Relationship between non-perfmorming loans and financial stability: Evidence from Bosnia and Herzegovina banking sector

Latest financial crisis resulted in non-performing loans growth what causes a lot ofproblems to financial stability of banking systems all around world. Aim of this paperwas 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 independentvariable. Vector autoregression analysis was employed in order to explore how theBosnia and Herzegovina banking sector financial stability responds to the impulseof changes in non-performing loans. Data for financial stability and non-performingloans for the period 2000-2017 were used. Main goal of this research is analysis offinancial 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 Herzegovinabanking sector negatively reacts to changes in non-performing loans. Regressionmodel showed that increase in non-performing loans leads to deterioration in financial stability of the banking sector. Results indicate long-term and short-termconnection between non-performing loans and financial stability. Furthermore, itwas disclosed that changes in financial stability have been caused by changes innon-performing loans. These results indicate the importance of non-performing loans monitoring as one of the main sources of systematic risk which could threatenbanking sector financial stability.