The education sector also needs a quality assurance rating system to help parents and students make informed choices regarding university education.
"Increasing private investments in university education could produce greater benefits including enhanced access to university education," the bank said.
Private investments would also help improve the quality of education with the increased competition.
"Creating a favourable environment for private investment in university education requires developing new legislation, regulations and accreditation policies," the bank said.
It suggested the government could seek alternative methods to encourage private investment in university education such as establishment of private degree awarding colleges or institutions in selected disciplines.
The government could also allow the establishment of affiliated university colleges, and joint or collaborative degrees, scholarships and research programmes with public universities.
The existing university education system could be improved with proposed and ongoing reforms aimed at improving the quality of education, expanding the intake and creating a more competitive environment.
The island's higher education system has been in crisis for several years with the government not having enough funds to upgrade the universities.
As a result the majority of those who qualify for university entrance where education is free are unable to get places on campus.
Pressure from leftwing politicians also prevents the government from privatising the universities or enabling more private sector investment in higher education.
The Central Bank said admission to university education is extremely competitive, and not more than 14 percent of those who qualify could gain admission to a university.
The bank also noted that education standards and quality of private institutions are not assured by any regulatory authority.
"Reports on some of these institutions indicate that they are affiliated to dubious institutions abroad."
The bank said foreign universities in developed countries and neighbours such as India, Nepal and Bangladesh serve as a 'safety valve' for Sri Lankan students who cannot gain admission to a local university.
Foreign qualified graduates are more in demand by the private sector than locally qualified ones.
This leaves "a vast array of local graduates unemployed, making it necessary for the government to employ them eventually as the 'employer of last resort', the bank said.
"One of the major problems of the university education in Sri Lanka is the mismatch between the supply and the demand," the bank said.
"The country has a supply driven university education system with insignificant relevance to labour market and economic requirements.
"About 32 per cent of the students admitted to local universities study social sciences and humanities and a significant proportion of such graduates find it difficult to obtain productive employment; they remain unemployed or underemployed for a long period of time leading to frustration and creating social problems.".