Note 10. Derivatives

Risk Management Objective of Using Derivatives

The Company enters into derivative financial instruments to manage risks related to differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments, currently related to select pools of variable rate loans. The Bank has also entered into interest rate derivative agreements as a service to certain qualifying customers. The Bank manages a matched book with respect to these customer derivatives in order to minimize their net risk exposure resulting from such agreements. The Bank also enters into risk participation agreements under which it may either sell or buy credit risk associated with a customer’s performance under certain interest rate derivative contracts related to loans in which participation interests have been sold to or purchased from other banks.

Fair Values of Derivative Instruments on the Balance Sheet

The table below presents the notional amounts and fair values of the Company’s derivative financial instruments as well as their classification in the consolidated balance sheets as of December 31, 2017 and 2016. Effective January 3, 2017, the Company’s central clearing counterparty amended its rulebook to legally characterize variation margin accounts as settlements, rather than being reflected separately as collateral. As a result of the change, the Company began prospectively reflecting derivative assets and liabilities net of the central clearing counterparty derivative margin account.


						Fair Values (1)
		Notional Amounts				Assets				Liabilities
	Type of	December 31,				December 31,				December 31,
(in thousands)	Hedge	2017		2016		2017		2016		2017		2016
Derivatives designated
as hedging instruments:
Interest rate swaps	Cash Flow	$	875,000	$	1,100,000	$	—	$	—	$	14,020	$	7,787
Interest rate swaps	Fair Value		483,110		—		—		—		2,475		—
		$	1,358,110	$	1,100,000	$	—	$	—	$	16,495	$	7,787
Derivatives not designated
as hedging instruments:
Interest rate swaps (2)	N/A	$	1,144,789	$	979,391	$	15,408	$	18,405	$	15,857	$	18,362
Risk participation agreements	N/A		119,951		84,732		23		50		109		105
Forward commitments to sell
residential mortgage loans	N/A		80,462		75,676		1,000		900		290		221
Interest rate-lock commitments
on residential mortgage loans	N/A		53,724		46,840		186		189		782		228
Foreign exchange forward
contracts	N/A		42,260		56,152		2,453		771		2,419		729
		$	1,441,186	$	1,242,791	$	19,070	$	20,315	$	19,457	$	19,645
Total derivatives		$	2,799,296	$	2,342,791	$	19,070	$	20,315	$	35,952	$	27,432
Less: netting adjustments (3)							(4,913)		—		(21,563)		—
Total derivate assets/liabilities							14,157		20,315		14,389		27,432

(1)

Derivative assets and liabilities are reported with other assets or other liabilities, respectively, in the consolidated balance sheets.

(2)

The notional amount represents both the customer accommodation agreements and offsetting agreements with unrelated financial institutions.

(3)

Represents balance sheet netting of derivative assets and liabilities for variation margin collateral held or placed with the same central clearing counterparty. See offsetting assets and liabilities for further information.

Cash Flow Hedges of Interest Rate Risk

The Company is party to various interest rate swap agreements designated and qualifying as cash flow hedges of the Company’s forecasted variable cash flows for pools of variable rate loans. For each agreement, the Company receives interest at a fixed rate and pays at a variable rate. The swap agreements expire as follows: notional amount of $250 million in 2019; $200 million in 2020; $425 million in 2022.

During the term of the swap agreements, the effective portion of changes in the fair value of the derivative instruments are recorded in Accumulated Other Comprehensive Income (“AOCI”) and subsequently reclassified into earnings in the periods that the hedged forecasted variable-rate interest payments affects earnings. The impact on AOCI is reflected in Note 11 – Stockholders’ Equity. There was no ineffective portion of the change in fair value of the derivative recognized directly in earnings.

Fair Value Hedges of Interest Rate Risk

During 2017, the Company entered into interest rate swap agreements that modify the Company’s exposure to interest rate risk by effectively converting a portion of the Company’s brokered certificates of deposit from fixed rates to variable rates. The maturities and call features of these interest rate swaps match the features of the hedged deposits. As interest rates fall, the decline in the value of the certificates of deposit is offset by the increase in the value of the interest rate swaps. Conversely, as interest rates rise, the value of the underlying hedged deposits increases, but the value of the interest rate swaps decreases, resulting in no impact on earnings. Interest expense is adjusted by the difference between the fixed and floating rates for the period the swaps are in effect. Hedge ineffectiveness on these transactions results in an increase or decrease in noninterest income.

Derivatives Not Designated as Hedges

Customer interest rate derivative program

The Bank enters into interest rate derivative agreements, primarily rate swaps, with commercial banking customers to facilitate their risk management strategies. The Bank enters into offsetting agreements with unrelated financial institutions, thereby mitigating its net interest rate risk exposure resulting from such transactions. Because the interest rate derivatives associated with this program do not meet hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings.

Risk participation agreements

The Bank also enters into risk participation agreements under which it may either assume or sell credit risk associated with a borrower’s performance under certain interest rate derivative contracts. In those instances where the Bank has assumed credit risk, it is not a direct counterparty to the derivative contract with the borrower and have entered into the risk participation agreement because it is a party to the related loan agreement with the borrower. In those instances in which the Bank has sold credit risk, it is the sole counterparty to the derivative contract with the borrower and has entered into the risk participation agreement because other banks participate in the related loan agreement. The Bank manages its credit risk under risk participation agreements by monitoring the creditworthiness of the borrower, based on the Bank’s normal credit review process.

Mortgage banking derivatives

The Bank also enters into certain derivative agreements as part of their mortgage banking activities. These agreements include interest rate lock commitments on prospective residential mortgage loans and forward commitments to sell these loans to investors on a best efforts delivery basis.

Customer foreign exchange forward contract derivatives

The Bank enters into foreign exchange forward derivative agreements, primarily forward currency contracts, with commercial banking customers to facilitate their risk management strategies. The Bank manages its risk exposure from such transactions by entering into offsetting agreements with unrelated financial institutions. Because the foreign exchange forward contract derivatives associated with this program do not meet hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings.

Effect of Derivative Instruments on the Income Statement

Derivative income consisting primarily of customer interest rate swap fees, net of fair value adjustments, is reflected in the income statement in other noninterest income, totaling $5.9 million, $5.2 million and $2.7 million for the years ended December 31, 2017, 2016 and 2015, respectively. The impact to interest income from cash flow hedges was $(0.3) million, $2.3 million, and $2.1 million for the years ended December 31, 2017, 2016, and 2015 respectively. The impact to interest income of the fair value hedge entered into in 2017 was $(0.8) million. The impact to noninterest income was minimal.

Credit Risk-Related Contingent Features

Certain of the Bank’s derivative instruments contain provisions allowing the financial counterparty to terminate the contracts in certain circumstances, such as the downgrade of the Bank’s credit ratings below specified levels, a default by the Bank on its indebtedness, or the failure of the Bank to maintain specified minimum regulatory capital ratios or its regulatory status as a well-capitalized institution. These derivative agreements also contain provisions regarding the posting of collateral by each party. As of December 31, 2017, the aggregate fair value of derivative instruments with credit-risk-related contingent features that were in a net liability position was $1.8 million, for which the Bank had posted collateral of $4.1 million.

Offsetting Assets and Liabilities

The Bank’s derivative instruments to certain counterparties contain legally enforceable netting provisions that allow for net settlement of multiple transactions to a single amount, which may be positive, negative, or zero. Agreements with certain bilateral counterparties require both parties to maintain collateral in the event that the fair values of derivative instruments exceed established exposure thresholds. For centrally cleared derivatives, the Company is subject to initial margin posting and daily variation margin exchange with the central clearinghouses. As noted above, effective January 3, 2017, the Company began to reflect its derivative assets and liabilities net of the central clearing party variation margin account in the Statement of Income. Offsetting information in regards to derivative assets and liabilities subject to these master netting agreements at December 31, 2017 and December 31, 2016 is presented in the following tables:



As of December 31, 2017
			Gross Amounts Offset in the		Net Amounts Presented in the		Gross Amounts Not Offset in the Statement of Financial Position
(in thousands)	Gross Amounts Recognized		Statement of Financial Position		Statement of Financial Position		Financial Instruments		Cash Collateral		Net Amount
Derivative Assets	$	7,155	$	(5,007)	$	2,148	$	2,148	$	—	$	—
Derivative Liabilities	$	24,015	$	(20,077)	$	3,938	$	2,148	$	4,099	$	(2,309)



As of December 31, 2016
			Gross Amounts Offset in the		Net Amounts Presented in the		Gross Amounts Not Offset in the Statement of Financial Position
(in thousands)	Gross Amounts Recognized		Statement of Financial Position		Statement of Financial Position		Financial Instruments		Cash Collateral		Net Amount
Derivative Assets	$	4,788	$	—	$	4,788	$	4,788	$	—	$	—
Derivative Liabilities	$	26,846	$	—	$	26,846	$	4,788	$	19,095	$	2,963

The Company has excess collateral compared to total exposure due to initial margin requirements for day-to-day rate volatility.