Gold-backed loans grew with rising gold prices, partly due to loose policy by the Federal Reserve which debased paper money, but prices started to collapse from late 2012.
S&P said in Sri Lanka gold-loans growth was also helped by a zero risk weight on capital and absence of restrictions on loan-to-value rations.
"Moreover, regulations do not require banks to submit the credit history of pawning borrowers to the Credit Information Bureau of Sri Lanka," the rating agency said.
"This increases moral hazard, given that default does no harm to an individual's credit history."
S&P said non-performing loans in gold loans were already rising. NPLs at banks analyzed by S&P rose to 1-5 percent as of April 30, from less than 1.0 percent in December 2011.
"We expect defaults in pawning loans to increase over the next 12 months unless gold prices stabilize," said Standard