The so-called Texas Ratio measures the financial health of a bank, credit union or similar institution by comparing its potential losses from "bad assets" to the total amount of capital it has available. The ratio's importance was identified, and named, in the 1980s by analysts examining a wave of bank failures in Texas. In general, a Texas Ratio higher than 1 suggests a bank is at higher risk of failure.
The Texas Ratio and Nonperforming Assets
To calculate the Texas Ratio for a particular bank, start by adding up all the bank's "nonperforming assets" – all the assets on its balance sheet that aren't generating a return. This includes loans that are in default, as well as "bank-owned" properties, which are homes and other real estate that the bank has foreclosed upon but that it hasn't been able to sell. Banking regulations require institutions to report how much they're carrying in nonperforming assets.
Troubled Asset Ratio and Available Capital
For the Texas Ratio calculation, a bank's available capital is the sum total of its equity capital and its loan loss reserves. Equity capital is essentially the book value of the bank – its total assets minus its liabilities. It is worth noting that bank customers' deposits are not included in equity capital. Deposits do not belong to the bank; they belong to the customers. Loan loss reserves are amounts that the company has set aside in its accounting books in anticipation of loans going into default.
Doing the Math
Divide nonperforming assets by available capital, and you have the bank's Texas ratio. For example, suppose a bank has nonperforming assets of $70 billion and total available capital of $80 billion. Divide $50 billion into $80 billion for a result of 0.875 or 87.5 percent. This figure is relatively high since it's nudging close to one or 100 percent. Proceed with caution if you are thinking about using this bank.
What It Means
A ratio higher than 1 tells you that the potential losses on the bank's books are greater than the book value of the bank itself. The analysts who devised the ratio identified that condition as a red flag for potential bank failure. An analysis by the Federal Reserve Bank of Dallas generally confirms that failure rates generally coincide with the ratio.
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