With so many banks ailing, the Texas ratio, a term that practically disappeared for more than a decade, has made a comeback.
The ratio is a simple and effective way to forecast bank failures.
"It has been very predictive of the banks with the most severe problems," said Curtis Carpenter, a managing director at Sheshunoff & Co. Investment Banking in Austin. "It's an excellent tool."
To determine a bank's Texas ratio, nonperforming assets are divided by tangible capital plus reserves. When the result exceeds 100%, the bank's ability to survive is considered to be questionable.
The ratio's predictive powers have been borne out in recent years.
Of the 120 banks with a Texas ratio exceeding 100% at the end of 2008, 60% have failed, according to Foresight Analytics, a unit of Trepp LLC.
"Basically, when you cut through the formula you are looking at how much of your capital is tied up in bad loans," said Joe Garrett, a principal at Garrett, Watts & Co. in San Francisco. "The banks that are failing, it isn't due to interest rate risk or anything else but bad loans."
Gerard Cassidy, a managing director of bank equity research at RBC Capital Markets, is credited with inventing the equation in the 1990s. In dissecting the failed Texas banks of the 1980s, he said, he realized there was a common thread.
He then moved to apply the ratio to Northeast banks as their asset-quality problems worsened.
"It has been a handy guide for us to use as a reference point for companies that are having financial problems," Cassidy said. "It worked well in telling us which banks to avoid and which would go out of business."
Once the ratio exceeds 100%, a bank tends to get caught in a "downward spiral" that is hard to escape, Cassidy said.
"What happens is your capital and reserves are your firewall, or sandbags, and nonperforming assets are a rising river," he said. "As the river exceeds your sandbags, it overflows and causes great damage when it starts to exceed your reserves and capital."
Typically, once the ratio reaches 100% it continues to rise, whittling away capital. That's because even though bad loans have leveled off, the denominator in the equation is reduced through chargeoffs from nonperforming loans that aren't paying interest.
After a decade of dormancy, the ratio resurfaced in recent years as banks began having problems — and analysts like Cassidy again needed a quick way to determine a bank's overall health.
The ratio, however, is not a perfect indicator of whether a bank will fail, but more of a reference point. Banks with Texas ratios of 100% or more can — and do — survive and those with ratios of less than 100% can and do fail.
Another wrinkle with the equation is that it isn't a regulator-defined ratio, causing industry watchers or consultants to use derivatives of it that often are still labeled as a Texas ratio.
And that can get confusing.
Rebel Cole, a professor of finance at DePaul University in Chicago, for example, said he sometimes uses a derivative of the Texas ratio that he developed while working for the International Monetary Fund.
He also refers to his model as a Texas ratio, though it differs from the best-known one. He calculates this ratio by taking total equity plus loan-loss reserves minus nonperforming assets divided by total assets.
"I use it when I am forecasting the financial condition of a bank," he said. "It is the best ratio I know of if you want to pick one number and compare apples to apples."
Another shortcoming is that while the Texas ratio provides an accurate snapshot of a bank's ability to manage asset problems, it doesn't go far beyond that.
"It is a good predictor of future failures, but obviously, it isn't capturing everything that leads to failure," said Matthew Anderson, a managing director at Foresight.
Sheshunoff's Carpenter agreed, noting the ratio doesn't account for liquidity risk.
The Texas ratio is most often used by investors determining whether they want to sink capital into a bank, yet it also can be a tool for banking companies.
F. Scott Dueser, the chairman, president and chief executive of First Financial Bankshares Inc. in Abilene, Texas, said his company uses the ratio to evaluate likely targets for acquisition.
As Texas banks are performing better than those in many other regions, Dueser said he hopes the origins of the Texas ratio will soon seem ironic. "We are going to outlive that name this time," he said, adding that he doesn't consider it a compliment to his state.
