What is the Texas Ratio?
The Texas Ratio is simple ratio developed to measure credit problems of particular banks. The Texas ratio divides the bank’s non-performing assets and loans by the firm’s tangible capital equity in addition to it’s loan loss reserve. A ratio of greater than 100 percent or 1:1 is considered a warning sign, and a high probability that the bank may fail.
History of Texas Ratio
The Texas ratio was originally conceived as a method to identify problem banks when an asset like oil or mortgage assets held on a bank’s balance sheet is falling in value. It was called the Texas Ratio because it was originally applied to banks in the 1980s during an oil crisis. It was used to accurately predict the failure of banks whom suffered from large declines because oil reserves backing loans dramatically decreased in value.
How to use the Texas Ratio?
If a Texas ratio of a bank is greater than 100% or 1:1 it indicates that a bank has a higher than normal probability of failure. The thought process is that a bank should always have enough tangible common equity and loan loss reserves to cover the banks non performing assets.
For example, a bank with $95 million in at risk loans and $100 million in tangible common equity to cover those loans would have a Texas Ratio of $95 million / $100 million , which is 95%. This is approaching the 100% threshold, which is considered very risky. At this point additional factors to consider would be trends in the non-performing assets, and the ratio in general.