TEXAS RATIO, POTENTIAL BANK FAILURES & URGENT NEED TO DIVERSIFY BANK RELATIONS
Keeping your money in a bank comes with the assumption that when you are ready to withdraw it, it will be available. This is a simple assumption that we take for granted, however there have been several times throughout history that this was not the case.
Bank failures occur when banks are unable to meet their obligations. The largest bank failure happened not so long ago, back in 2008 when Washington Mutual collapsed with $307 billion in assets. When bank failures happen, panic arises over what will happen with the money. To prevent this wave of panic, studies have developed a set of statistics which can indicate a bank’s likeliness of failure. This is called the Texas Ratio. We will unpack the ratio and what it means, but let’s begin by going over how a bank works.
How do banks make money?
Banks transactions are simple at a model level. Banks solicit deposits from customers through checking and money market accounts. Banks then use this money deposited to lend to other customers at a higher interest rate. The difference between interest paid on checking and money market accounts and interest earned from loans is called “Net Interest Margin” and constitutes the banks’ main profit.
However, to have the bank stay successful, two things need to be in check:
The bank must have enough liquidity that when the customer withdraws funds, they are able to do so.
2. Credit risk
Customers must be a safe credit risk and likely to make their loan payments. This assumption is the basis for the Texas Ratio.
What is the Texas Ratio?
The Texas Ratio is a metric that analysts use to predict which banks are likely to experience credit-related issues, or in other words, it predicts the banks’ with customers unwilling to repay their loans. When Texas ratio is larger than 100% or 1, those banks are likely to fail.
This ratio was developed by Gerard Cassidy and colleagues at RBC Capital Markets. The formula used to calculate Texas Ratio is:
Non-performing assets are loans that aren’t being paid back on time meaning that the principal and interest of the loan are over 90 days past due.
Tangible common equity is a measure of a bank’s physical capital. This is calculated by subtracting intangible assets and preferred equity from the bank’s book value.
Loan loss reserves are money bank’s set aside in the case of loans that move from non-performing into default.
The Texas Ratio seeks to see if a bank has enough money set aside in case loans are not paid. This ratio determines whether banks are prepared to absorb losses while maintaining other obligations. If a bank makes too many bad loans and can not cover the losses, it will fail. This is what happened with Washington Mutual, causing depositors to withdraw all their funds.
Why is the Texas Ratio important?
So we know Texas Ratio can be used to predict bank failure, but what does this mean in regards to real estate?
Here are Four Points that come to our mind:
1. Banks can be tenants in commercial offices and shopping centers. When they want to lease a space, the property owner should review the Texas Ratio to determine the bank’s strength and the likelihood of success.
2.Commercial property developers often have large deposit balances in checking accounts. It is again recommended to review the Texas Ratio for the bank where the money is held in to ensure it will not fail. If a bank collapses, insurance covers balances to a certain point but any additional funds will be at risk.
3. If you keep all your money in one bank and that bank fails, then you will be in a very difficult situation in case you need further funds for your business. Recent example could be how large banks fail to serve their clients for their PPP applications, while local/ regional banks successfully helped them in the process.
4.Failure of a bank financing the deal might have a big negative impact as well. To make sure that the deal will go through and get financed, I would also check the healthiness of the bank financing it.
Here is a website that can be used to check out the healthiness of a bank: https://www.depositaccounts.com/banks/health.aspx
The Texas Ratio is a useful tool in evaluating potential tenants, predicting bank failures, and simply staying aware of finances, the market, and the economy as a whole. We recommend using all the tools at your disposal to create a full understanding of your finances.