How Strong is your Bank? This Formula Helps You Find Out
There are several good reasons to avoid banks that are highly likely to fail. For starters, your money might be at risk anytime you’re outside of FDIC coverage limits. But bank failures are also inconvenient. So how can you predict which banks are on thin ice? You’ll never know for sure, but you can watch for common red flags and stick to stronger banks.
A bank’s Texas Ratio is one indicator that helps you determine how risky a bank is, and might give you advance warning of a bank that has made bad investments (without the ability to absorb big losses).
Texas Ratio Formula
To calculate the Texas Ratio, divide the bank’s bad assets by the assets available to cover those losses. More specifically:
- Divide nonperforming assets by tangible common equity and loan-loss reserves.
Nonperforming assets include defaulted loans and real estate that the bank has taken possession of through foreclosure. Those assets are risks that could potentially become expenses for the bank. However, some loans might be government-backed loans, and the bank will be reimbursed if those loans default. When doing your own calculations, be sure to separate loans issued under government programs.
Next, you’ll want to know how easily the bank can handle those expenses. When calculating tangible equity, be sure to remove intangible assets like goodwill—since the bank can’t write a check out of the “goodwill” account to pay creditors.
A bank with a high Texas Ratio—especially if the ratio approaches 1 (or 100%)—is riskier than a bank with a lower Texas Ratio.
Example: assume a bank has nonperforming assets of $90 billion, and tangible common equity plus loan-loss reserves of $100 billion. Divide $90 billion into $100 billion for a result of .9 or 90%. This is a relatively high ratio, and you should only use this bank with caution. For example, you might consider this bank if the ratio is clearly decreasing, you’re staying below FDIC coverage limits, and you know that there’s a solid plan in place to further reduce the ratio.
If you don’t like the idea of calculating the ratio yourself—remember that you’ll have to dig through filings and separate out government-guaranteed loans—find out if somebody has already done the work for you. Websites might publish Texas Ratios (or lists of banks with the highest and lowest ratios, which might provide enough information to make a decision).
Using the Texas Ratio
The Texas Ratio is helpful, but no single indicator is foolproof. Banks can and do stay solvent even with high ratios, and good banks sometimes go bad (so it’s important to watch the trajectory as well as the level of your bank’s ratio). In addition to the Texas Ratio, several other rating methods are available:
- Veribanc provides research reports starting at $5 per bank.
- BauerFinancial creates Star Ratings.
You might also gain insight into regional banks and credit unions by keeping up with the news. Changes in personnel and repeated appearances in the headlines might be cause for suspicion.
Of course, it’s also helpful to watch the bank’s product offerings:
- If the bank is uncompetitive, it might mean it can’t afford to pay high interest rates on savings accounts (or offer low rates on loans)—so why not switch banks anyway?
- If the bank looks too good to be true, it might be taking extra risk in a desperate attempt to attract money quickly.
In the 1980s, the state of Texas experienced an economic boom largely driven by energy, but the party couldn’t last forever. Banks helped finance the boom, and they didn’t always get repaid when things went bust. While banks in other states experienced similar results, Texas was remarkable: According to the Federal Reserve Bank of Dallas, “the state led the nation in bank failures every year from 1986 through 1992.” Gerard Cassidy then developed the calculation and coined the phrase “Texas Ratio.”
Texas got a bad rap because of timing: The ratio was invented during an oil boom. Other regions have seen their own boom and bust economic cycles.