97 † Corresponding author © 2014 Conscientia Beam. All Rights Reserved. DOES RISK MANAGEMENT AFFECT ON BANK EFFICIENCY? AN ANALYSIS OF SRI LANKAN BANKING SECTOR J.M. Ruwani Fernando 1 --- P.D.Nimal 2 1 Lecturer, Department of Finance, Faculty of Commerce and Management Studies, University of Kelaniya, Sri Lanka 2 Senior Lecturer, Department of Finance Faculty of Management Studies and Commerce, University of Sri Jayewardenepura, Sri Lanka ABSTRACT Increasing competition in the finance sector in Sri Lank has created a huge competition among the banking sector. The high level of competition improved the bank efficiency and efficiency creates risk to the banks. Therefore, risk management is a vital in achieving efficiency. Therefore, this study addresses the question on “whether the Sri Lankan banks are efficient and how risk management improves the banks’ efficiency?. The main objective of the study was to identify the efficiency of the banks by incorporating risk factors. This study adopted second Stage Data Envelopment Analysis based on Licensed Domestic Commercial Banks in Sri Lanka for the period from 2005 to 2011. At the first stage it use DEA to finds the efficiency scores by incorporating risk factors such as Credit, Market and Operational risk. In the second stage it applies Tobit regression to find the influence of external environment factors on bank efficiency. The mean efficiency of Sri Lankan banks is high when it compares with the other well countries such as India, UK, US, Taiwan and Islamic Banks located in London. Risk management has improved the efficiency of the Licensed Commercial Banks in Sri Lanka. Therefore, banks should identify their standing on the market on efficiency levels and should analyze their inefficiencies to improve the efficiencies further. Keywords: Efficiency, Risk Management, Data Envelopment Analysis, Banks. 1. INTRODUCTION Banking industry is the backbone of a financial system. The importance of the stability in banking sector in a financial system was highlighted by various scholars during the recent financial crisis (Tafri et al., 2011). At the end of year 2011 there are 24 licensed commercial banks operates in Sri Lanka with 9 licensed specialized banks. Early banking in Sri Lanka traced back to as only the lenders and pawn brokers. Now the operations of banks are extended to several areas such as different schemes of loan grants and deposits, leasing, investments, foreign exchange operations and facilitating for international trade. Therefore, when considers risk of banks now they are more exposed to various risk (Nadarajah, 2009). In Sri Lanka numbers of foreign banks are now same as the local banks since there are 12 domestic and 12 foreign banks are now International Journal of Management and Sustainability 2014 Vol. 3, No. 2, pp. 97-110 ISSN(e): 2306-0662 ISSN(p): 2306-9856 © 2014 Conscientia Beam. All Rights Reserved.