What is 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 investment decision. It is calculated by taking 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.
Texas Ratio Formula
- Non-Performing Assets: This is the 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 which is 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.
How is Texas Ratio Calculated & interpreted?
- Analyst or investor 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 one can find it over there.
- A ratio below 1 indicates that the bank has lower non-performing assets as compared to its resources. As this ratio approaches 1, it indicates that the bank has fewer resources to cover the loss from non-performing assets. If this ratio is 1 or above, then the chances of bank failure are 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 of the 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 which is secured by the government. I.e., If a federal loan program guarantees any non-performing loan, then these losses are compensated by the government. Therefore, it makes sense to adjust this ratio by subtracting the government-sponsored loan from non-performing assets.
Below is the modified formula as follow:
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?
An analyst calculated 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 as 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. 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. It is one of the indicators which give a signal in advance to analyst or investor about the bank’s investments.
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. It can be interpreted by investors like the ratio approaches or exceeds 1, chances of bank failure rise, but it does not assure the bank failure.
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