DERIVATIVES

In the normal course of business, Citizens enters into a variety of derivative transactions in order to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates and foreign currency exchange rates. These transactions include interest rate swap contracts, interest rate options, foreign exchange contracts, residential loan commitment rate locks, interest rate future contracts, swaptions, forward commitments to sell to-be-announced mortgage securities (“TBAs”), forward sale contracts and purchase options. The Company monitors the results of each transaction to ensure that management’s intent is satisfied. The Company does not use derivatives for speculative purposes.

The Company’s derivative instruments are recognized on the Consolidated Balance Sheets at fair value. Information regarding the valuation methodology and inputs used to estimate the fair value of the Company’s derivative instruments is described in Note 19 “Fair Value Measurements.”

Derivative assets and derivative liabilities are netted by counterparty on the balance sheet if a “right of setoff” has been established in a master netting agreement between the Company and the counterparty. This netted derivative asset or liability position is also netted against the fair value of any cash collateral that has been pledged or received in accordance with a Credit Support Annex.

The following table presents derivative instruments included on the Consolidated Balance Sheets in derivative assets and derivative liabilities:



	December 31, 2018								December 31, 2017
(in millions)	Notional Amount ⁽¹⁾		Derivative Assets			Derivative Liabilities			Notional Amount ⁽¹⁾		Derivative Assets			Derivative Liabilities
Derivatives designated as hedging instruments:
Interest rate contracts		$12,050		$5			$—			$13,300		$—			$—
Derivatives not designated as hedging instruments:
Interest rate contracts	117,076		301			277			80,180		538			379
Foreign exchange contracts	9,866		129			113			9,882		148			149
Other contracts	3,555		14			25			1,039		7			5
Total derivatives not designated as hedging instruments			444			415					693			533
Gross derivative fair values			449			415					693			533
Less: Gross amounts offset in the Consolidated Balance Sheets ⁽²⁾			(87		)	(87		)			(72		)	(72		)
Less: Cash collateral applied ⁽²⁾			(45		)	(36		)			(4		)	(151		)
Total net derivative fair values presented in the Consolidated Balance Sheets				$317			$292					$617			$310

⁽¹⁾The notional or contractual amount of interest rate derivatives and foreign exchange contracts is the amount upon which interest and other payments under the contract are based. For interest rate contracts, the notional amount is typically not exchanged. Therefore, notional amounts should not be taken as the measure of credit or market risk, as they do not measure the true economic risk of these contracts.

⁽²⁾ Amounts represent the impact of enforceable master netting agreements that allow the Company to net settle positive and negative positions as well as collateral paid and received.

The Company’s derivative transactions are internally divided into three sub-groups: institutional, customer and residential loan.

Institutional derivatives

The institutional derivatives portfolio primarily consists of interest rate swap agreements that are used to hedge the interest rate risk associated with the Company’s loans and financing liabilities (i.e., borrowed funds, deposits, etc.).

Citizens enters into certain interest rate swap agreements to hedge the risk associated with floating rate loans. By entering into receive-fixed/pay-floating interest rate swaps, the Company is able to minimize the variability in the cash flows of these assets due to changes in interest rates. Citizens also uses receive-fixed/pay-floating interest rate swaps to manage the interest rate exposure on its medium term borrowings by effectively converting a portion of the fixed rate debt to floating. Citizens has outstanding interest rate swap agreements designed to hedge a portion of the Company’s borrowed funds and deposit liabilities. By entering into a pay-fixed/receive-floating interest rate swap, a portion of these liabilities has been effectively converted to a fixed rate liability for the term of the interest rate swap agreement. The goal of the Company’s interest rate hedging activity is to manage interest rate sensitivity so that movements in interest rates do not significantly adversely affect net interest income. For derivatives designated for hedging purposes, net interest accruals are treated as an adjustment of interest income or interest expense of the item being hedged.

Customer derivatives

The customer derivatives portfolio consists of interest rate swap agreements and option contracts that are transacted to meet the financing needs of the Company’s customers. Swap agreements and interest rate option agreements are transacted to effectively minimize the Company’s market risk associated with the customer derivative products. The customer derivatives portfolio also includes foreign exchange contracts that are entered into on behalf of customers for the purpose of hedging exposure related to cash orders and loans and deposits denominated in foreign currencies. The primary risks associated with these transactions arise from exposure to changes in foreign currency exchange rates and the ability of the counterparties to meet the terms of the contract. To manage this market risk, Citizens enters into offsetting foreign exchange contracts.

Residential loan derivatives

Citizens enters into residential loan commitments that allow residential mortgage customers to lock in the interest rate on a residential mortgage while the loan undergoes the underwriting process. Citizens also uses forward sales contracts to protect the value of residential mortgage loans and loan commitments that are being underwritten for future sale to investors in the secondary market. Citizens also hedges the fair market value movements of certain mortgage servicing rights using various interest rate derivative contracts.

Citizens has certain derivative transactions which are designated as fair value or cash flow hedges, described as follows:

Derivatives designated as hedging instruments

The Company’s institutional derivatives portfolio qualifies for hedge accounting treatment. This includes interest rate swaps that are designated as highly effective fair value and cash flow hedging relationships. Citizens formally documents at inception all hedging relationships, as well as risk management objectives and strategies for undertaking various accounting hedges. Additionally, Citizens uses dollar offset or regression analysis at the hedge’s inception, and monthly thereafter, to assess whether the derivatives are expected to be, or have been, highly effective in offsetting changes in the hedged item’s expected cash flows. The Company discontinues hedge accounting treatment when it is determined that a derivative is not expected to be, or has ceased to be, effective as a hedge and then reflects changes in fair value in earnings after termination of the hedge relationship.

Fair value hedges

If a derivative is designated as a fair value hedge, gains or losses attributable to the change in fair value of the derivative instrument, as well as the gains and losses attributable to the change in fair value of the hedged item, are recognized in other income in the period in which the change in fair value occurs. Hedge ineffectiveness is recognized as other income to the extent the changes in fair value of the derivative do not offset the changes in fair value of the hedged item. Changes in the fair value of derivatives that do not qualify as hedges are recognized immediately in other income.

Citizens has entered into interest rate swap agreements to manage the interest rate exposure on its medium term borrowings. The change in value of fair value hedges, to the extent that the hedging relationship is effective, is recorded through other income and offset against the change in the fair value of the hedged item.

The following table presents the effect on other income of fair value hedges, specifically hedges of interest rate risk on borrowings using interest rate swaps, described above, in millions:



Amounts Recognized in Other Income for the Year Ended December 31,
2018								2017							2016
Derivative		Hedged Item			Hedge Ineffectiveness			Derivative			Hedged Item		Hedge Ineffectiveness		Derivative			Hedged Item		Hedge Ineffectiveness
	$8		($9	)		($1	)		($26	)		$27		$1		($6	)		$5		($1	)

Cash flow hedges

Citizens has outstanding interest rate swap agreements designed to hedge a portion of the Company’s floating rate assets, and financing liabilities (including its borrowed funds). All of these swaps have been deemed as highly effective cash flow hedges. The effective portion of the hedging gains and losses associated with these hedges are recorded in OCI; the ineffective portion of the hedging gains and losses is recorded in earnings (other income). Hedging gains and losses on derivative contracts reclassified from OCI to current period earnings are included in the line item in the accompanying Consolidated Statements of Operations in which the hedged item is recorded and in the same period that the hedged item affects earnings. During the next 12 months, there are $15 million in pre-tax net losses on derivative instruments included in OCI expected to be reclassified to net interest income in the Consolidated Statements of Operations.

Hedging gains and losses associated with the Company’s cash flow hedges are immediately reclassified from OCI to current period earnings (other income) if it becomes probable that the hedged forecasted transactions will not occur during the originally specified time period.

The following table presents the effect of cash flow hedges on net income and stockholders’ equity:



	Amounts Recognized for the Year Ended December 31,
(in millions)	2018			2017			2016
Effective portion of loss recognized in OCI ⁽¹⁾		($44	)		($23	)		($100	)
Amount of net (loss) gain reclassified from OCI to interest income ⁽²⁾	(55		)	25			90
Amount of net gain (loss) reclassified from OCI to interest expense ⁽²⁾	12			—			(27		)
Amounts reclassified from OCI to other income ⁽³⁾	—			—			(5		)

⁽¹⁾The cumulative effective gains and losses on the Company’s cash flow hedging activities are included on the accumulated other comprehensive loss line item on the Consolidated Balance Sheets.

⁽²⁾This amount includes both (i) the amortization of effective gains and losses associated with the Company’s terminated cash flow hedges and (ii) the current reporting period’s interest settlements realized on the Company’s active cash flow hedges. Both (i) and (ii) were previously included on the accumulated other comprehensive loss line item on the Consolidated Balance Sheets and were subsequently recorded as adjustments to the interest income or expense of the underlying hedged item.

⁽³⁾This includes gains and losses attributable to previously hedged cash flows where the likelihood occurrence of those cash flows is no longer probable.

Derivatives not designated as hedging instruments

Economic hedges

The Company’s customer derivatives are recorded on the Consolidated Balance Sheets at fair value. These include interest rate and foreign exchange derivative contracts that are designed to meet the hedging and financing needs of the Company’s customers. The mark-to-market gains and losses associated with the customer derivatives are mitigated by mark-to-market gains and losses on interest rate and foreign exchange derivative contracts transacted. Citizens also purchases interest rate floors primarily to hedge the exposure related to customer deposit products that have embedded minimum interest rate guarantees. Citizens utilizes interest rate floors in non-qualifying hedging relationships.

The Company’s residential loan derivatives (including residential loan commitments and forward sales contracts) are recorded on the Consolidated Balance Sheets at fair value. Citizens also uses derivatives to hedge the risk of changes in the fair value of its residential MSR portfolio measured at fair value. Certain residential MSRs are accounted for at fair value with changes in the fair value influenced primarily by changes in interest rates. Derivatives used to hedge the fair value of residential MSRs include TBAs, interest rate swaptions, interest rate futures and interest rate swaps.

The following table presents the effect of economic hedges on noninterest income:



	Affected Line Item in the Consolidated Statements of Operations	Amounts Recognized in Noninterest Income for the Year Ended December 31,
(in millions)		2018			2017			2016
Economic Hedge Type
Customer interest rate contracts	Foreign exchange and interest rate products		$5			$5			($23	)
Customer foreign exchange contracts	Foreign exchange and interest rate products	(54		)	172			(81		)
Derivatives transactions to hedge interest rate risk	Foreign exchange and interest rate products	43			46			70
Derivatives transactions to hedge foreign exchange risk	Foreign exchange and interest rate products	158			(151		)	95
Residential loan commitments	Mortgage banking fees	(3		)	2			(2		)
Forward sale contracts	Mortgage banking fees	21			(8		)	6
Interest rate derivative contracts used to hedge residential MSRs	Mortgage banking fees	35			—			—
Total			$205			$66			$65