors. Amid the increasing prevalence of financial frauds and scams involving digital payment channels, the Central Bank introduced policy initiatives aimed at strengthening the security of digital payment methods and improving public awareness of related risks. Measures were also taken to strengthen the resolution framework, financial consumer protection, and Anti-Money Laundering, Countering the Financing of Terrorism and Countering Proliferation Financing (AML/CFT/CPF) framework, alongside preparations for Sri Lanka’s third Mutual Evaluation of its AML/CFT/CPF framework by the Asia Pacific Group on Money Laundering (APG) as well as initiatives aimed at improving financial inclusion.

Financial Stability Outlook

The outlook for financial stability remains broadly positive, provided that the ongoing economic recovery remains sustained, fiscal consolidation progresses, and prudent policy implementation continues. However, the outlook is contingent on external developments, including geopolitical and financial market uncertainties, as well as domestic vulnerabilities arising from any excessive expansion and sectoral concentration of credit, along with evolving cyber risks. Continued monitoring and timely policy intervention will therefore remain important in preserving financial stability. Prolonged geopolitical tensions and energy price shocks could weaken external balances and increase inflationary pressures, thereby impacting the repayment capacity of borrowers. These effects could amplify existing domestic vulnerabilities, including higher growth in collateral backed lending to households, rising Stage 2 exposures and declining liquidity and capital buffers. Financial market resilience will increasingly be shaped by the ability to strengthen investor confidence, improve market liquidity, deepen domestic capital markets, and attract a broader and more stable foreign investor base, thereby enhancing the market’s capacity to absorb shocks and support efficient price discovery. Overall, maintaining financial stability will require a well-calibrated combination of prudent monetary, macroprudential and regulatory policies, supported by sustained progress in structural reforms. Priorities of the financial sector should therefore focus on preserving strong capital and liquidity buffers across financial institutions, strengthening the management of climate-related and cyber risks, enhancing resolution and crisis-preparedness frameworks, and ensuring that credit expansion remains commensurate with underlying economic activity and risk conditions. These efforts will be essential in mitigating the buildup of systemic vulnerabilities, strengthening the financial system’s shock-absorbing capacity, and safeguarding financial stability over the medium term.