Latest financial crisis resulted in non-performing loans growth what causes a lot of problems to financial stability of banking systems all around world. Aim of this paper was to examine the impulse response function of financial stability and non-performing loans in Bosnia and Herzegovina banking sector. For that purpose, non-performing loans were defined as dependent and financial stability was an independent variable. Vector autoregression analysis was employed in order to explore how the Bosnia and Herzegovina banking sector financial stability responds to the impulse of changes in non-performing loans. Data for financial stability and non-performing loans for the period 2000-2017 were used. Main goal of this research is analysis of financial stability response on changes in non-performing loans. Therefore, the purpose of this paper is modelling relations between non-performing loans and financial stability. The study showed that financial stability of Bosnia and Herzegovina banking sector negatively reacts to changes in non-performing loans. Regression model showed that increase in non-performing loans leads to deterioration in financial stability of the banking sector. Results indicate long-term and short-term connection between non-performing loans and financial stability. Furthermore, it was disclosed that changes in financial stability have been caused by changes in non-performing loans. These results indicate the importance of non-performing loans monitoring as one of the main sources of systematic risk which could threaten banking sector financial stability.
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