DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

Objectives

The Bank maintains an overall interest rate risk management strategy that actively incorporates the use of interest rate derivatives including unleveraged interest rate swaps, purchased options, combinations of options, and may include futures and other forward interest rate contracts. The Bank’s objective for using derivatives is to manage risks, primarily interest rate risk. The Bank uses derivatives to manage volatility in interest income, interest expense, earnings, and capital by adjusting our interest rate sensitivity to minimize the impact of fluctuations in interest rates. Derivatives are used to stabilize forecasted interest receipts from variable-rate assets and to modify the coupon or the duration of fixed-rate financial assets or liabilities as we consider advisable.

We also provide certain borrowers access to over-the-counter interest rate derivatives by selling interest rate derivatives to our customers, which we generally offset with interest rate derivatives executed with other dealers or central clearing houses. The Bank also provides commercial clients short-term foreign currency spot trades or forward contracts with a maturity of generally 90 days or less that are also largely offset by foreign currency trades with closely mirroring terms executed with other dealer counterparties or central clearing houses.

We apply hedge accounting to certain derivatives executed for risk management purposes as subsequently described in more detail. However, we do not apply hedge accounting to all the derivatives involved in our risk management activities. Derivatives not designated as accounting hedges are not speculative and are used to economically manage our exposure to interest rate movements and other identified risks, including offsetting customer-facing derivatives. These derivatives either do not require the use of hedge accounting for their economic impact to be accurately reflected in our financial statements or they do not meet the strict hedge accounting requirements.

Accounting

We record all derivatives on the Consolidated Balance Sheet at fair value in Other Assets or Other Liabilities regardless of the accounting designation of each derivative. The Bank enters into International Swaps and Derivatives Association, Inc. (ISDA) master netting agreements, or similar agreements, with substantially all derivative counterparties. See Note 4, “Offsetting Assets and Liabilities” for more information. Where legally enforceable, these master netting agreements give the Bank, in the event of default or the triggering of other specified contingent events by the counterparty, the right to liquidate securities held as collateral and to offset receivables and payables with the same counterparty. For purposes of the Consolidated Balance Sheet, the Bank does not offset derivative assets and liabilities and cash collateral held with the same counterparty where it has a legally enforceable master netting agreement and reports all derivatives on a gross fair value basis. Note 3 discusses the process to estimate fair value for derivatives. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting accounting designation. Derivatives used to hedge the exposure to changes in the fair value of assets, liabilities, or firm commitments attributable to interest rates or other eligible risks, are considered fair value hedges. Derivatives used to hedge the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.

Fair Value Hedges - For derivatives designated as fair value hedges, changes in the fair value of the derivative are recognized in earnings together with the change in the fair value of the hedged item due to the risk being hedged. The Bank reports the earnings effect of the hedging instrument in the same Consolidated Income Statement line item in which the earnings effect of the hedged item is reported, generally Interest Income or Expense for hedges of interest rate risk of an interest-bearing financial asset or liability. The amounts from the derivative and hedged item for active fair value hedges and the location where they are recorded are detailed in the schedules below.

We currently have one active fair value hedging strategy that is a hedge of the change in fair value of LIBOR benchmark swap rate component of the contractual coupon cash flows of the Bank’s long-term debt. The objective of the hedge is to manage to the interest rate risk associated with changes in the LIBOR benchmark interest rate for $500 million of fixed-rate bonds issued in August of 2018 and subsequently hedged in September 2018. The swap and bonds mature concurrently in August of 2021. All debt basis adjustments from previously designed fair value hedges were fully amortized prior to 2018. The Bank’s existing fair value interest rate hedge is expected to be perfectly effective because the critical terms of the hedging instrument and hedged item match.

Cash flow hedges - For derivatives designated and qualifying as cash flow hedges ineffectiveness is not measured or separately disclosed. The entire change in the fair value of the hedging instrument is deferred in OCI until the hedged transaction affects earnings, at which point amounts deferred in OCI are reclassified to earnings and reported in the same income statement line item used to present the earnings effect of the hedged item or forecasted transactions. We use interest rate swaps, options and combination of options in our cash flow hedging strategy to eliminate or reduce the variable cash flows associated primarily with floating-rate commercial loans due to changes in any separately identifiable and reliably measurable contractual interest rate index. The Bank had 23 interest rate swaps designated as cash flow hedges in existence during 2018. Of these 23, six of the swaps matured during the 2018 fiscal year. The Bank has 17 interest rate swaps designated as cash flow hedges as of December 31, 2018. These swaps have an aggregate notional amount of approximately $688 million and a weighted average maturity of approximately 1.3 years and a weighted average received-fixed strike rate of approximately 1.59%. We use these receive-fixed and pay-floating rate interest rate swap agreements as cash flow hedges of the variable-rate interest receipts of certain pools of loan assets.

We expect to replace the maturing cash flow hedges and potentially increase cash flow hedging to reduce asset-sensitivity and exposure to falling interest rates throughout 2019. Replacement hedges will likely be a combination of received-fixed and pay-floating interest rate swaps and purchased floors, or combinations of purchased floors and other sold options to help offset the cost of the purchased floors’ premium.

During 2016 we closed our branch in Grand Cayman, Grand Cayman Islands B.W.I. and no longer have foreign operations. No derivatives were designated as hedges of investments in foreign operations during 2018.

We assess the effectiveness of each hedging relationship by comparing the changes in fair value or cash flows on the derivative hedging instrument with the changes in fair value or cash flows on the designated hedged item or transaction for the risk being hedged. For derivatives not designated as accounting hedges, changes in fair value are recognized in earnings. The remaining basis adjustments recorded to hedged items in fair value hedging relationships as well as any amounts remaining in AOCI for hedging relationships terminated prior to the maturity date documented in the hedge designation are accreted or amortized to interest income or expense over the originally designated period of the hedging relationship for cash flow hedges as the hedged transactions affect earnings or to the contractual maturity dates of the hedged items in fair value hedges.

Collateral and Credit Risk

Exposure to credit risk arises from the possibility of nonperformance by counterparties. No significant losses on derivative instruments have occurred as a result of counterparty nonperformance. Financial institutions which are well-capitalized and well-established are the counterparties for those derivatives entered into for asset-liability management and to offset derivatives sold to our customers. The Bank reduces its counterparty exposure for derivative contracts by centrally clearing all eligible derivatives.

For those derivatives that are not centrally cleared, the counterparties are typically financial institutions or customers of the Bank. For those that are financial institutions, as noted above, we manage our credit exposure through the use of a Credit Support Annex (“CSA”) to an ISDA master agreement with each counterparty. Eligible collateral types are documented by the CSA and controlled under the Bank’s general credit policies. Collateral balances are typically monitored on a daily basis. A valuation haircut policy reflects the fact that collateral may fall in value between the date the collateral is called and the date of liquidation or enforcement. In practice, all of the Bank’s collateral held as credit risk mitigation under a CSA is cash.

We offer interest rate swaps to our customers to assist them in managing their exposure to changing interest rates. Upon issuance, all of these customer swaps are immediately offset through closely matching derivative contracts, such that the Bank minimizes its interest rate risk exposure resulting from such transactions. Most of these customers do not have the capability for centralized clearing. Therefore, we manage the credit risk through loan underwriting which includes a credit risk exposure formula for the swap, the same collateral and guarantee protection applicable to the loan and credit approvals, limits, and monitoring procedures. Fee income from customer swaps is included in other service charges, commissions and fees. Nevertheless, the related credit risk is considered and measured when and where appropriate. See Notes 6 and 15 for further discussion of our underwriting, collateral requirements, and other procedures used to address credit risk.

Our non-customer facing derivative contracts generally require us to pledge collateral for derivatives that are in a net liability position at a given balance sheet date. Certain of these derivative contracts contain credit-risk-related contingent features that include the requirement to maintain a minimum debt credit rating. We may be required to pledge additional collateral if a credit-risk-related feature were triggered, such as a downgrade of our credit rating. However, in past situations, not all counterparties have demanded that additional collateral be pledged when provided for under their contracts. At December 31, 2018, the fair value of our derivative liabilities was $39 million, for which we were required to pledge cash collateral of approximately $45 million in the normal course of business. If our credit rating were downgraded one notch by either Standard & Poor’s or Moody’s at December 31, 2018, there would likely be no additional collateral required to be pledged. As a result of the Dodd-Frank Act, all newly eligible derivatives entered into are cleared through a central clearinghouse. Derivatives that are centrally cleared do not have credit-risk-related features that require additional collateral if our credit rating were downgraded.

Derivative Amounts

Selected information with respect to notional amounts and recorded gross fair values at December 31, 2018 and 2017, and the related gain (loss) of derivative instruments for the years then ended is summarized as follows:



	December 31, 2018						December 31, 2017
	Notional amount		Fair value				Notional amount		Fair value
(In millions)	Notional amount		Other assets		Other liabilities		Notional amount		Other assets		Other liabilities
Derivatives designated as hedging instruments
Cash flow hedges:
Interest rate swaps	$	687	$	—	$	—	$	1,138	$	—	$	—
Fair value hedges:
Interest rate swaps	500		—		—		—		—		—
Total derivatives designated as hedging instruments	1,187		—		—		1,138		—		—
Derivatives not designated as hedging instruments
Interest rate swaps	253		1		1		223		1		—
Interest rate swaps for customers ¹	5,652		40		36		4,550		28		33
Foreign exchange	389		4		2		913		9		7
Total derivatives not designated as hedging instruments	6,294		45		39		5,686		38		40
Total derivatives	$	7,481	$	45	$	39	$	6,824	$	38	$	40

¹Notional amounts include both the customer swaps and the offsetting derivative contracts. The fair values reflect gross termination values of our derivatives prior to netting of variation margin (collateral) postings and other offsetting derivatives with the Bank’s Central Counterparty Clearing entities.



	Year Ended December 31, 2018												Year Ended December 31, 2017
	Amount of derivative gain (loss) recognized/reclassified
(In millions)	OCI			Reclassified from AOCI to interest income			Noninterest income (expense)			Offset to interest expense			OCI			Reclassified from AOCI to interest income		Noninterest income (expense)			Offset to interest expense
Derivatives designated as hedging instruments
Cash flow hedges: ¹
Interest rate swaps	$	(1	)	$	(4	)							$	(8	)	$	4
Fair value hedges:
Terminated swaps on long-term debt										$	(1	)									$	—
Total derivatives designated as hedging instruments	(1		)	(4		)				(1		)	(8		)	4					—
Derivatives not designated as hedging instruments
Interest rate swaps							$	(1	)									$	(1	)
Interest rate swaps for customers							14											11
Foreign exchange							18											17
Total derivatives	$	(1	)	$	(4	)	$	31		$	(1	)	$	(8	)	$	4	$	27		$	—

Note: These schedules are not intended to present at any given time the Bank’s long/short position with respect to its derivative contracts.


¹	Amounts recognized in OCI and reclassified from AOCI represent the effective portion of the derivative gain (loss). For the 12 months following December 31, 2018, we estimate that $(5) million will be reclassified from AOCI into interest income.

The following schedule presents derivatives used in fair value hedge accounting relationships, as well as pre-tax gains/(losses) recorded on such derivatives and the related hedged items for the periods presented.



	Gain/(loss) recorded in income
	Year Ended December 31, 2018							Year Ended December 31, 2017
(In millions)	Derivatives²		Hedged items			Total income statement impact		Derivatives²		Hedged items		Total income statement impact
Interest rate swaps¹	$	5	$	(5	)	$	—	$	—	$	—	$	—


¹	Consists of hedges of benchmark interest rate risk of fixed-rate long-term debt. Gains and losses were recorded in net interest expense.

² The income for the derivative does not reflect interest income/expense to be consistent with the presentation of the gains/(losses) on the hedged items.

The following schedule provides selected information regarding the long-term debt in the statement of financial position in which the hedged item is included.



	Carrying amount of the hedged assets/(liabilities)					Cumulative amount of fair value hedging adjustment included in the carrying amount of the hedged assets/(liabilities)
(In millions)	2018			2017		2018			2017
Long-term debt	$	(505	)	$	—	$	(5	)	$	—

The fair value of derivative assets was reduced by a net credit valuation adjustment of $3 million and $2 million at December 31, 2018 and 2017, respectively. The fair value of derivative liabilities was reduced by a net debit valuation adjustment of $1 million at both December 31, 2018 and 2017. These adjustments are required to reflect both our own nonperformance risk and the respective counterparty’s nonperformance risk.