Is the New Bank Policy on Pledged Land Choking SMEs?

Small and medium enterprises form the backbone of Sri Lanka’s economy. They account for more than 75% of all businesses and contribute significantly to employment, regional development, and post-crisis recovery. Yet, as the country struggles to regain economic stability, a new challenge is emerging one that is rarely discussed but deeply consequential. Banks have tightened rules around land pledged as collateral for business loans, and SMEs are increasingly finding themselves trapped in a regulatory chokehold.

This article examines how the new banking approach is affecting entrepreneurs, why it is happening, and what policy corrections are needed to ensure financial stability without suffocating the SME sector.

Why Land Matters for SMEs

In Sri Lanka, most SMEs operate informally or semi-formally. Many lack audited accounts, long credit histories, or strong cash-flow documentation. For decades, the simplest way to secure a loan was to pledge personal land often family property passed down through generations.

Land has therefore functioned as:

• the main collateral class for SME credit
• the only asset most entrepreneurs can use
• a substitute for weak financial statements
• a trust mechanism between borrower and lender

When banks change how they treat pledged land, SMEs feel the shock immediately.

What Has Changed in the Banks’ Policy?

Banks have adopted a stricter internal framework for collateral valuation, collateral eligibility, and risk scoring. The most impactful changes include:

1. Tighter Valuation Requirements

Banks now discount land value more aggressively sometimes by 30-50% when assessing loan limits, especially if:

• the land is agricultural
• the title has minor defects or delays
• the land is outside municipal limits
• there are co-owners

This reduces the loan amount SMEs qualify for, even when the land is legitimately worth more.

2. New Compliance Filters

Before releasing funds, banks increasingly require:

• updated survey plans
• 10–15 years of title records
• municipal approvals
• clearance from multiple registries

For SMEs with cash-flow needs, these delays are fatal.

3. Reclassification of Pledged-Land Loans

Banks are instructed to reclassify certain SME facilities as high-risk, regardless of collateral strength, if:

• business income has declined
• the sector is considered volatile
• tax filings are inconsistent
• financial statements are informal

Collateral no longer guarantees favourable classification.

4. Reduced Loan-to-Value (LTV) Ratios

Where banks once gave loans up to 70–80% of a land’s forced-sale value, many now reduce this to:

• 50–60% for residential land
• 40–50% for agricultural land
• 30–40% for outstation land

Overnight, SMEs lose access to working capital.

5. Increased Monitoring and Documentation

Even after a loan is approved, banks require:

• proof of business activity
• tax compliance
• invoices for every drawdown
• regular financial updates

This adds administrative burden many SMEs cannot manage.

How This Is Choking SMEs

1. Cash Flow Is Disrupted

Working capital facilities the lifeline for SMEs are restricted because the pledged land is valued conservatively. A business that previously received Rs. 10 million on its land may now only qualify for Rs. 5-6 million.

2. Growth Plans Are Stalled

SMEs cannot expand, hire, or purchase machinery because banks refuse to extend or enhance existing facilities.

3. Existing Loans Come Under Pressure

When banks reclassify facilities based on risk rather than collateral, SMEs face:

• higher interest rates
• shorter repayment periods
• frequent reviews
• pressure to produce audited accounts

This increases operational stress.

4. Forced Diversification into Informal Credit

Unable to obtain funds from banks, SMEs turn to:

• private lenders
• lease companies with high rates
• informal credit networks

This creates a debt spiral.

5. Family Assets Are at Risk

Because the land used as collateral is often personal, the impact extends beyond the business. Families face:

• anxiety over potential foreclosure
• inability to refinance
• inter-generational tension over joint-ownership land

This creates social and economic instability.

Why Banks Are Doing This

Banks have legitimate concerns:

1. Rising Non-Performing Loans (NPLs)

Post-crisis, NPL ratios increased, pressuring banks to enforce stricter risk controls.

2. Pressure from Regulators

Regulatory bodies expect banks to:

• avoid overvaluation
• ensure strong title checks
• comply with AML and KYC standards
• maintain high solvency ratios

3. Economic Uncertainty

Volatility in land prices and the overall economy makes collateral less reliable than before.

4. IMF & CB-Driven Financial Sector Reforms

Structural adjustments require:

• better risk hedging
• conservative credit policies
• reduced exposure to SME defaults

These factors combine into tougher loan conditions.

The Core Problem: SMEs Are Being Treated as High-Risk by Default

The real issue is not the existence of stricter policies but the one-size-fits-all application.

Banks treat all SMEs as inherently risky entities, ignoring:

• sector differences
• quality of business plans
• historical repayment performance
• land with strong market value

This blanket approach results in healthy businesses being blocked from capital.

What Should Change: Policy Recommendations

1. Introduce a Separate SME Collateral Framework

Land pledged for SMEs should follow a different valuation formula, recognising the unique nature of SME financing.

2. Government-Backed Credit Guarantees

The State or Central Bank can absorb part of the risk, allowing banks to lend more confidently.

3. Fast-Track Title Verification

Digitalising title deeds, survey plans, and land records can cut delays drastically.

4. Sector-Specific LTV Adjustments

Manufacturing, agriculture, and exports should have tailored LTV ratios.

5. Reduce Documentation for Repeat Borrowers

SMEs with proven repayment history should qualify for simplified reviews.

6. Create SME Credit Counsellors

Banks can assign dedicated officers trained in SME financing to reduce misunderstandings.

7. Expand Credit via Development Banks

State banks and DFIs can offer more flexible SME financing where commercial banks hesitate.

Conclusion: A Necessary Policy Applied in a Harmful Way

The new banking approach to pledged land was designed to protect the financial system. But without balance, it is throttling the very sector needed to revive Sri Lanka’s economy. SMEs require capital to survive, grow, and drive national productivity. A rigid, uniform application of collateral rules will only deepen the crisis.

Sri Lanka needs a more intelligent, flexible, risk-based model one that preserves banking stability without suffocating the entrepreneurial backbone of the country.