Effect Of Financial Risks on Financial Stability of Licensed Commercial Banks in Sri Lanka

Abstract

Introduction: This study examines the effect of financial risks including credit, market, operational, and liquidity risks on the financial stability of licensed commercial banks in Sri Lanka. Financial stability is pivotal for Sri Lanka’s economic resilience, especially in the face of challenging economic conditions. However, financial risks pose considerable challenges to banks’ financial stability. This study seeks to explore an identified empirical gap by examining the impact of these financial risks on the long-term sustainability of banks in Sri Lanka. Methodology: The study follows a quantitative approach, analyzing secondary data collected from 13 domestic licensed commercial banks in Sri Lanka over 10 years (2014–2023). Credit risk, market risk, operational risk, and liquidity risk are the independent variables used in this study, and the dependent variable is financial stability. Bank size is also included as a control variable for this study. This research employs panel data regression with random effects and diagnostic tests for the analysis.

Findings: The findings reveal that credit risk and operational risk have a significant effect on financial stability, while market risk is only significant with financial stability under interest rate risk. Liquidity risk does not have a significant effect on financial stability in Sri Lankan banks.

Conclusion: The study concludes that credit risk and operational risk are key determinants of financial stability in Sri Lankan banks. Even risk factors deemed insignificant in the current context should be monitored, as they have the potential to become impactful in the future. The study underscores that risk management strategies are vital to maintaining banks’ stability and fostering sustainable economic growth. Future research may consider analyzing the impact of other types of risks on banks’ financial stability.