In order to counter the effect of the continued decline in pawning advances on productive sectors of the economy, the Monetary Board granted approval to implement a credit guarantee scheme on pawning advances on behalf of the Government, the Central Bank said in its May monetary policy statement.
Gold-backed loans from banks have contracted after gold prices fell and borrowers defaulted making banks more cautious to lend.
It will be self-funding operation, which will give a comfort to the banks, so that the appetite for gold backed lending will not diminish, Central Bank Governor Nivard Cabraal said.
The Central Bank will contribute an initial 500 million rupees to the fund on behalf of the Government.
Lenders are now given about 65 percent of the gold value as loans and the credit guarantee will allow them to loan about 15 percent more, he said.
The coverage will apply to new loans, he said.
The price of gold has been volatile in recent years and fell to around 1300 US dollars an ounce after peaking around 1700 to 1800 dollars in the same year.
Gold-backed loans have been a hassle-free credit scheme used around Sri Lanka, because the collateral can be easily sold to recover defaulted loans, at least until now.
Sri Lanka's private credit growth has slackened in 2013 after the end of a balance of payments crisis in 2011/2012 and loan growth became negative in February and March.
The Central Bank said there was further room for lending rates to come down.