Sri Lanka’s banking sector is becoming increasingly exposed to the country’s rapidly expanding real estate market, raising concerns over whether financial institutions are adequately prepared to withstand a sudden downturn in property prices.
The Central Bank of Sri Lanka (CBSL), in its Financial Stability Review 2026, has identified rising real estate prices and growing banking exposure as emerging domestic risks, warning that a sharp correction could undermine collateral values, weaken borrowers’ repayment capacity and create wider financial instability.
By end-June 2026, lending to real estate-related activities had reached nearly Rs. 2 trillion, representing 13.7% of total loans and advances in the banking sector.
The exposure includes financing for land purchases, residential and commercial construction, property development, renovation and condominium projects.
The scale of this exposure is particularly significant because real estate lending has returned to strong growth following its contraction in 2024.
Residential property activities account for more than 80% of the sector’s banking exposure, indicating that the housing market remains the principal driver of lending.
While the Central Bank reported an improvement in loan quality, the underlying figures suggest that vulnerabilities have not disappeared.
The Stage 3 loans ratio for real estate lending declined to 10.4% by end-June 2026 from 14% a year earlier. Nevertheless, this remained above the overall banking-sector ratio of 9.1%.
More troubling is the condition of construction-related small and medium enterprises, which continued to record Stage 3 loan ratios exceeding 20%.
This raises questions about the capacity of smaller contractors, suppliers and developers to withstand further increases in financing costs and possible weaknesses in property demand.
The interest-rate environment has also become less favourable for borrowers.
The CBSL increased its Overnight Policy Rate by 100 basis points to 8.75% on May 26, 2026, its first increase since June 2023. Market interest rates and Government securities yields subsequently adjusted upwards.
For property buyers who depend on housing loans, higher financing costs could reduce affordability and delay repayments. Developers carrying large construction loans could also face cash-flow difficulties if sales slow or projects remain incomplete.
The greatest systemic danger arises from the relationship between property prices and bank collateral.
Banks commonly assess lending against the estimated market value of land, buildings and other property offered as security. If valuations rise rapidly during a boom, financial institutions may extend larger loans on the assumption that collateral values will remain strong.
A subsequent market correction could reverse that position, leaving banks with security worth considerably less than the outstanding loans.
The Central Bank has specifically warned that this could adversely affect collateral values and borrower repayment capacity, generating negative spillovers across the financial system.
The issue is particularly important given the construction industry’s contribution to banking-sector credit expansion. Construction accounts for more than 10% of total banking credit and was among the sectors contributing over 10% of credit expansion during the year to end-2Q 2026.
The regulator’s findings point to the need for closer scrutiny of banks’ property-related lending, independent valuation practices, and developer debt exposure and concentration risks.
Financial institutions should also be assessed on whether their stress-testing exercises adequately account for falling property prices, higher interest rates and declining demand.
Ultimately, the concern is not simply whether Sri Lanka’s property market continues to grow, but whether banks are financing sustainable development or accumulating excessive exposure to increasingly expensive assets.
With nearly Rs. 2 trillion at stake, the consequences of inadequate supervision could extend far beyond the real estate industry to depositors, businesses and the wider economy.
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