Note 10. Derivatives

On January 1, 2018, the Company adopted the provisions of Accounting Standards Update (ASU) 2017-12, “Derivatives and Hedging,” using the modified retrospective transition approach. As a result of adoption of the update, the Company has made certain adjustments to its existing designation documentation for active hedging relationships to take advantage of specific provisions of the update. Adoption of this guidance did not have a material impact on the Company’s financial condition or results of operations. Following is a discussion of the provisions of the guidance relevant to the Company:

Ineffectiveness measurement and presentation

The provisions of the update eliminate the concept of ineffectiveness from an accounting perspective. The guidance provides that, as long as a hedging instrument is designated and the results of the effectiveness testing support that the instrument qualifies for hedge accounting treatment, there will be no periodic measurement or recognition of ineffectiveness. Rather, the full impact of hedge gains and losses will be recognized in the period in which the hedged transactions impact the entity’s earnings.

Presentation of reclassifications from Accumulated Other Comprehensive Income

The update provides that amounts in Accumulated Other Comprehensive Income that are included in the assessment of effectiveness should be reclassified into earnings in the same period in which the hedged forecasted transactions impact earnings. As such, the Company will recognize all reclassifications out of Other Comprehensive Income in the same statement of income line item in which the earnings effect of the hedged item is presented.

Changes to hedged risk

The update also states that if the designated hedged risk changes during the life of the hedging relationship, an entity may continue to apply hedge accounting as long as the hedging instrument is highly effective at achieving offsetting cash flows attributable to the revised hedged risk. Regardless of the description of the hedged transactions contained in the initial designation documentation, the Company intends to utilize this provision in the updated guidance to the extent possible.

Risk component hedging in fair value hedges

The update allows an entity to make a one-time transition election regarding the fair value measurement methodology applied to fair value hedges in place at adoption. The Company did not elect either of the one-time transition options; rather, it will continue to measure the hedged items as documented in the initial hedge documentation.

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, primarily related to select pools of variable rate loans and obligations under brokered certificates of deposit. The Bank has also entered into interest rate and foreign currency exchange 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, 2018 and 2017.



		December 31, 2018						December 31, 2017
				Derivative (1)						Derivative (1)
(in thousands)	Type of Hedge	Notional or Contractual Amount		Assets		Liabilities		Notional or Contractual Amount			Assets		Liabilities
Derivatives designated
as hedging instruments:
Interest rate swaps	Cash Flow	$	875,000	$	3,954	$	9,173	$	875,000	$	—	$	14,020
Interest rate swaps	Fair Value		483,110		—		2,089		483,110		—		2,475
		$	1,358,110	$	3,954	$	11,262	$	1,358,110	$	—	$	16,495
Derivatives not designated
as hedging instruments:
Interest rate swaps (2)	N/A	$	1,277,404	$	23,670	$	24,669	$	1,144,789	$	15,408	$	15,857
Risk participation agreements	N/A		171,222		10		131		119,951		23		109
Forward commitments to sell
residential mortgage loans	N/A		77,208		110		664		80,462		1,000		290
Interest rate-lock commitments
on residential mortgage loans	N/A		59,119		464		67		53,724		186		782
Foreign exchange forward
contracts	N/A		37,749		751		718		42,260		2,453		2,419
Visa Class B derivative contract	N/A		43,753		—		7,304		—		—		—
		$	1,666,455	$	25,005	$	33,553	$	1,441,186	$	19,070	$	19,457
Total derivatives		$	3,024,565	$	28,959	$	44,815	$	2,799,296	$	19,070	$	35,952
Less: netting adjustments (3)					(11,979)		(22,588)				(4,913)		(21,563)
Total derivate assets/liabilites					16,980		22,227				14,157		14,389

(1)

Derivative assets and liabilities are reported in 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. During the year ended December 31, 2018, the Company terminated five of its shorter-term swap agreements with notional amounts totaling $450 million and entered into five longer-term agreements with notional amounts totaling $450 million. The Company paid termination fees of approximately $10.6 million to settle the interest rate swap liabilities. During the year ended December 31, 2017, the Company terminated two swap agreements and paid termination fees of approximately $1.1 million. The resulting accumulated other comprehensive loss is being amortized over the remaining maturities of the designated instruments. Amortization of other comprehensive loss on terminated cash flow hedges totaled $6.0 million and $0.6 million for the years ended December 31, 2018 and 2017, respectively. The notional amounts of the swap agreements in place at December 31, 2018 expire as follows: $425 million in 2022; $350 million in 2023; $100 million in 2024.

Fair Value Hedges of Interest Rate Risk

The Company is party to 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 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 has 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 its 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 foreign 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.

Visa Class B derivative contract

As a member of Visa U.S.A. Inc. (“Visa USA”), the Company received a certain number of Visa Class B common shares following the 2007 restructuring of Visa USA and its affiliates and the 2008 initial public offering of Visa Inc. (“Visa”). The Visa Class B common shares are subject to certain selling restrictions until the final resolution of certain litigation related to interchange fees involving Visa (the “covered litigation”), at which time the shares are convertible into Visa Class A common shares based on a conversion rate dependent upon the ultimate cost of resolving the covered litigation.

During the fourth quarter of 2018, the Company sold the majority of its Visa Class B holdings, at which time it entered into a derivative agreement with the purchaser whereby the Company will make or receive cash payments whenever the conversion ratio of the Visa Class B shares into Visa Class A shares is adjusted. The conversion ratio changes when Visa deposits funds to a litigation escrow established by Visa to pay settlements for certain litigation, for which Visa is indemnified by Visa USA members. The Company is also required to make periodic financing payments to the purchaser until all of Visa’s covered litigation matters are resolved. Thus, the derivative contract extends until the end of Visa’s Covered Litigation matters, the timing of which is uncertain.

The contract includes a contingent accelerated termination clause based on the credit ratings of the Company. As of December 31, 2018, the Company had not received or paid collateral related to this contract, and the fair value of the liability associated with this contract was $7.3 million. Refer to Note 19 – Fair Value of Financial Instruments for discussion of the valuation inputs and process for this derivative liability.

Effect of Derivative Instruments on the Statements of Income

The effects of derivative instruments on the consolidated statements of income for the years ended December 31, 2018, 2017 and 2016 are presented in the table below. For the years ended December 31, 2018 and 2017, the reduction of interest income attributable to cash flow hedges includes amortization of accumulated other comprehensive loss that resulted from termination of certain interest rate swap contracts.



		Year Ended
		December 31,
Derivative Instruments:	Location of Gain (Loss) Recognized in the Statement of Income:	2018		2017		2016
Interest rate swaps - cash flow hedges	Interest income	$	(4,497)	$	(280)	$	2,310
Interest rate swaps - fair value hedges	Interest expense		(2,343)		829		-
All other instruments	Other noninterest income		5,368		5,870		5,196
Total		$	(1,472)	$	6,419	$	7,506

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, 2018, the Company was not in violation of any such provisions.

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. The Company reflects its derivative assets and liabilities net of the central clearing party variation margin account in the Statements of Income. Offsetting information in regards to derivative assets and liabilities subject to these master netting agreements at December 31, 2018 and 2017 is presented in the following tables:



December 31, 2018
			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	$	16,167	$	(12,842)	$	3,325	$	1,846	$	—	$	1,479
Derivative Liabilities	$	23,811	$	(21,651)	$	2,160	$	1,846	$	2,871	$	(2,557)



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)

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