Texas Ratio

Texas Ratio: Meaning and How It Works

Key takeaways
* The Texas ratio assesses a bank’s credit stress by comparing non-performing assets to the capital available to cover losses.
* Formula: Texas ratio = Non-performing assets / (Tangible common equity + Loan loss reserves).
* A ratio above 100% means non-performing assets exceed the bank’s tangible equity plus reserves and signals elevated risk, though it does not guarantee failure.
* Use the ratio alongside other metrics and trend analysis for a fuller view of a bank’s health.

What the Texas Ratio Measures

The Texas ratio is an early-warning indicator of potential credit problems at a bank. It measures whether a bank’s problem assets (loans in default and foreclosed real estate) are large relative to the capital and reserves that could absorb losses. It was developed to highlight banks under stress and has been used to compare institutions or monitor regional banking problems.

Formula

Texas ratio = Non-performing assets
               —————————
               Tangible common equity + Loan loss reserves

• Non-performing assets include loans in default and real estate owned (foreclosed properties) that may turn into losses.
• Tangible common equity excludes intangible items (for example, goodwill) that cannot be used to absorb losses.
• Loan loss reserves are funds set aside to cover expected loan losses.

Interpreting the Ratio

• 0–50%: Generally low relative stress.
• 50–100%: Elevated risk — warrants closer monitoring.
• Above 100%: Non-performing assets exceed tangible equity plus reserves; indicates significant strain and a higher chance of failure.

Keep in mind:
* A high Texas ratio signals risk but is not definitive proof a bank will fail. Some institutions operate with high ratios while undergoing restructuring or receiving external support.
* Trends matter more than a single value. A falling ratio suggests improving asset quality or growing capital; a rising ratio indicates deteriorating credit conditions.

Example

If a bank has:
* Non-performing assets = $100 billion
Tangible common equity = $120 billion
Loan loss reserves not shown separately in this example (assume zero for simplicity)

Texas ratio = $100B / $120B = 0.83 (83%)

An 83% ratio is high and worth monitoring, but context and trend are necessary to assess risk.

Uses and Users

• Investors use the Texas ratio to gauge credit risk and compare peers.
• Bank customers may check the ratio when they hold deposits above FDIC insurance limits.
• Regulators and analysts use it as one component of broader stress testing and risk assessments.

Limitations and Caveats

• The ratio is backward-looking and depends on accounting definitions and timely recognition of non-performing assets.
• Different banks may report loan categories and reserves differently, reducing comparability.
• It should be combined with other measures (capital ratios, liquidity metrics, profitability, loan loss trends) and qualitative information (management actions, regulatory support) for a comprehensive view.

How to Use It Practically

1. Gather the bank’s non-performing assets, tangible common equity, and loan loss reserves from financial statements.
2. Calculate the Texas ratio using the formula above.
3. Compare the ratio to peer banks and the institution’s historical trend.
4. Investigate reasons for changes (loan charge-offs, capital raises, reserve builds).
5. Use the ratio as an early signal to dig deeper, not as a sole decision tool.

Conclusion

The Texas ratio is a simple, useful indicator of a bank’s potential credit stress by comparing problem assets to the capital available to absorb losses. It is most powerful when used over time and alongside other financial and qualitative analyses.