DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

Risk Management Objectives of Using Derivatives

Customers Bancorp is exposed to certain risks arising from both its business operations and economic conditions. Customers Bancorp manages economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and durations of its assets and liabilities. Specifically, Customers Bancorp enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. Customers Bancorp’s derivative financial instruments are used to manage differences in the amount, timing, and duration of Customers Bancorp’s known or expected cash receipts and its known or expected cash payments principally related to certain fixed-rate borrowings. Customers Bancorp also has interest-rate derivatives resulting from a service provided to certain qualifying customers, and therefore, they are not used to manage the Bank’s interest-rate risk in assets or liabilities. The Bank manages a matched book with respect to its derivative instruments used in this customer service in order to minimize its net risk exposure resulting from such transactions.

Cash Flow Hedges of Interest Rate Risk

Customers Bancorp’s objectives in using interest-rate derivatives are to add stability to interest expense and to manage exposure to interest rate movements. To accomplish this objective, the Bancorp primarily uses interest rate swaps as part of its interest-rate-risk management strategy. Interest-rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Bancorp's making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

The effective portion of changes in the fair value of derivatives designated and qualifying as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During 2014, such derivatives were used to hedge the variable cash flows associated with a forecasted issuance of debt. The ineffective portion of the change in fair value of the derivatives is to be recognized directly in earnings. During 2014, Customers Bancorp did not record any hedge ineffectiveness.

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the Bancorp’s variable-rate debt. The Bancorp does not expect to reclassify any amounts from accumulated other comprehensive income to interest expense during the next 12 months as Customers Bancorp’s derivatives are effective after April 2016.

Customers Bancorp is hedging its exposure to the variability in future cash flows for forecasted transactions over a maximum period of 24 months (excluding forecasted transactions related to the payment of variable interest on existing financial instruments).

At December 31, 2014, Customers Bancorp had one outstanding interest rate derivative with a notional amount of $150.0 million that was designated as a cash flow hedge of interest rate risk. The hedge expires in April of 2019.

Derivatives Not Designated as Hedging Instruments

The Bank executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies (typically the loan customers will swap a floating rate loan to a fixed rate loan). The customer interest rate swaps are simultaneously offset by interest rate swaps that the Bank executes with a third party in order to minimize interest rate risk exposure resulting from such transactions. Since the interest rate swaps associated with this program do not meet the hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting third-party market swaps are recognized directly in earnings. At December 31, 2014, the Bancorp had 44 interest rate swaps with an aggregate notional amount of $251.9 million related to this program. At December 31, 2013, the Bancorp had 28 interest rate swaps with an aggregate notional amount of $150.3 million related to this program.

The Bank enters into residential mortgage loan commitments in connection with its mortgage banking activities to fund mortgage loans at specified rates and times in the future. These commitments are short-term in nature and generally expire in 30 to 60 days. The residential mortgage loan commitments that relate to the origination of mortgage loans that will be held for sale are considered derivative instruments under applicable accounting guidance and are reported at fair value, with changes in fair value recorded directly to earnings. At December 31, 2014 and December 31, 2013, the Bank had an outstanding notional balance of residential mortgage loan commitments of $3.8 million and $7.1 million, respectively.

During first quarter 2014, the Bank purchased credit derivatives to hedge the performance risk associated with one of its counterparties. These derivatives are not designated as hedging instruments and are reported at fair value, with changes in fair value reported directly in earnings. At December 31, 2014, the Bank had an outstanding notional balance of credit derivatives of $13.4 million.

Fair Value of Derivative Instruments on the Balance Sheet

The following table presents the fair value of the Bancorp’s derivative financial instruments as well as the classification on the balance sheet.



	December 31, 2014
	Derivative Assets			Derivative Liabilities
	Balance Sheet			Balance Sheet
	Location	Fair Value		Location	Fair Value
(amounts in thousands)
Derivatives designated as cash flow hedges:
Interest rate swaps	Other assets	$	—	Other liabilities	$	1,945
Total		$	—		$	1,945
Derivatives not designated as hedging instruments:
Interest rate swaps	Other assets	$	7,332	Other liabilities	$	7,771
Credit contracts	Other assets	177		Other liabilities	—
Residential mortgage loan commitments	Other assets	43		Other liabilities	—
Total		$	7,552		$	7,771



	December 31, 2013
	Derivative Assets			Derivative Liabilities
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
(amounts in thousands)
Derivatives not designated as hedging instruments:
Interest rate swaps	Other assets	$	3,523	Other liabilities	$	3,537
Residential mortgage loan commitments	Other assets	240		Other liabilities	—
Total		$	3,763		$	3,537

Effect of Derivative Instruments on Comprehensive Income

The following table presents the effect of the Bancorp’s derivative financial instruments on comprehensive income for the years ended December 31, 2014 and 2013. Interest rate swap income amounts include premiums received from Bank customers.



	December 31, 2014
	Income Statement Location	Amount of income (loss) recognized in earnings
(amounts in thousands)
Derivatives not designated as hedging instruments:
Interest rate swaps	Other non-interest income	$	550
Credit Contracts	Other non-interest income	(91		)
Residential mortgage loan commitments	Mortgage loan and banking income	(197		)
Total		$	262



	December 31, 2013
	Income Statement Location	Amount of income recognized in earnings
(amounts in thousands)
Derivatives not designated as hedging instruments:
Interest rate swaps	Other non-interest income	$	711
Residential mortgage loan commitments	Mortgage loan and banking income	240
Total		$	951



	December 31, 2014
				Location of Gain	Amount of Gain (Loss)
	Amount of Loss			(Loss) Reclassified	Reclassified from
	Recognized in OCI on			from Accumulated	Accumulated OCI into
	Derivatives (Effective			OCI into Income	Income (Effective
	Portion) (1)			(Effective Portion)	Portion)
(amounts in thousands)
Derivatives in cash flow hedging relationships:
Interest rate swaps	$	(1,264	)	Interest expense	$	—

(1) Net of taxes

Credit-risk-related Contingent Features

By entering into derivative contracts, the Bank is exposed to credit risk. The credit risk associated with derivatives executed with Bank customers is the same as that involved in extending the related loans and is subject to the same standard credit policies. To mitigate the credit-risk exposure to major derivative dealer counterparties, the Bancorp only enters into agreements with those that maintain credit ratings of high quality.

Agreements with major derivative dealer counterparties contain provisions whereby default on any of the Bancorp’s indebtedness would be considered a default on its derivative obligations. The Bancorp also has entered into agreements that contain provisions under which the counterparty could require the Bancorp to settle its obligations if the Bancorp fails to maintain its status as a well/adequately-capitalized institution. As of December 31, 2014, the fair value of derivatives in a net liability position (which includes accrued interest but excludes any adjustment for nonperformance-risk) related to these agreements was $9.9 million. In addition, the Bancorp has collateral posting thresholds with certain of these counterparties and at December 31, 2014, had posted $10.0 million of cash as collateral. The Bancorp records posted cash as a reduction in the outstanding balance of cash and cash equivalents and an increase in the balance of other assets.

Disclosures about Offsetting Assets and Liabilities

The following tables present derivative instruments that are subject to enforceable master netting arrangements. The Bancorp’s interest rate swaps with institutional counterparties are subject to master netting arrangements and are included in the table below. Interest rate swaps with commercial banking customers and residential mortgage loan commitments are not subject to master netting arrangements and are excluded from the table below. The Bancorp has not made a policy election to offset its derivative positions.



	Offsetting of Financial Assets and Derivative Assets at
	December 31, 2014
							Gross Amounts Not Offset in the Consolidated Balance Sheet
	Gross Amount of Recognized Assets		Gross Amounts Offset in the Consolidated Balance Sheet		Net Amounts of Assets Presented in the Consolidated Balance Sheet		Financial Instruments		Cash Collateral Received		Net Amount
(amounts in thousands)
Description
Interest rate swap derivatives with institutional counterparties	$	192	$	—	$	192	$	192	$	—	$	—



	Offsetting of Financial Assets and Derivative Assets at
	December 31, 2013
							Gross Amounts Not Offset in the Consolidated Balance Sheet
	Gross Amount of Recognized Assets		Gross Amounts Offset in the Consolidated Balance Sheet		Net Amounts of Assets Presented in the Consolidated Balance Sheet		Financial Instruments		Cash Collateral Received		Net Amount
(amounts in thousands)
Description
Interest rate swap derivatives with institutional counterparties	$	392	$	—	$	392	$	392	$	—	$	—



	Offsetting of Financial Liabilities and Derivative Liabilities at
	December 31, 2014
							Gross Amounts Not Offset in the Consolidated Balance Sheet
	Gross Amount of Recognized Liabilities		Gross Amounts Offset in the Consolidated Balance Sheet		Net Amounts of Liabilities Presented in the Consolidated Balance Sheet		Financial Instruments		Cash Collateral Pledged		Net Amount
(amounts in thousands)
Description
Interest rate swap derivatives with institutional counterparties	$	9,703	$	—	$	9,703	$	192	$	9,511	$	—



	Offsetting of Financial Liabilities and Derivative Liabilities at
	December 31, 2013
	Gross Amount of Recognized Liabilities		Gross Amounts Offset in the Consolidated Balance Sheet		Net Amounts of Liabilities Presented in the Consolidated Balance Sheet		Financial Instruments		Cash Collateral Pledged		Net Amount
(amounts in thousands)
Description
Interest rate swap derivatives with institutional counterparties	$	3,191	$	—	$	3,191	$	392	$	2,799	$	—