Is It Time to Rename the Texas Ratio?

By many economic measures, Texas currently stands atop the other forty-nine states as a beacon of success.

Through September, Texas has added more than one-third of the nation’s net new jobs since the national recovery began in mid-2009. Texas’ share of total U.S. exports is more than 17%, far and away the highest percentage among the fifty states. And Texas is the No. 1 producer of oil and gas in the nation, with about 45% of all active drilling rigs.

But even though Texas jobs, Texas exports and the Texas rig count all signal strength and stability, there is one economic measure, the Texas Ratio, that Texans—especially Texas bankers—would like to have renamed.

The Texas Ratio is often used to measure the riskiness of a bank and its likelihood of failure. But recently, it has lost its distinctiveness as being uniquely Texan. Conceived about 30 years ago, the ratio is an early warning metric that can identify banks that might fail if dragged down further by bad loans. The ratio is calculated by dividing a bank’s bad debt by the amount of money available to absorb troubled assets. The ratio’s creators found that Texas banks in the 1980s with a ratio of 100% or more strongly signaled that they were about to go bust.

Indeed, nearly 19% of Texas banks in 1988 had a Texas ratio of more than 100%. And in 1989, Texas had a record 133 bank failures—about 9% of the total banks in the Lone Star state and 65% of total bank failures in the nation that year.

The late 1980s were a rough time for banking in Texas. Generally speaking, Texas banks overextended credit and lowered lending standards to booming energy and real estate sectors. Risky lending policies were predicated on ever-increasing oil prices and real estate values and claims that “this time it’s different.” As a result, more and more investors—and speculators—jumped in with blind capital and fueled a bubble in which assets were largely unsecured and inadequately collateralized with insufficient down payments. With little skin in the game and the oil and real estate booms quickly turning to busts, borrowers started defaulting on payments and walking away from unfinished projects. Before long, the noncurrent loan rate topped 10%, as the Texas banking industry suffered losses every quarter from 1986 to 1990.

The pattern described above has played itself out time and time again. To be sure, the recent housing boom and bust that precipitated the 2008 financial panic is the most recent example. But Texas, and Texas banks, weathered this crisis far better than most states and has so far recovered faster and stronger.

Texas had a relatively stable housing market during the last national housing boom and bust. According to data collected by the Federal Housing Finance Agency, national home prices peaked in 2007 at 67% above their 2000 level, roughly double the 37% increase for Texas home prices over the same time. In California and Florida, the increase during this period was more than double the national average, at about 138%. But since the housing price peak in 2007, national home prices have declined 17% and about 36% in California and 42% in Florida, whereas prices have increased by almost 2% in Texas.

Fewer housing development regulations and an ample supply of undeveloped land likely helped dampen home price gains in Texas during the run-up. With smaller price gains and greater restrictions on home equity lending, Texas housing markets were not as susceptible to unconventional loans with relaxed lending standards where borrowers had small or no down payments.

And perhaps Texas bankers learned and subsequently applied some important lessons from the 1980s Texas panic. More recently, Texas bankers have not made as many bad loans. Texas has more banks than any other state but has had only two of the more than 240 bank failures in the U.S. since the beginning of 2010.

Despite a plethora of government-mandated banking rules and regulations, Texas bankers appear to have done better by sticking with the basic fundamentals of lending, also known as the “four C’s”: credit, character, capacity and collateral. Even so, Texas bankers tell me they are concerned. They are overwhelmed. They are fatigued. And they are suffocating under the burden of new and proposed regulations enacted as a reaction to the excesses of a few very large institutions and from practices encouraged by previous legislation. Community banks in Texas believe they are under attack and being punished for problems they did not create with one-size-fits-all regulatory “solutions.”

Currently just seven banks in Texas, or 1.25%, have Texas ratios of 100% or more, compared with 5.25% of banks in the United States. Today, four states have a greater percentage of banks with Texas ratios above 100% than Texas did at the height of its 1980s banking crisis: Georgia (28.5%), Nevada (20%), Florida (20%) and Arizona (20%).

So the Texas ratio may have been a descriptive moniker when it was developed. But now, the metric does not seem to apply to Texas banks. Perhaps it’s time to rename the Texas ratio and rediscover that successful banking comes from knowing your customer. The best way to lessen the impact from the next panic is likely not with more laws and regulation but with individual institutional adherence to the Four C’s. Make that the Texas Four C’s.