Sri Lanka's banks are lending again, pushing out credit at the fastest pace in years as bad loans melt away and record profits pile up.

It is a striking turn for a system that, barely two years ago, was staring into the abyss. When the island defaulted on its foreign debt in 2022 and the economy shrank 7.3%, its lenders were left nursing a pile of soured loans, frozen out of dollar funding and exposed to a state that could no longer pay its bills. The recovery of the banks since then has become one of the clearest gauges of whether Sri Lanka's wider escape from crisis will hold.

“HNB's strong balance sheet expansion, disciplined risk management and sustained investment in digital capabilities position the bank to play an essential role in supporting the country's revival,” Hatton National Bank chairman Nihal Jayawardena said, capturing a confidence that has spread across the sector as the worst of the crisis recedes.

From default to recovery

The 2022 collapse hit the banks through several channels at once. They held government paper that suddenly looked worthless, lent heavily to loss-making state enterprises such as the Ceylon Electricity Board and the Ceylon Petroleum Corporation, and watched borrowers buckle as inflation topped 70% and the rupee lost half its value. Non-performing loans climbed towards 13% of the book.

When Colombo restructured its debt, though, it spared the banks the worst of the pain. The 2023 domestic debt optimisation left commercial banks' rupee treasury bills and bonds untouched, loading the burden instead onto the central bank and the Employees' Provident Fund, whose members' retirement savings absorbed some $8.8bn of the hit. Banks still took losses on foreign-currency instruments and had to provision heavily against SOE and private exposures, but their core rupee holdings emerged intact, a deliberate choice to protect financial stability.

With the $2.9bn International Monetary Fund (IMF) programme now anchoring policy and the external-debt restructuring close to complete — the latest bilateral deals, including a $267mn agreement with South Korea, have been signed off — the ground under the banks has steadied. The economy grew 5% in both 2024 and 2025, and although higher energy costs are expected to slow expansion to around 4% this year, the rebound has been enough to revive demand for credit.

Bad loans in retreat

The clean-up is visible in the numbers. The sector's stage-three loan ratio — the local measure of bad debt — fell to 9.4% by the first quarter of 2026, from 12.7% a year earlier, according to the Central Bank of Sri Lanka (CBSL). Impairment cover has risen to just under 60%, and the credit-to-deposit ratio has pushed back above 70% for the first time in three years.

Lending has roared back. Credit granted by the banking system grew 24.4% year on year in the first quarter, against a feeble 7.9% a year earlier, as falling interest rates — the CBSL has held its policy rate at 8.75% after a pre-emptive rise in May — tempted businesses and households back to the loan desk.

Profitability has dipped from the extraordinary highs booked when banks were feasting on high-yielding government paper. Sector profit after tax slipped 7.1% in the first quarter as operating costs climbed, and return on equity eased to 14.8% from 18.7%. Even so, capital remains ample: the aggregate capital adequacy ratio stood at 18.3%, comfortably above the regulatory floor, giving lenders room to keep growing their books.

The big lenders

The state giants that dominate the system have led the way. Bank of Ceylon, the country's largest lender, posted a record pre-tax profit of LKR120.8bn ($364mn) in 2025, while state-owned rival People's Bank booked LKR64.4bn before tax and LKR40bn after, both fresh highs. Together the two hold roughly a third of banking-system assets and remain the government's workhorses in the treasury market.

Among the private banks, Commercial Bank of Ceylon, the biggest, lifted net profit 44% to LKR58.5bn on a balance sheet of LKR3.26 trillion, and became the first private-sector lender to grow its loan book past LKR1.9 trillion, up 37.5% on the year. Its gross stage-three ratio dropped to 5.81% from 7.80%.

Hatton National Bank (HNB) grew group profit to LKR49.8bn and expanded advances by a record LKR354bn to more than LKR1.5 trillion, while its net bad-loan ratio fell to barely 1%. Sampath Bank raised profit 11% to LKR30.2bn and grew its loan book 27% to LKR1.2 trillion, as its stage-three ratio tumbled to 9.6% from 13.7%. Behind them, Seylan Bank, DFCC Bank, National Development Bank (NDB) and Nations Trust Bank make up a competitive second tier, all riding the same recovery in credit demand.

The sovereign shadow

For all the improvement, the banks remain tethered to the state that nearly sank them. Years of buying treasury bills and bonds to fund the deficit have left them with heavy holdings of government securities, so their health is still bound up with the sovereign's — the same nexus that turned a fiscal crisis into a banking one in 2022.

The ratings tell the story of a slow climb back. S&P Global Ratings in July affirmed Sri Lanka at 'CCC+/C' with a stable outlook, still deep in speculative territory but a world away from the 'default' grades of three years ago, and flagged that sustained growth and fiscal repair could open the way to an upgrade. Net government debt, above 100% of GDP even after restructuring, is projected to fall towards 92% this year and 83% by 2029. Foreign investors have taken note, buying rupee government bonds for eight straight weeks.

A bellwether worth watching

The banks matter beyond their own profits. A financial system that can shed bad loans, rebuild capital and lend into a recovery is the surest sign that Sri Lanka's escape from default is turning into something durable rather than a pause between crises. Their return to record earnings is, in effect, the recovery reading its own vital signs.

The risks have not vanished. Higher import costs are again pressing on reserves, the current account is slipping back into deficit and inflation has crept up to 7.3%. But for the first time since the crash, Sri Lanka's lenders are growing their books faster than their bad debts — and doing it off a state that, however fragile, is once more paying its way.