HNB CEO says strong loan growth testing bank margins, liquidity as funding mix shifts

HNB CEO/Managing Director and HNBIB Chairman Damith Pallewatte 

The banking sector has delivered solid financial results and rapid balance sheet expansion over the past year, but the pace of growth is now creating new pressures on margins, liquidity, and funding costs, Hatton National Bank (HNB) Managing Director and CEO and HNB Investment Bank (HNBIB) Chairman Damith Pallewatte said.

Speaking at the HNBIB Investment Outlook and Market Strategy 2026 Forum last week, Pallewatte said loan growth in 2025 had been exceptional by historical standards, driven in part by a structural shift in bank balance sheets.

“Banks have recorded good results, but not to the extent of the challenges that they have,” he said. “The growth that we have seen in assets, especially the loan books, was phenomenal in 2025. Banks would have grown maybe twice or three times what they would normally grow in a year.”

He said a key driver was the reallocation of assets away from Government securities, as yields on Treasury instruments declined sharply.

“If you look at the total size of balance sheets, you will notice a shift from previously held Government security portfolios to loans and advances, because Government security yields have become very nominal compared to what banks can deploy in lending,” Pallewatte said.

That shift, however, has come at a cost. Pallewatte said the expansion in lending has increased pressure on net interest margins, while rising funding costs have added to the strain.

“We have seen significant pressure on margins and some pressure on liquidity,” he said. “Liquidity in the market is getting liquidated, and, as a result, deposit rates have started to increase, which puts additional pressure on interest rates.”

He noted that lending rates have already begun to edge up in recent weeks and warned that sustained credit growth could keep upward pressure on rates. “If loan growth continues at this pace, it can put further pressure on interest rates on a continuous basis,” he said.

Pallewatte said the reopening of vehicle imports has also played a role, diverting credit towards consumption-related lending and tightening liquidity conditions.

“With the vehicle import market opening, we have seen a portion of loan growth shifting towards consumption,” he said. “That has added pressure on rates as well as liquidity in the market.”

Despite these pressures, Pallewatte said banks have continued to support borrowers, including in the aftermath of Cyclone Ditwah, even as they managed balance sheet risks.

“When a natural calamity happens, we need to support our borrowers, and we continue to do that,” he said. “That also puts some pressure on the balance sheet, but banks have managed to maintain improving asset quality, which helps in attracting better funding.”

On the broader financial system, Pallewatte said regulatory changes, particularly lower single borrower limits, are beginning to reshape how large corporates fund their expansion.

“With single borrower limits coming down, we are seeing investment banks getting more opportunities,” he said. “Large conglomerates will increasingly have to shift to capital markets to raise funds, rather than relying solely on bank borrowings.”

He said 2026 is likely to be the first year in which this shift becomes more visible, as the regulatory framework is now fully in place. “This is the first time these regulations are effective, so capital markets will have to take their own path in terms of how funding is raised outside the banking sector,” he said.

On the macro outlook, Pallewatte said that while stability has improved, Sri Lanka remains far from achieving the level of foreign direct investment (FDI) needed to accelerate growth sustainably.

“When we speak to investors about bringing in FDIs, we clearly have a long way to go,” he said. “The framework has not worked as much as we anticipated in terms of attracting the level of investment required.”

He cautioned that targeting growth of around 5% may not be sufficient over the medium term, particularly given the risk of another debt restructuring after 2028. “We need to target much more than 5% if we are to reach a level that we are comfortable with,” he said. “Otherwise, we will never avoid a second debt restructuring.”

Pallewatte said FDI would need to play a much larger role in any credible growth strategy, alongside continued management of Government debt and fiscal pressures, which could influence interest rates, exchange rates, and credit demand.

He noted that the reduction in public sector borrowing from banks, alongside rising private sector credit, was a positive development. “We have seen public credit decline while private credit has increased,” he said. “It is healthy if private sector credit continues to flow into productive areas.”

On Cyclone Ditwah, Pallewatte said the economic impact appeared far more limited than during past disasters.

“The cyclone did not have the kind of impact we saw during the tsunami or earlier events,” he said. “The business engine is still running, generating revenue and supporting growth, even though the Government faces infrastructure-related costs.”

Looking ahead, he said underlying macro adjustments could lead to firmer interest rates and exchange rate movements that favour exporters over importers.

“In a country that depends heavily on imports, these shifts will matter,” he said. “That is where we are likely to see the next set of pressures and adjustments emerge.”