Charting Banking IX: the Texas Ratio theory

by PlanMaestro

We have been discussing how risky loans can impact a bank’s performance. It is time to ask how much is too much.

The Texas ratio was invented in the 1980s when a group of bankers at RBC Capital Markets tried to predict which Texan banks were to go bankrupt after the oil patch boom and bust. They noticed how banks entered in a downward spiral when total capital (equity plus reserves) was lower than non-performing assets. Therefore:

Texas Ratio = NPAs / (TE + LLR)

NPAs = non-performing assets

TE = tangible equity

LLR = loan loss reserves

A Texas ratio reaching that 100% watermark also may coincide with government officials getting worried about the bank becoming management’s lottery ticket and taking unwarranted risks with the backing of FDIC insurance just to get back in the game. While at the same time raising the tap for a final collapse like in the S&L crisis. That is what Cease and Desist orders try to avoid.

Once again from we have the Texas ratio, slightly  modified, by state for banks with less than $2 billion in assets. On the list of complicated states we have some expected visitors like Florida, Georgia, Washington, Puerto Rico, Oregon and new ones like South Carolina, Arizona, Michigan and Maryland.

Growing ratios of 50% or more are worrying, specially when is the average for a whole state:

  • The ratio can get close to 100% running risks already discussed
  • At these levels banks usually stop lending to preserve liquidity and capital

This is what in Japan in the 1990s was called a Zombie Bank, a living dead. Given the banking sector key economic role, the FDIC pressures them to raise capital with formal or informal capital plans and letters of agreement. In the next part, were are going to see the states with the best Texas ratio and discuss the practical use of the Texas ratio