Family problem - how would you handle this?

It sounds like your sister has some sort of mental illness. I don't think there is anything you can do besides forgive her, avoid her, and move on with your life. Make sure your parents know that you don't want your kids to have any exposure to your sister. If that's a problem, you will just have to find someone else to look after your kids. And if your parents want to spend some time with them, they will have to come to your house.