Can connect via SSH - but not via SFTP? Exit status 127
It most probably means that the /usr/lib/openssh/sftp-server does not exist.
Make sure the Subsystem directive points to an existing path:
Subsystem sftp /usr/lib/openssh/sftp-server
Or actually, nowadays you typically use the internal-sftp instead:
Subsystem sftp internal-sftp
See OpenSSH: Difference between internal-sftp and sftp-server.
For me it was client configuration fault. 127 code means that command wasnt found. I changed WinSCP config to use "/bin/sftp-server" instead of "default" by mistake. Check your client config.