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Latest financial crisis resulted in non-performing loans growth what causes a lot of problems in financial stability of banking systems all around world. This paper examines the impulse response function of financial stability measured by capital adequacy ratio and non-performing loans in Bosnia and Herzegovina banking sector. 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. Before running the vector autoregression analysis, the determination of appropriate lags length through the Akaike Information Criterion, Schwarz’s Bayesian Information Criterion and Hannan and Quinn Information Criterion was carried out. Quarterly data for capital adequacy 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, purpose of this paper is modelling relations between non-performing loans and financial stability. The study shows that financial stability of Bosnia and Herzegovina banking sector, measured by capital adequacy ratio, negatively reacts to changes in non-performing loans. Regression model have shown that increase in non-performing loans leads to deterioration in financial stability of the banking sector. Results indicate on long-term and short-term connection between these variables and causation of changes in financial stability from non-performing loans. These results indicate on importance of non-performing loans monitoring as one of the main sources of systematic risk which could threaten banking sector financial stability.