Sri Lanka banks have strategically increased their dollar assets while reducing foreign borrowings, with a growing focus on lending to foreign governments and institutions, according to the Central Bank’s Financial Stability Report for June 2025.
Sri Lanka banks shift dollar balances from deposits to foreign loans and government investments
Sri Lanka’s financial sector is undergoing a major structural shift as banks continue to reallocate their foreign currency resources away from traditional holdings toward more active investments abroad. The Sri Lanka banks have reduced foreign borrowings, raised more foreign currency deposits locally, and significantly increased their participation in foreign loans and sovereign securities.
According to the Central Bank’s latest Financial Stability Report, Sri Lankan banks held foreign exchange balances of USD 2.9 billion in foreign institutions by the end of the second quarter of 2024. This reflects a decline of USD 790.2 million compared to the previous year. Domestic systemically important banks (D-SIBs) accounted for USD 1.4 billion of these balances, while foreign banks held around USD 1.2 billion.
By June 2025, foreign currency liabilities of the banking sector had risen 7.6 percent to USD 13.3 billion, up from 3.6 percent the year before. This expansion was primarily driven by foreign currency deposits, which have grown steadily since the second quarter of 2023. In contrast, foreign borrowings were reduced by 11.2 percent, with several banks opting not to renew existing credit lines. This trend has strengthened their net foreign asset position.
Unlike in the past, when Sri Lankan banks borrowed heavily to lend domestically, they have now shifted strategy by investing their dollar balances in foreign syndicated loans and government securities. This repositioning comes in the wake of monetary stabilization efforts and reflects growing confidence in the banking sector’s liquidity. Analysts have urged the government to structure syndicated loans through local banks to service maturing debt, reducing the need for costly central bank swaps.
Flushed with dollars after the restoration of monetary stability, Sri Lankan banks have financed major foreign institutions, including the State Bank of India and energy firms in Singapore. The central bank confirmed that financial institutions have diverted foreign currency funds from offshore balances into more productive assets abroad.
“The banking sector significantly diverted FCY funds from balances with financial institutions abroad to FCY loans and investments in foreign sovereign securities,” the Central Bank report noted. “Increased investments by banks in foreign sovereign securities contributed to a notable increase in FCY investments.”
D-SIBs have emerged as the largest investors, holding 84.8 percent of foreign sovereign securities. Although these assets carry minimal credit risk, they are still subject to foreign exchange volatility. The distribution of these securities indicates a strategic preference for Fair Value Through Other Comprehensive Income (FVTOCI) instruments, giving banks more flexibility to adjust their portfolios while accounting for fair value changes.
The shift in banking behavior is closely linked to the stabilization of interest rates and the repayment of Sri Lanka Development Bonds with rupee securities. As banks gained liquidity, they used their deposits to purchase dollars rather than extend fresh loans, allowing them to clear mismatches in their books and cover provisions for international bond losses. This resulted in billions of dollars being held in foreign accounts, including NOSTRO accounts, and a reduction in foreign credit line obligations.
Consequently, net foreign currency assets of Sri Lankan banks grew 42.5 percent year-on-year to USD 1.5 billion by the end of the second quarter of 2025, surpassing pre-crisis levels. This reflects a remarkable turnaround from the years of negative foreign asset positions following the potential output targeting crisis.
The underlying dynamics of this transformation are rooted in past policy decisions. After the civil war, banks borrowed aggressively from abroad to lend domestically and to the government. This was encouraged by macroeconomic policies, including central bank swaps that offered foreign exchange risk guarantees. However, when the currency collapsed due to inflationary open market operations, the central bank incurred massive foreign exchange losses. Some of these losses were later offset when the rupee appreciated from 360 to 300 against the US dollar.
The irony of the current situation is that the same inflationary pressures that once led to crisis are now generating profits for the central bank as the rupee is gradually debased. This, however, places renewed pressure on households, state-owned enterprises, and public debt levels. Analysts argue that if the central bank’s inflationary frameworks are not restrained by legislative measures, similar vulnerabilities could re-emerge.
With high private savings rates, Sri Lanka has a strong foundation to build reserves and maintain currency strength. Experts suggest that maintaining prudent banking practices, coupled with disciplined monetary policy, will be key to ensuring financial resilience.
The reallocation of foreign currency assets signals a significant strategic change in how Sri Lankan banks operate. By financing foreign governments and major corporations abroad, they are diversifying their income sources while improving their net foreign asset positions. However, this also increases their exposure to global market dynamics, making effective risk management more critical than ever.