RELATED ARTICLE "Can Low Oil Prices Cripple the Texas Banking System?" Southwest Economy, May/June 1999 (Text or PDF)

Regional Economy
The Financial Health of Texas Banks

Dallas Fed Senior Vice President and Director of Research Harvey Rosenblum evaluates the Texas banking industry and gives a historical perspective.

Following Texas' economic boom in the 1970s, most Texas banks entered the 1980s as the envy of the U.S. banking system. Texas banks were among the most well-capitalized and highly profitable banks in the country. This situation was quickly reversed.

Oil-dependent Texas banks were ill prepared for the plunge in oil prices during the 1980s. By 1987, large percentages of Texas banks were severely undercapitalized, and record levels of red ink appeared on their income statements. Bank failures became noticeable in 1986 and soared in 1987-90 (Chart 1). In early 1987, the number of banks in Texas stood at nearly 2,000; if Texas were a country, it would have ranked second (the United States being first) in the number of banks. Many of the failed banks had been chartered only a few years, but many of Texas' largest and most well-established banks failed or received outside capital infusions. At one point in 1988, more than half of all Texas banks were rated "problem banks" by their primary federal supervisory agency.[1]

To examine the overall financial condition of Texas banks, I devised a somewhat oversimplified measure of financial health. I considered a bank to be healthy if it simultaneously passed three tests: (1) it was well capitalized; (2) it was profitable; and (3) it had a below-average ratio of troubled (nonperforming) assets. Banks that passed all three tests were designated "healthy" banks; those that failed all three were deemed "sick" banks.[2] Banks that passed only one or two of these criteria were considered "not well." While such a measure may not give a strictly accurate or complete picture of a bank's financial health, it may nonetheless provide some clues about a bank's propensity (that is, its willingness and ability) to expand credit. By this particular measure of financial health, fewer than half of Texas banks were healthy in 1988 (Chart 2), and these healthy banks accounted for less than one-fourth of Texas banking assets at the time (Chart 3). While "only" 15 percent of Texas banks were sick in 1988, they accounted for almost 30 percent of Texas banking assets. Roughly three-fourths of Texas banking assets were in the hands of banks that were either sick or not well.

As the number of sick and financially weakened Texas banks began to increase, their loans and assets began to shrink. Unprofitable and undercapitalized banks concentrated on collecting old loans and became reluctant to make new ones. Between 1985 and 1991, the volume of loans on the books of Texas banks fell by more than half, adjusted for inflation (Chart 4). Within Texas, talk of a "Texas credit crunch" was widespread. Debate raged about whether the drop in bank lending was primarily a decrease in loan demand stemming from the recession levels of economic activity; whether banks were simply unwilling or unable to lend due to constraints imposed by their balance sheet weakness; or whether regulatory standards designed to curtail bank asset expansion actually encouraged asset contraction to achieve minimum required capital-to-asset ratios.[3]

What's Different Now

Interstate branching. Bank branching was prohibited in Texas before 1987, with the result that Texas banks could not diversify their risks geographically. These banks were subject to the particular forces that moved the Texas economy, chiefly oil prices. More recently, many of Texas' larger banking entities have become part of very large, multistate branching networks, thereby diversifying their geographic risks across many different economic markets. In 1998, 54 percent of Texas banking assets were controlled by banks headquartered outside Texas; that percentage was zero before 1987. Furthermore, research by Dallas Fed economists Steve Brown and Mine Yucel shows that the Texas economy is only one-fourth as sensitive to changes in oil prices now as it was during the early 1980s.

Credit exposure. During the second half of the 1980s, the Texas banking industry experienced a depression. Unlike a recession, a depression is more than an economic event; it is a psychological trauma that becomes indelibly stamped in one's memory and in the industry's "genetic code." In these circumstances, it takes a long time to forget the ordeal, and behaviors are altered to avoid repeating past mistakes associated with the event. On average, Texas banks have a loan-to-asset ratio about 10 percentage points below its 1986 levels, and their ratio of commercial and industrial loans to total loans is three-fifths of what it was in the early 1980s. The balance sheets of Texas banks reflect more caution than they did a decade and a half ago.

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