Texas Ratio

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What Is The Texas Ratio?

Texas Ratio measures the riskiness of financial institutions such as banks and helps investors understand the credit riskiness of the bank before making an investment decision. It is calculated by taking a financial institution's non-performing assets and dividing the same by the sum of the bank's tangible common equity and bank's loan loss reserve.

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Texas Ratio Formula

Texas Ratio = (Non - Performing Assets + Real Estate Owned) / (Tangible Common Equity + Loan Loss Reserves)

  • Non-Performing Assets: These are loans and advances offered by the bank for which it received no principal and interest payment from the borrower. Usually, this loan and advances are classified as non – performing assets post borrower defaults on loan for more than 90 days.
  • Real Estate Owned by Bank: Property kept as collateral by the borrower, now taken by the bank because of non-payment of dues (interest & principal payment).
  • Tangible Common equity: Equity capital less intangible assets owned by the bank (e.g., Goodwill)
  • Loan Loss Reserves: Banks estimate the loss on loans due to defaults and non-payment by the borrowers.

Texas-Ratio

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How Is Texas Ratio Calculated & interpreted?

  •  Analysts or investors can calculate this ratio by using the component mentioned above in the formula. Components are non-performing assets, real estate owned by the bank (i.e., foreclosed property), loan loss reserve & tangible common equity. Some websites publish the texas ratios so that one can find them over there.
  • A ratio below 1 indicates that the bank has lower non-performing assets than its resources. As this ratio approaches 1, the bank has fewer resources to cover the loss from non-performing assets. If this ratio is one or above, then bank failure is high.
  • An investor can use this ratio as an effective indicator to measure credit problems in the bank. But it does not guarantee the failure of banks. In some cases, the bank with a high ratio managed to stay solvent.
  • Some analysts use a modified version of the Texas ratio, which considers the loan secured by the government. I.e., If a federal loan program guarantees any non-performing loan, then the government compensates for these losses. Therefore, adjusting this ratio by subtracting the government-sponsored loan from non-performing assets makes sense.

Below is the modified formula as follow:

Modified Texas Ratio = (Non-Performing Assets - Government-Sponsored Non-Performing Loans + Real Estate Owned) / (Tangible Common Equity + Loan Loss Reserves);

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Example

Brian Tylor is looking to invest his fund in one of the following banks. Before investing, he asked an analyst to check which of these banks is more solvent and safer?

Texas Ratio Example

An analyst calculated the Texas ratio to suggest a less risky bank to Mr. Taylor. After considering all the details of the banks, Analysts suggested investing in ABC bank. It has more equity resources to absorb the loss of bad loans compared to other banks, i.e., PQR & XYZ.

Use Of Taxes Ratio

During the 1980s, Gerard Cassidy introduced the Texas ratio to predict the potential credit problem in the banking system. It is one of the indicators which give a signal in advance to analysts or investors about the bank's investments. If the bank has made too many bad loans and has little equity resources to cover the loss on this bad loan, the bank could fail.

Conclusion

It is simply a precautionary indicator. It considers non-performing assets, government-sponsored loans, real estate owned, Tangible equity capital & loan loss reserves of the bank to come up with a ratio. Investors can interpret that as the ratio approaches or exceeds 1, the chances of bank failure rise, but it does not assure the bank failure.

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