The Texas ratio is an informal measure of a bank's strength, calculated by dividing a bank's troubled loans by its capital. Texas ratio was developed in the 1980s by RBC Capital Markets analyst Gerard Cassidy as a predictor of probable bank performance during the real estate bubble of that time. It was found that when the ratio equals 1.00 or greater, the bank is in significant danger of failure.
In the United States, banks are highly regulated with respect to the amount of capital they have in reserve and the quality of the loans they've issued. When a bank fails, the Federal Deposit Insurance Corporation (FDIC) steps in, seizes its assets and provides for the relatively normal continuation of business to prevent financial panic. The FDIC doesn't make public its calculations, nor does it announce which banks, if any, are in danger of failure. In the absence of such information from the FDIC, potential investors can use the Texas ratio as a fairly reliable guideline.
The FDIC carefully and consistently monitors banks' performances, and is aware that a bank might fail long before it actually does; however, in order to avoid precipitating a panic, it will not share such sensitive data. Potential investors must rely on publicly-available data, such as those used to calculate the Texas ratio, the components of which are readily available from a bank's balance sheet. Specifically, the non-performing assets used in the calculation are all loans that are more than 90 days delinquent, plus all real estate owned (REO) due to foreclosure, and the capital is the sum of equity and loss reserves. Nationwide in the 1980s, and again in the 1990s in New England, the Texas ratio was a reliable indicator of troubled banks.
While the Texas ratio might be a reliable guideline of which banks are potential failures, it's not a guaranteed predictor of failure. Banks whose Texas ratio slips over the 1.00 mark often are able to raise sufficient capital to avoid FDIC seizure. Wise investors and customers can sometimes recognize banks that are trying to raise capital, and use that as additional information in making their investment decisions. For example, banks will offer highly favorable rates in certificates of deposit (CDs), often as much as half a percentage point, or even more, above the rates offered by its competitors. Because such rates are not guaranteed beyond the date of an FDIC seizure, prudent investors might refrain from buying such CDs when the offering banks have a high Texas ratio.