Non-performing loans in Sri Lanka's banking system had risen to 5.6 percent of total loans by end 2013 from 3.
7 percent from end 2012 with 75 percent of the increase coming from gold loans.
The Central Bank has announced a credit guarantee that will allow banks to loan up to 80 percent of gold value against the current 65 percent, in a bid to boost lending to agricultural and small businesses that depended on the system.
Fitch said Sri Lanka's regulatory treatment of a zero risk weight to gold was mis-characterised the risks associated with such loans.
While they may be "low risk", they were not "risk free" Fitch said.
A significant share of gold-backed loans were made by Sri Lanka's largest state banks, whose reported capital adequacy would be much lower if a higher risk weight was applied, Fitch said.
There were mass defaults of pawning loans after gold prices fell from 1800 to 1300 US dollars an ounce, levels in late 2013, where they have traded in a narrow range.
Last week g