NOTE 9—DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

Use of Derivatives

We manage asset and liability positions and market risk exposure and limits in accordance with market risk management policies that are approved by our Board of Directors. Our primary market risks stem from the impact on our earnings and economic value of equity from changes in interest rates and, to a lesser extent, changes in foreign exchange rates. We employ several techniques to manage our interest rate sensitivity, which include changing the duration and re-pricing characteristics of various assets and liabilities by using interest rate derivatives. Our current policies also include the use of derivatives to hedge exposures denominated in foreign currency so we may limit our earnings and capital ratio exposures to foreign exchange risk. We execute our derivative contracts in both the over-the-counter (“OTC”) and exchange-traded derivative markets. Under the Dodd-Frank Act, we are required to clear eligible derivative transactions through Central Counterparty Clearinghouses (“CCPs”) such as the Chicago Mercantile Exchange (“CME”) and Clearnet (“LCH”), which are often referred to as “central clearinghouses.” The majority of our derivatives are interest rate swaps. In addition, we may use a variety of other derivative instruments, including caps, floors, options, futures and forward contracts, to manage our interest rate and foreign exchange risks. We offer various interest rate, foreign exchange rate and commodity derivatives as an accommodation to our customers within our Commercial Banking business, and usually offset our exposure through derivative transactions with other counterparties.

Derivatives Counterparty Credit Risk

Derivative instruments contain an element of credit risk that arises from the potential failure of a counterparty to perform according to the terms of the contract. Our exposure to derivative counterparty credit risk, at any point in time, is represented by the fair value of derivatives in a gain position, or derivative asset position, assuming no recoveries of underlying collateral.

To mitigate the risk of counterparty default, we enter into legally enforceable master netting agreements and collateral agreements, where possible, with certain derivative counterparties. We generally enter into these agreements on a bilateral basis with our counterparties. These bilateral agreements typically provide the right to offset exposures and require one counterparty to post collateral on derivative instruments in a net liability position to the other counterparty. Certain of these bilateral agreements include provisions requiring that our debt maintain a credit rating of investment grade or above by each of the major credit rating agencies. In the event of a downgrade of our debt credit rating below investment grade, some of our counterparties would have the right to terminate the derivative contract and close out the existing positions.

We also clear certain OTC derivatives with central clearinghouses through futures commission merchants (“FCMs”) as part of the regulatory requirement. The use of the central clearinghouses and the FCMs reduces our bilateral counterparty credit exposures while it increases our credit exposures to CCPs and FCMs. We are required by CCPs to post initial and variation margin to mitigate the risk of non-payment through our FCMs. Our FCM agreements governing these derivative transactions generally include provisions that may require us to post more collateral or otherwise change terms in our agreements under certain circumstances. Effective January 3, 2017, the CME amended its rulebook to legally characterize variation margin cash payments for cleared OTC derivatives as a settlement of the position rather than collateral. We adopted this variation margin rule change in the second quarter of 2017. As a result, we began reducing the corresponding derivative assets and liabilities for CME-cleared OTC derivatives to reflect the settlement of these positions. Variation margin payments for LCH-cleared OTC derivatives continue to be characterized as collateral.

We record counterparty credit risk valuation adjustments (“CVAs”) on our OTC derivative contracts to properly reflect the credit quality of the counterparty. We consider collateral and legally enforceable master netting agreements that mitigate our credit exposure to each counterparty in determining the counterparty credit risk valuation adjustment, which may be adjusted in future periods due to changes in the fair value of the derivative contracts, collateral and creditworthiness of the counterparty. We also adjust the fair value of our derivative liabilities to reflect the impact of our own credit quality (“DVAs”). We calculate this adjustment by comparing the spreads on our credit default swaps to the discount benchmark curve.

Accounting for Derivatives

Our derivatives are designated as either qualifying accounting hedges or free-standing derivatives. Qualifying accounting hedges are designated as fair value hedges, cash flow hedges or net investment hedges. Free-standing derivatives primarily consist of customer-accommodation derivatives and economic hedges that do not qualify for hedge accounting.

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Fair Value Hedges: We designate derivatives as fair value hedges when they are used to manage our exposure to changes in the fair value of certain financial assets and liabilities, which fluctuate in value as a result of movements in interest rates. Changes in the fair value of derivatives designated as fair value hedges are recorded in earnings together with offsetting changes in the fair value of the hedged item and any resulting ineffectiveness. Our fair value hedges consist of interest rate swaps that are intended to modify our exposure to interest rate risk on various fixed-rate assets and liabilities.

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Cash Flow Hedges: We designate derivatives as cash flow hedges when they are used to manage our exposure to variability in cash flows related to forecasted transactions. Changes in the fair value of derivatives designated as cash flow hedges are recorded as a component of AOCI, to the extent that the hedge relationships are effective, and amounts are reclassified from AOCI to earnings as the forecasted transactions impact earnings. To the extent that any ineffectiveness exists in the hedge relationships, the amounts are recorded in current period earnings. Our cash flow hedges use interest rate swaps and floors that are intended to hedge the variability in interest receipts or interest payments on some of our variable-rate assets or liabilities. We also enter into foreign currency forward derivative contracts to hedge our exposure to variability in cash flows related to intercompany borrowings denominated in foreign currency.

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Net Investment Hedges: We use net investment hedges to manage the foreign currency exposure related to our net investments in foreign operations that have functional currencies other than the U.S. dollar. Changes in the fair value of net investment hedges are recorded in the translation adjustment component of AOCI, offsetting the translation gain or loss from those foreign operations. We execute net investment hedges using foreign exchange forward contracts to hedge the translation exposure of the net investment in our foreign operations.

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Free-Standing Derivatives: We use free-standing derivatives to hedge the risk of changes in the fair value of residential MSRs, mortgage loan origination and purchase commitments and other interests held. We also categorize our customer accommodation derivatives and the related offsetting contracts as free-standing derivatives. Changes in the fair value of free-standing derivatives are recorded in earnings as a component of other non-interest income.

Balance Sheet Presentation

The following table summarizes the notional and fair values of our derivative instruments on as of June 30, 2017 and December 31, 2016, which are segregated by derivatives that are designated as accounting hedges and those that are not, and are further segregated by type of contract within those two categories. The total derivative assets and liabilities are adjusted on an aggregate basis to take into consideration the effects of legally enforceable master netting agreements and any associated cash collateral received or pledged.

Table 9.1: Derivative Assets and Liabilities at Fair Value



	June 30, 2017								December 31, 2016
	Notional or Contractual Amount		Derivative⁽¹⁾⁽⁵⁾						Notional or Contractual Amount		Derivative⁽¹⁾
(Dollars in millions)	Notional or Contractual Amount		Assets			Liabilities			Notional or Contractual Amount		Assets			Liabilities
Derivatives designated as accounting hedges:
Interest rate contracts:
Fair value hedges	$	51,592	$	124		$	89		$	40,480	$	295		$	569
Cash flow hedges	58,700		30			89			50,400		151			287
Total interest rate contracts	110,292		154			178			90,880		446			856
Foreign exchange contracts:
Cash flow hedges	5,802		0			143			5,620		108			9
Net investment hedges	2,716		1			101			2,396		163			0
Total foreign exchange contracts	8,518		1			244			8,016		271			9
Total derivatives designated as accounting hedges	118,810		155			422			98,896		717			865
Derivatives not designated as accounting hedges:
Interest rate contracts covering:
MSRs⁽²⁾	1,491		11			2			1,696		17			21
Customer accommodation	42,657		571			437			39,474		670			530
Other interest rate exposures⁽³⁾	2,837		36			12			1,105		33			8
Total interest rate contracts	46,985		618			451			42,275		720			559
Other contracts	1,055		0			6			1,767		57			14
Total derivatives not designated as accounting hedges	48,040		618			457			44,042		777			573
Total derivatives	$	166,850	$	773		$	879		$	142,938	$	1,494		$	1,438
Less: netting adjustment⁽⁴⁾			(309		)	(355		)			(539		)	(336		)
Total derivative assets/liabilities			$	464		$	524				$	955		$	1,102

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⁽¹⁾	Derivative assets and liabilities presented above exclude valuation adjustments related to non-performance risk. As of June 30, 2017 and December 31, 2016, the cumulative CVA balances were $4 million and $6 million, respectively, and the cumulative DVA balances were less than $1 million as of both June 30, 2017 and December 31, 2016.


⁽²⁾	Includes interest rate swaps and to-be-announced contracts.


⁽³⁾	Includes mortgage-related derivatives.


⁽⁴⁾	Represents balance sheet netting of derivative assets and liabilities, and related payables and receivables for cash collateral held or placed with the same counterparty. See Table 9.2 for further information.


⁽⁵⁾	Reflects a reduction of derivative assets of $58 million and a reduction of derivative liabilities of $348 million on our consolidated balance sheets as of June 30, 2017 as a result of adoption of the CME variation margin rule change in the second quarter of 2017.

Offsetting of Financial Assets and Liabilities

Derivative contracts and repurchase agreements that we execute bilaterally in the OTC market are governed by enforceable master netting arrangements where we generally have the right to offset exposure with the same counterparty. Either counterparty can generally request to net settle all contracts through a single payment upon default on, or termination of, any one contract. We elect to offset the derivative assets and liabilities under netting arrangements for balance sheet presentation where a right of setoff exists. Derivative contracts that are cleared with central clearinghouses through FCMs are not subject to offsetting due to the uncertainty existing around an end-user’s ability to setoff these derivative contracts. Therefore, as of June 30, 2017 and December 31, 2016, we did not offset our derivative positions cleared through clearinghouses.

We also maintain collateral agreements with certain derivative counterparties. For bilateral derivatives, we review our collateral positions on a daily basis and exchange collateral with our counterparties in accordance with standard International Swaps and Derivatives Association documentation and other related agreements. Agreements with certain bilateral counterparties require both parties to maintain collateral in the event the fair values of derivative instruments exceed established exposure thresholds. For centrally cleared derivatives, we are subject to initial margin and daily variation margin posting with the central clearinghouses. Acceptable types of collateral are typically in the form of cash or high quality liquid securities.

The exchange of collateral is dependent upon the fair value of the derivative instruments as well as the fair value of the pledged collateral. When valuing collateral, an estimate of the variation in price and liquidity over time is subtracted in the form of a “haircut” to discount the value of the collateral pledged.

The following table presents as of June 30, 2017 and December 31, 2016 the gross and net fair values of our derivative assets and liabilities and repurchase agreements, as well as the related offsetting amounts permitted under U.S. GAAP. The table also includes cash and non-cash collateral received or pledged associated with such arrangements. The collateral amounts shown are limited to the extent of the related net derivative fair values or outstanding balances, thus instances of over-collateralization are not shown.

Table 9.2: Offsetting of Financial Assets and Financial Liabilities



	Gross Amounts		Gross Amounts Offset in the Balance Sheet						Net Amounts as Recognized		Securities Collateral Held Under Master Netting Agreements
(Dollars in millions)	Gross Amounts		Financial Instruments			Cash Collateral Received			Net Amounts as Recognized		Securities Collateral Held Under Master Netting Agreements			Net Exposure
As of June 30, 2017
Derivatives assets⁽¹⁾⁽²⁾	$	773	$	(117	)	$	(192	)	$	464	$	0		$	464
As of December 31, 2016
Derivatives assets⁽¹⁾⁽²⁾	1,494		(152		)	(387		)	955		(11		)	944



	Gross Amounts		Gross Amounts Offset in the Balance Sheet						Net Amounts as Recognized		Securities Collateral Pledged Under Master Netting Agreements
(Dollars in millions)	Gross Amounts		Financial Instruments			Cash Collateral Pledged			Net Amounts as Recognized					Net Exposure
As of June 30, 2017
Derivatives liabilities⁽¹⁾⁽²⁾	$	879	$	(117	)	$	(238	)	$	524	$	0		$	524
Repurchase agreements⁽³⁾	958		0			0			958		(958		)	0
As of December 31, 2016
Derivatives liabilities⁽¹⁾⁽²⁾	1,438		(152		)	(184		)	1,102		0			1,102
Repurchase agreements	992		0			0			992		(992		)	0

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⁽¹⁾	Reflects a reduction of derivative assets of $58 million and a reduction of derivative liabilities of $348 million on our consolidated balance sheets as of June 30, 2017 as a result of adoption of the CME variation margin rule change in the second quarter of 2017.

⁽²⁾

We received cash collateral from derivative counterparties totaling $234 million and $448 million as of June 30, 2017 and December 31, 2016, respectively. We also received securities from derivative counterparties with a fair value of $1 million and $16 million as of June 30, 2017 and December 31, 2016, respectively, which we have the ability to re-pledge. We posted $837 million and $1.5 billion of cash collateral as of June 30, 2017 and December 31, 2016, respectively.


⁽³⁾	Represents customer repurchase agreements that mature the next business day. As of June 30, 2017, we pledged collateral with a fair value of $977 million under these customer repurchase agreements, which were primarily agency RMBS securities.

Income Statement Presentation and AOCI

Fair Value Hedges and Free-Standing Derivatives

The net gains (losses) recognized in earnings related to derivatives in fair value hedging relationships and free-standing derivatives are presented below for the three and six months ended June 30, 2017 and 2016.

Table 9.3: Gains and Losses on Fair Value Hedges and Free-Standing Derivatives



	Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in millions)	2017			2016			2017			2016
Derivatives designated as accounting hedges:⁽¹⁾
Fair value interest rate contracts:
Gains recognized in earnings on derivatives	$	138		$	182		$	93		$	390
Losses recognized in earnings on hedged items	(132		)	(175		)	(93		)	(367		)
Net fair value hedge ineffectiveness gains (losses)	6			7			0			23
Derivatives not designated as accounting hedges:⁽¹⁾
Interest rate contracts covering:
MSRs	3			8			3			18
Customer accommodation	6			7			16			12
Other interest rate exposures	14			16			21			31
Total interest rate contracts	23			31			40			61
Other contracts	0			(9		)	0			(9		)
Total gains on derivatives not designated as accounting hedges	23			22			40			52
Net derivative gains recognized in earnings	$	29		$	29		$	40		$	75

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⁽¹⁾	Amounts are recorded in our consolidated statements of income in other non-interest income.

Cash Flow and Net Investment Hedges

The table below shows the net gains (losses) related to derivatives designated as cash flow hedges and net investment hedges for the three and six months ended June 30, 2017 and 2016.

Table 9.4: Gains and Losses on Derivatives Designated as Cash Flow Hedges and Net Investment Hedges



	Three Months Ended June 30,					Six Months Ended June 30,
(Dollars in millions)	2017			2016		2017			2016
Gains (losses) recorded in AOCI:
Cash flow hedges:
Interest rate contracts	$	69		$	192	$	39		$	618
Foreign exchange contracts	5			0		9			0
Subtotal	74			192		48			618
Net investment hedges:
Foreign exchange contracts	(58		)	122		(80		)	163
Net derivatives gains (losses) recognized in AOCI	$	16		$	314	$	(32	)	$	781
Gains (losses) recorded in earnings:
Cash flow hedges:
Gains (losses) reclassified from AOCI into earnings:
Interest rate contracts⁽¹⁾	$	24		$	48	$	61		$	98
Foreign exchange contracts⁽²⁾	5			1		8			0
Subtotal	29			49		69			98
Gains (losses) recognized in earnings due to ineffectiveness:
Interest rate contracts⁽²⁾	4			0		3			3
Net derivative gains (losses) recognized in earnings	$	33		$	49	$	72		$	101

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⁽¹⁾	Amounts reclassified are recorded in our consolidated statements of income in interest income or interest expense.


⁽²⁾	Amounts are recorded in our consolidated statements of income in other non-interest income or other interest income.

In the next 12 months, we expect to reclassify to earnings net after-tax gains of $47 million currently recorded in AOCI as of June 30, 2017. These amounts will offset the cash flows associated with the hedged forecasted transactions. The maximum length of time over which forecasted transactions were hedged was approximately seven years as of June 30, 2017. The amount we expect to reclassify into earnings may change as a result of changes in market conditions and ongoing actions taken as part of our overall risk management strategy.