Fair Value Measurements

The Company determines the fair values of its financial instruments based on the fair value hierarchy, which requires an entity to maximize the use of quoted prices and observable inputs and to minimize the use of unobservable inputs when measuring fair value. The Company elected fair value accounting for mortgages held for sale. The Company believes the election for mortgages held for sale (which are economically hedged with free-standing derivatives) will reduce certain timing differences and better match changes in the value of these assets with changes in the value of derivatives used as economic hedges for these assets. At December 31, 2017 and 2016, all mortgages held for sale are carried at fair value.

The following table shows the differences between fair value carrying amount of mortgages held for sale measured at fair value and the aggregate unpaid principal amount the Company is contractually entitled to receive at maturity on December 31, 2017 and 2016.



(Dollars in thousands)	Fair value carrying amount		Aggregate unpaid principal		Excess of fair value carrying amount over (under) unpaid principal
December 31, 2017
Mortgages held for sale reported at fair value:
Total Loans	$	13,123	$	12,967	$	156	(1)
December 31, 2016
Mortgages held for sale reported at fair value:
Total Loans	$	15,849	$	15,809	$	40	(1)

(1) The excess of fair value carrying amount over (under) unpaid principal is included in mortgage banking income and includes changes in fair value at and subsequent to funding and gains and losses on the related loan commitment prior to funding.

Financial Instruments on Recurring Basis:

The following is a description of the valuation methodologies used for financial instruments measured at fair value on a recurring basis:

Investment securities available-for-sale are valued primarily by a third party pricing agent. Prices supplied by the independent pricing agent, as well as their pricing methodologies and assumptions, are reviewed by the Company for reasonableness and to ensure such prices are aligned with market levels. In general, the Company’s investment securities do not possess a complex structure that could introduce greater valuation risk. The portfolio mainly consists of traditional investments including U.S. Treasury and Federal agencies securities, federal agency mortgage pass-through securities, and general obligation and revenue municipal bonds. Pricing for such instruments is fairly generic and is easily obtained. On a quarterly basis, prices supplied by the pricing agent are validated by comparison to prices obtained from other third party sources for a material portion of the portfolio.

The valuation policy and procedures for Level 3 fair value measurements of available-for-sale debt securities are decided through collaboration between management of the Corporate Accounting and Funds Management departments. The changes in fair value measurement for Level 3 securities are analyzed on a periodic basis under a collaborative framework with the aforementioned departments. The methodology and variables used for input are derived from the combination of observable and unobservable inputs. The unobservable inputs are determined through internal assumptions that may vary from period to period due to external factors, such as market movement and credit rating adjustments.

Both the market and income valuation approaches are implemented using the following types of inputs:


•	U.S. treasuries are priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.


•	Government-sponsored agency debt securities and corporate bonds are primarily priced using available market information through processes such as benchmark curves, market valuations of like securities, sector groupings and matrix pricing.


•	Other government-sponsored agency securities, mortgage-backed securities and some of the actively traded REMICs and CMOs, are primarily priced using available market information including benchmark yields, prepayment speeds, spreads and volatility of similar securities.


•	Inactively traded government-sponsored agency securities are primarily priced using consensus pricing and dealer quotes.

•

State and political subdivisions are largely grouped by characteristics, i.e., geographical data and source of revenue in trade dissemination systems. Since some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities. Local direct placement municipal securities, with very little market activity, are priced using an appropriate market yield curve which incorporates a credit spread assumption.


•	Marketable equity (common) securities are primarily priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.

Mortgages held for sale and the related loan commitments and forward contracts (hedges) are valued using a market value approach and utilizing an appropriate current market yield and a loan commitment closing rate based on historical analysis.

Interest rate swap positions, both assets and liabilities, are valued by a third party pricing agent using an income approach and utilizing models that use as their basis readily observable market parameters. This valuation process considers various factors including interest rate yield curves, time value and volatility factors. Validation of third party agent valuations is accomplished by comparing those values to the Company’s swap counterparty valuations. Management believes an adjustment is required to “mid-market” valuations for derivatives tied to its performing loan portfolio to recognize the imprecision and related exposure inherent in the process of estimating expected credit losses as well as velocity of deterioration evident with systemic risks imbedded in these portfolios. Any change in the mid-market derivative valuation adjustment will be recognized immediately through the Consolidated Statements of Income.

The following table shows the balance of assets and liabilities measured at fair value on a recurring basis.



(Dollars in thousands)	Level 1		Level 2		Level 3		Total
December 31, 2017
Assets:
Investment securities available-for-sale:
U.S. Treasury and Federal agencies securities	$	27,971	$	440,148	$	—	$	468,119
U.S. States and political subdivisions securities	—		113,845		2,155		116,000
Mortgage-backed securities - Federal agencies	—		287,910		—		287,910
Corporate debt securities	—		31,294		—		31,294
Foreign government and other securities	—		—		710		710
Total investment securities available-for-sale	27,971		873,197		2,865		904,033
Mortgages held for sale	—		13,123		—		13,123
Accrued income and other assets (interest rate swap agreements)	—		5,167		—		5,167
Total	$	27,971	$	891,487	$	2,865	$	922,323

Liabilities:
Accrued expenses and other liabilities (interest rate swap agreements)	$	—	$	5,262	$	—	$	5,262
Total	$	—	$	5,262	$	—	$	5,262

December 31, 2016
Assets:
Investment securities available-for-sale:
U.S. Treasury and Federal agencies securities	$	20,164	$	400,669	$	—	$	420,833
U.S. States and political subdivisions securities	—		130,276		2,699		132,975
Mortgage-backed securities - Federal agencies	—		252,574		—		252,574
Corporate debt securities	—		35,076		—		35,076
Foreign government and other securities	—		—		807		807
Total debt securities	20,164		818,595		3,506		842,265
Marketable equity securities	8,202		—		—		8,202
Total investment securities available-for-sale	28,366		818,595		3,506		850,467
Mortgages held for sale	—		15,849		—		15,849
Accrued income and other assets (interest rate swap agreements)	—		6,621		—		6,621
Total	$	28,366	$	841,065	$	3,506	$	872,937

Liabilities:
Accrued expenses and other liabilities (interest rate swap agreements)	$	—	$	6,743	$	—	$	6,743
Total	$	—	$	6,743	$	—	$	6,743

The following table shows the changes in Level 3 assets and liabilities measured at fair value on a recurring basis.



(Dollars in thousands)	U.S. States and political subdivisions securities			Foreign government and other securities			Investment securities available-for-sale
Beginning balance January 1, 2017	$	2,699		$	807		$	3,506
Total gains or losses (realized/unrealized):
Included in earnings	—			—			—
Included in other comprehensive income	31			3			34
Purchases	1,437			500			1,937
Issuances	—			—			—
Sales	—			—			—
Settlements	—			—			—
Maturities	(2,012		)	(600		)	(2,612		)
Transfers into Level 3	—			—			—
Transfers out of Level 3	—			—			—
Ending balance December 31, 2017	$	2,155		$	710		$	2,865

Beginning balance January 1, 2016	$	4,528		$	809		$	5,337
Total gains or losses (realized/unrealized):
Included in earnings	—			—			—
Included in other comprehensive income	(24		)	(2		)	(26		)
Purchases	1,100			—			1,100
Issuances	—			—			—
Sales	—			—			—
Settlements	—			—			—
Maturities	(2,905		)	—			(2,905		)
Transfers into Level 3	—			—			—
Transfers out of Level 3	—			—			—
Ending balance December 31, 2016	$	2,699		$	807		$	3,506

There were no gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at December 31, 2017 or 2016. No transfers between levels occurred during 2017 or 2016.

The following table shows the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a recurring basis.



(Dollars in thousands)	Fair value		Valuation Methodology	Unobservable Inputs	Range of Inputs
December 31, 2017
Investment securities available-for-sale
Direct placement municipal securities	$	2,155	Discounted cash flows	Credit spread assumption	2.21% - 2.93%

Foreign government	$	710	Discounted cash flows	Market yield assumption	0.35% - 1.23%


December 31, 2016
Investment securities available-for-sale
Direct placement municipal securities	$	2,699	Discounted cash flows	Credit spread assumption	0.92% - 3.17%

Foreign government	$	807	Discounted cash flows	Market yield assumption	0.28% - 1.12%

The sensitivity to changes in the unobservable inputs and their impact on the fair value measurement can be significant. The significant unobservable input for direct placement municipal securities are the credit spread assumptions used to determine the fair value measure. An increase (decrease) in the estimated spread assumption of the market will decrease (increase) the fair value measure of the securities. The significant unobservable input for foreign government securities are the market yield assumptions. The market yield assumption is negatively correlated to the fair value measure. An increase (decrease) in the determined market yield assumption will decrease (increase) the fair value measurement.

Financial Instruments on Non-recurring Basis:

The Company may be required, from time to time, to measure certain other financial assets at fair value on a non-recurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower of cost or market accounting or impairment charges of individual assets.

The Credit Policy Committee (CPC), a management committee, is responsible for overseeing the valuation processes and procedures for Level 3 measurements of impaired loans, other real estate and repossessions. The CPC reviews these assets on a quarterly basis to determine the accuracy of the observable inputs, generally third party appraisals, auction values, values derived from trade publications and data submitted by the borrower, and the appropriateness of the unobservable inputs, generally discounts due to current market conditions and collection issues. The CPC establishes discounts based on asset type and valuation source; deviations from the standard are documented. The discounts are reviewed periodically, annually at a minimum, to determine they remain appropriate. Consideration is given to current trends in market values for the asset categories and gain and losses on sales of similar assets. The Loan and Funds Management Committee of the Board of Directors is responsible for overseeing the CPC.

Discounts vary depending on the nature of the assets and the source of value. Aircraft are generally valued using quarterly trade publications adjusted for engine time, condition, maintenance programs, discounted by 10%. Likewise, autos are valued using current auction values, discounted by 10%; medium and heavy duty trucks are valued using trade publications and auction values, discounted by 15%. Construction equipment is generally valued using trade publications and auction values, discounted by 20%. Real estate is valued based on appraisals or evaluations, discounted by 20% at a minimum with higher discounts for property in poor condition or property with characteristics which may make it more difficult to market. Commercial loans subject to borrowing base certificates are generally discounted by 20% for receivables and 40-75% for inventory with higher discounts when monthly borrowing base certificates are not required or received.

Impaired loans and related write-downs are based on the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are reviewed quarterly and estimated using customized discounting criteria, appraisals and dealer and trade magazine quotes which are used in a market valuation approach. In accordance with fair value measurements, only impaired loans for which a reserve for loan loss has been established based on the fair value of collateral require classification in the fair value hierarchy. As a result, only a portion of the Company’s impaired loans are classified in the fair value hierarchy.

Partnership investments and the adjustments to fair value primarily result from application of lower of cost or fair value accounting. The partnership investments are priced using financial statements provided by the partnerships. Quantitative unobservable inputs are not reasonably available for reporting purposes.

The Company has established MSRs valuation policies and procedures based on industry standards and to ensure valuation methodologies are consistent and verifiable. MSRs and related adjustments to fair value result from application of lower of cost or fair value accounting. For purposes of impairment, MSRs are stratified based on the predominant risk characteristics of the underlying servicing, principally by loan type. The fair value of each tranche of the servicing portfolio is estimated by calculating the present value of estimated future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, servicing costs, and other economic factors. Prepayment rates and discount rates are derived through a third party pricing agent. Changes in the most significant inputs, including prepayment rates and discount rates, are compared to the changes in the fair value measurements and appropriate resolution is made. A fair value analysis is also obtained from an independent third party agent and compared to the internal valuation for reasonableness. MSRs do not trade in an active, open market with readily observable prices and though sales of MSRs do occur, precise terms and conditions typically are not readily available and the characteristics of the Company’s servicing portfolio may differ from those of any servicing portfolios that do trade.

Other real estate is based on the fair value of the underlying collateral less expected selling costs. Collateral values are estimated primarily using appraisals and reflect a market value approach. Fair values are reviewed quarterly and new appraisals are obtained annually. Repossessions are similarly valued.

For assets measured at fair value on a nonrecurring basis the following represents impairment charges (recoveries) recognized on these assets during the year ended December 31, 2017 and 2016, respectively: impaired loans - $0.50 million and $0.00 million; partnership investments - $0.00 million and $0.00 million; MSRs - $0.00 million and $0.00 million; repossessions - $0.79 million and $0.58 million, and other real estate - $0.05 million and $0.00 million.

The following table shows the carrying value of assets measured at fair value on a non-recurring basis.



(Dollars in thousands)	Level 1		Level 2		Level 3		Total
December 31, 2017
Impaired loans - collateral based	$	—	$	—	$	7,994	$	7,994
Accrued income and other assets (partnership investments)	—		—		1,000		1,000
Accrued income and other assets (mortgage servicing rights)	—		—		4,349		4,349
Accrued income and other assets (repossessions)	—		—		10,114		10,114
Accrued income and other assets (other real estate)	—		—		1,312		1,312
Total	$	—	$	—	$	24,769	$	24,769

December 31, 2016
Impaired loans - collateral based	$	—	$	—	$	6,280	$	6,280
Accrued income and other assets (partnership investments)	—		—		1,032		1,032
Accrued income and other assets (mortgage servicing rights)	—		—		4,297		4,297
Accrued income and other assets (repossessions)	—		—		9,373		9,373
Accrued income and other assets (other real estate)	—		—		704		704
Total	$	—	$	—	$	21,686	$	21,686

The following table shows the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a non-recurring basis.



(Dollars in thousands)	Carrying Value		Fair value		Valuation Methodology	Unobservable Inputs	Range of Inputs
December 31, 2017
Impaired loans	$	7,994	$	7,994	Collateral based measurements including appraisals, trade publications, and auction values	Discount for lack of marketability and current conditions	3% - 20%

Mortgage servicing rights	4,349		7,187		Discounted cash flows	Constant prepayment rate (CPR)	8.6% - 20.7%
						Discount rate	9.6% - 12.5%

Repossessions	10,114		10,493		Appraisals, trade publications and auction values	Discount for lack of marketability	3% - 10%

Other real estate	1,312		1,441		Appraisals	Discount for lack of marketability	7% - 9%

December 31, 2016
Impaired loans	$	6,280	$	6,280	Collateral based measurements including appraisals, trade publications, and auction values	Discount for lack of marketability and current conditions	0% - 100%

Mortgage servicing rights	4,297		7,484		Discounted cash flows	Constant prepayment rate (CPR)	8.6% - 15.0%
						Discount rate	9.6% - 12.5%

Repossessions	9,373		9,452		Appraisals, trade publications and auction values	Discount for lack of marketability	0% - 4%

Other real estate	704		752		Appraisals	Discount for lack of marketability	0% - 16%

GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or non-recurring basis.

The following table shows the fair values of the Company’s financial instruments.



(Dollars in thousands)	Carrying or Contract Value		Fair Value		Level 1		Level 2		Level 3
December 31, 2017
Assets:
Cash and due from banks	$	73,635	$	73,635	$	73,635	$	—	$	—
Federal funds sold and interest bearing deposits with other banks	4,398		4,398		4,398		—		—
Investment securities, available-for-sale	904,033		904,033		27,971		873,197		2,865
Other investments	25,953		25,953		25,953		—		—
Mortgages held for sale	13,123		13,123		—		13,123		—
Loans and leases, net of reserve for loan and lease losses	4,432,795		4,428,848		—		—		4,428,848
Mortgage servicing rights	4,349		7,187		—		—		7,187
Interest rate swaps	5,167		5,167		—		5,167		—
Liabilities:
Deposits	$	4,752,730	$	4,745,111	$	3,482,757	$	1,262,354	$	—
Short-term borrowings	214,595		214,595		206,862		7,733		—
Long-term debt and mandatorily redeemable securities	70,060		67,857		—		67,857		—
Subordinated notes	58,764		57,103		—		57,103		—
Interest rate swaps	5,262		5,262		—		5,262		—
Off-balance-sheet instruments *	—		286		—		286		—

December 31, 2016
Assets:
Cash and due from banks	$	58,578	$	58,578	$	58,578	$	—	$	—
Federal funds sold and interest bearing deposits with other banks	49,726		49,726		49,726		—		—
Investment securities, available-for-sale	850,467		850,467		28,366		818,595		3,506
Other investments and trading account securities	22,458		22,458		22,458		—		—
Mortgages held for sale	15,849		15,849		—		15,849		—
Loans and leases, net of reserve for loan and lease losses	4,099,528		4,107,079		—		—		4,107,079
Mortgage servicing rights	4,297		7,484		—		—		7,484
Interest rate swaps	6,621		6,621		—		6,621		—
Liabilities:
Deposits	$	4,333,760	$	4,332,744	$	3,277,108	$	1,055,636	$	—
Short-term borrowings	291,943		291,943		163,652		128,291		—
Long-term debt and mandatorily redeemable securities	74,308		73,149		—		73,149		—
Subordinated notes	58,764		51,031		—		51,031		—
Interest rate swaps	6,743		6,743		—		6,743		—
Off-balance-sheet instruments *	—		382		—		382		—

* Represents estimated cash outflows required to currently settle the obligations at current market rates.

The methodologies for estimating fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above. The estimated fair value approximates carrying value for cash and due from banks, federal funds sold and interest bearing deposits with other banks, and other investments. The methodologies for other financial assets and financial liabilities are discussed below:

Loans and Leases — For variable rate loans and leases that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values of other loans and leases are estimated using discounted cash flow analyses which use interest rates currently being offered for loans and leases with similar terms to borrowers of similar credit quality.

Deposits — The fair values for all deposits other than time deposits are equal to the amounts payable on demand (the carrying value). Fair values of variable rate time deposits are equal to their carrying values. Fair values for fixed rate time deposits are estimated using discounted cash flow analyses using interest rates currently being offered for deposits with similar remaining maturities.

Short-Term Borrowings — The carrying values of Federal funds purchased, securities sold under repurchase agreements, and other short-term borrowings, including the liability related to mortgage loans available for repurchase under GNMA optional repurchase programs, approximate their fair values.

Long-Term Debt and Mandatorily Redeemable Securities — The fair values of long-term debt are estimated using discounted cash flow analyses, based on our current estimated incremental borrowing rates for similar types of borrowing arrangements. The carrying values of mandatorily redeemable securities are based on our current estimated cost of redeeming these securities which approximate their fair values.

Subordinated Notes — Fair values are estimated based on calculated market prices of comparable securities.

Off-Balance-Sheet Instruments — Contract and fair values for certain of our off-balance-sheet financial instruments (guarantees) are estimated based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

Limitations — Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments. Because no market exists for a significant portion of our financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other such factors.

These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. These estimates are subjective in nature and require considerable judgment to interpret market data. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange, nor are they intended to represent the fair value of the Company as a whole. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The fair value estimates presented herein are based on pertinent information available to management as of the respective balance sheet date. Although the Company is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.

Other significant assets, such as premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures. Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.