The number of U.S. banks with an adjusted Texas ratio above 100% rose for the third consecutive quarter and grew to its largest size since the second quarter of 2020.

However, large amounts of unrealized losses in some banks' available-for-sale portfolios — which impact tangible common equity — appear responsible for the spike rather than a severe slippage in credit or a large regulatory capital shortfall. After excluding accumulated other comprehensive income, or AOCI, from tangible common equity, no U.S. banks had a Texas ratio above 100% at Sept. 30, according to an analysis by S&P Global Market Intelligence.

S&P Global Market Intelligence defines the adjusted Texas ratio as nonperforming assets plus loans 90 days or more past due — excluding delinquent government-guaranteed loans and other real estate owned covered by loss-sharing agreements with the Federal Deposit Insurance Corp. — divided by tangible equity plus loan loss reserves. Allowance for credit losses on off-balance sheet credit exposures are not included in loan loss reserves. A high Texas ratio does not necessarily imply potential failure, but the ratio is a good measure of a bank's ability to absorb future losses.

AOCI impacts Q3 Texas ratios

Changes in the values of available-for-sale portfolios are captured in AOCI, but AOCI losses are not an immediate regulatory issue given that regulatory capital rules allow most banks to add the book value losses to regulatory capital, Troutman Pepper attorneys wrote on the company's website.

However, "banks will need to remain watchful for potential regulatory issues related to AOCI losses," they added. "At some point these AOCI losses may become a regulatory issue if the unrealized losses have a negative impact on a bank's earnings rating or if the portfolio needs to be accessed for liquidity purposes and the unrealized losses have to be realized."

Some investors have questioned whether banks might have to recognize unrealized losses to meet growing liquidity needs in the face of deposit outflows, Raymond James analysts wrote in a Nov. 14 note.

"Should banks be forced to sell AFS/HTM securities to fund deposit outflows, those losses would be realized and flow through the income statement, in turn weighing on regulatory capital," the analysts wrote. "While forced sales from the HTM book is somewhat of a black swan event, it is not out of the realm of possibility. In fact, we are hearing more investors considering this in their investment outlooks."

While AOCI losses may not create a capital problem for a stand-alone company, advisers have suggested they can hinder some banks' efforts to pursue a sale, as with Philadelphia-based Republic First Bancorp Inc.

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Thirteen U.S. banks and thrifts posted an adjusted Texas ratio above 100% in the third quarter, up from six in the previous quarter, and the third consecutive quarterly increase following a steady decline throughout 2021.

The median adjusted ratio for the U.S. banking industry rose slightly for the second consecutive quarter to 3.14% in the third quarter from 3.10% in the linked quarter. The increase in the second quarter was the first quarter-over-quarter increase in two years.

For banks with Texas ratios above 100%, all but Monticello, Iowa-based Citizens State Bank saw lower tangible equity balances in the third quarter due to the unrealized losses on available-for-sale portfolios recognized in the quarter.

Who's on the list

Eudora, Kan.-based Kaw Valley State Bank had the highest Texas ratio by far at 15,500% at the end of the third quarter as its tangible equity fell into negative territory due to growing unrealized losses in its available-for-sale portfolio. Securities equated to 57.7% of Kaw Valley's assets and nearly 85% of the institution's securities were expected to reprice or mature in more than five years.

Rotan, Texas-based First National Bank and Tampa, Kan.-based Tampa State Bank rounded out the top three with 859.5% and 815.9%, respectively. Of the six banks that posted a Texas ratio above 100% in the second quarter, Tampa State Bank, Citizens State Bank and Elmwood, Ill.-based Farmers State Bank did not fall below the 100% threshold in the third quarter.

Another nine banks had an adjusted ratio between 70% and 100% at the end of the third quarter, up from seven in the second quarter. Of these banks, Alva, Okla.-based BancCentral NA; Monterey, Calif.-based Monterey County Bank; and Hazard, Ky.-based Peoples Bank & Trust Co. of Hazard posted ratios above the 100% threshold in the second quarter.

Excluding AOCI

With AOCI removed in tangible equity, no banks posted a Texas ratio greater than 100%. Excluding AOCI, Kenyon, Minn.-based Security State Bank of Kenyon had the highest Texas ratio at 75.4%.