Sri Lanka’s banking sector, long considered the backbone of economic recovery efforts, is facing renewed scrutiny as foreign reserve buffers show signs of weakening even while capital and profitability indicators appear robust. The data reveal a complex picture: on one hand, banks are reporting stronger capital adequacy and asset quality; on the other, the system’s net foreign assets are eroding, exposing a vulnerability that has historically triggered crises.
Reserves under Pressure
Central Bank of Sri Lanka (CBSL) data show that net foreign assets (NFA) of the banking system peaked at US$3.3 billion in April 2025, just before a rate cut aimed at stimulating credit. But the momentum was short-lived: NFAs fell to US$3.15 billion in May, US$2.96 billion in June, and further down to US$2.90 billion by July.
The central bank’s own position mirrored this decline. CBSL’s NFA stood at US$1.54 billion in May, dipped to US$1.41 billion in June, and saw only a modest recovery to US$1.46 billion in July. Though the bank purchased US$142 million from the interbank market in August, this was overshadowed by recurring debt repayments about US$75 million monthly to India for Asian Clearing Union loans and additional outflows for IMF liabilities.
Commercial banks have also seen their reserves shrink. Many had earlier borrowed from abroad to provide dollar loans domestically including to the Ceylon Petroleum Corporation during the forex crisis and are now repaying those obligations. Some have also invested in international sovereign bonds or extended dollar loans to private borrowers, reducing net foreign assets further.
Capital and Profitability Cushion
Despite this external weakness, the banking system’s prudential indicators show resilience. Sector-wide Capital Adequacy Ratios (CAR) are around 18–19% in mid-2025, comfortably above regulatory minima and higher than 2024 levels, supported by retained earnings and capital injections. Liquidity ratios also remain solid, even as reserves decline.
A closer look at major banks underscores this strength:
Hatton National Bank (HNB) reported a Net Stage-3 (NPL) ratio of 1.59% and stronger profits in H1 2025.Sampath Bank posted robust profit growth with stable asset quality.Commercial Bank of Ceylon maintained a CAR of around 18%, boosted by earlier capital raising.Bank of Ceylon (state-owned) disclosed a CAR of 17.4%, alongside steady deposit growth.
At the sector level, CBSL data confirm the trend: the average regulatory capital to risk-weighted assets rose to 19.3% in Q1 2025, up from 17.7% the year before. Non-performing loans (NPLs) are manageable, with most large banks reporting ratios under 3%.
Fragile Gains, Familiar Risks
While capital and liquidity look sound, analysts caution that strong balance sheets do not offset the risks of falling reserves. Net foreign assets plunged to negative US$6.4 billion in April 2022, after CBSL used borrowed reserves to defend the rupee. That collapse set the stage for the sovereign default, a reminder that Sri Lanka’s banks remain vulnerable when external buffers evaporate.
Recent CBSL practices such as using inflationary swaps with commercial banks to boost gross reserves have raised concerns of returning to post-war style reserve management, when borrowed dollars were presented as reserves but later proved unusable for debt repayment.
Moreover, the Treasury’s reliance on the central bank to source dollars for external debt repayments has created a policy trap. Instead of independently sourcing foreign exchange, fiscal authorities depend on CBSL’s interventions, tightening monetary policy options and raising the specter of a second default if inflows stall.
The Bigger Policy Picture
Sri Lanka’s policy framework itself remains a subject of debate. Critics argue that IMF-inspired single-policy regimes, designed around “abundant reserves,” have historically destabilized the rupee by undermining classical monetary anchors. By contrast, Asian economies that stuck to stricter reserve discipline maintaining credible external anchors—achieved long-term stability and growth.
For Sri Lanka, the lesson is that capital buffers and profitability cannot shield banks from external shocks if net foreign assets continue to deteriorate. Without disciplined reserve-building and fiscal independence in managing foreign debt, the sector’s apparent strength risks becoming a mirage.
Outlook
As of mid-2025, Sri Lanka’s banks appear healthier on paper: they are well capitalised, profitable, and reporting improved loan books. Yet beneath the surface, the system is once again dependent on fragile reserve management, exposed to government borrowing needs, and pressured by accelerating private credit.
The real test lies ahead. Unless policymakers pair monetary discipline with a fiscal strategy that reduces reliance on CBSL reserves, Sri Lanka’s banking stability could unravel as quickly as it was built.
