Note 8 – Fair Market Value of Financial Assets and Liabilities

Fair Value Measurements

ASC 820, Fair Value Measurements, defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. ASC 820 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. Fair value measurements must maximize the use of observable inputs and minimize the use of unobservable inputs. In this standard, the FASB clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, ASC 820 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy is as follows:

Level 1 Inputs – Quoted prices in active markets for identical assets or liabilities.

Level 2 Inputs – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 Inputs – Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

Recurring Measurements

The following tables present the fair value measurements of assets recognized in the accompanying balance sheets measured at fair value on a recurring basis as of June 30, 2016 and December 31, 2015 and indicate the level within the fair value hierarchy of the valuation techniques.

			Fair Value Measurements at June 30, 2016 Using
(in thousands)	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets measured – recurring basis
Available-for-sale securities:
U.S. Treasury and government agencies	$	220,861	$	45,023	$	175,838	$	0
State and political subdivisions		122,947		0		122,947		0
U.S. government sponsored agency mortgage-backed securities		210,048		0		210,048		0
CRA investment funds		25,259		25,259		0		0
Mortgage servicing rights		2,797		0		0		2,797

			Fair Value Measurements at December 31, 2015 Using
(in thousands)	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets measured – recurring basis
Available-for-sale securities:
U.S. Treasury and government agencies	$	239,394	$	44,702	$	194,692	$	0
State and political subdivisions		129,215		0		129,215		0
U.S. government sponsored agency mortgage-backed securities		201,576		0		201,576		0
CRA investment funds		24,751		24,751		0		0
Mortgage servicing rights		3,236		0		0		3,236

Following is a description of the valuation methodologies and inputs used for assets measured at fair value on a recurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets pursuant to the valuation hierarchy. These valuation methodologies were applied to all of CTBI’s financial assets carried at fair value. CTBI had no liabilities measured and recorded at fair value as of June 30, 2016 and December 31, 2015. There have been no significant changes in the valuation techniques during the quarter or six months ended June 30, 2016. For assets classified within Level 3 of the fair value hierarchy, the process used to develop the reported fair value is described below.

Available-for-Sale Securities

Securities classified as available-for-sale are reported at fair value on a recurring basis. U.S. Treasury and government agencies and CTBI’s CRA investment funds are classified as Level 1 of the valuation hierarchy where quoted market prices are available in the active market on which the individual securities are traded.

If quoted market prices are not available, CTBI obtains fair value measurements from an independent pricing service, such as Interactive Data, which utilizes pricing models to determine fair value measurement. CTBI reviews the pricing quarterly to verify the reasonableness of the pricing. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other factors. U.S. Treasury and government agencies, state and political subdivisions, and U.S. government sponsored agency mortgage-backed securities are classified as Level 2 inputs.

In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy. Fair value determinations for Level 3 measurements are estimated on a quarterly basis where assumptions used are reviewed to ensure the estimated fair value complies with accounting standards generally accepted in the United States. As of June 30, 2016 and December 31, 2015, CTBI did not own any securities valued using Level 3 inputs.

Mortgage Servicing Rights

Mortgage servicing rights do not trade in an active, open market with readily observable prices. CTBI reports mortgage servicing rights at fair value on a recurring basis with subsequent remeasurement of MSRs based on change in fair value.

In determining fair value, CTBI utilizes the expertise of an independent third party. Accordingly, fair value is determined by the independent third party by utilizing assumptions about factors such as mortgage interest rates, discount rates, mortgage loan prepayment speeds, market trends and industry demand. Due to the nature of the valuation inputs, mortgage servicing rights are classified within Level 3 of the hierarchy. Fair value determinations for Level 3 measurements of mortgage servicing rights are tested for impairment on a quarterly basis where assumptions used are reviewed to ensure the estimated fair value complies with accounting standards generally accepted in the United States. See the table below for inputs and valuation techniques used for Level 3 mortgage servicing rights.

Transfers between Levels

There were no transfers between Levels 1, 2, and 3 as of June 30, 2016.

Level 3 Reconciliation

Following is a reconciliation of the beginning and ending balances of recurring fair value measurements recognized in the accompanying balance sheet using significant unobservable (Level 3) inputs for the three and six months ended June 30, 2016 and 2015:

Mortgage Servicing Rights
	Three Months Ended						Six Months Ended
	June 30						June 30
(in thousands)	2016			2015			2016			2015
Beginning balance	$	2,908		$	2,797		$	3,236		$	2,968
Total recognized gains (losses)
Included in net income		(160	)		446			(540	)		285
Issues		127			213			221			297
Settlements		(78	)		(221	)		(120	)		(315	)
Ending balance	$	2,797		$	3,235		$	2,797		$	3,235

Total gains (losses) for the period included in net income attributable to the change in unrealized gains or losses related to assets still held at the reporting date	$	(160	)	$	446		$	(540	)	$	285

Realized and unrealized gains and losses for items reflected in the tables above are included in net income in the consolidated statements of income as follows:

Noninterest Income
	Three Months Ended					Six Months Ended
	June 30					June 30
(in thousands)	2016			2015		2016			2015
Total gains (losses)	$	(238	)	$	225	$	(660	)	$	(30	)

Nonrecurring Measurements

The following tables present the fair value measurements of assets recognized in the accompanying balance sheets measured at fair value on a nonrecurring basis as of June 30, 2016 and December 31, 2015 and indicate the level within the fair value hierarchy of the valuation techniques.

			Fair Value Measurements at June 30, 2016 Using
(in thousands)	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets measured – nonrecurring basis
Impaired loans (collateral dependent)	$	3,973	$	0	$	0	$	3,973
Other real estate/assets owned		1,335		0		0		1,335

			Fair Value Measurements at December 31, 2015 Using
(in thousands)	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets measured – nonrecurring basis
Impaired loans (collateral dependent)	$	3,192	$	0	$	0	$	3,192
Other real estate/assets owned		6,798		0		0		6,798

Following is a description of the valuation methodologies and inputs used for assets measured at fair value on a nonrecurring basis and recognized in the accompanying balance sheet, as well as the general classification of such assets pursuant to the valuation hierarchy. For assets classified within Level 3 of the fair value hierarchy, the process used to develop the reported fair value is described below.

Impaired Loans (Collateral Dependent)

The estimated fair value of collateral-dependent impaired loans is based on the appraised fair value of the collateral, less estimated cost to sell. Collateral-dependent impaired loans are classified within Level 3 of the fair value hierarchy.

CTBI considers the appraisal or evaluation as the starting point for determining fair value and then considers other factors and events in the environment that may affect the fair value. Appraisals of the collateral underlying collateral-dependent loans are obtained when the loan is determined to be collateral-dependent and subsequently as deemed necessary by the Chief Credit Officer. Appraisals are reviewed for accuracy and consistency by the Chief Credit Officer. Appraisers are selected from the list of approved appraisers maintained by management. The appraised values are reduced by discounts to consider lack of marketability and estimated cost to sell if repayment or satisfaction of the loan is dependent on the sale of the collateral. These discounts and estimates are developed by the Chief Credit Officer by comparison to historical results.

Loans considered impaired under ASC 310-35, Impairment of a Loan, are loans for which, based on current information and events, it is probable that the creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans are subject to nonrecurring fair value adjustments to reflect subsequent (i) partial write-downs that are based on the observable market price or current appraised value of the collateral or (ii) the full charge-off of the loan carrying value. Quarter-to-date fair value adjustments on impaired loans disclosed above were $0.3 million, $1.0 million, and $(0.02) million for the quarters ended June 30, 2016, December 31, 2015, and June 30, 2015, respectively. Year-to-date adjustments were $0.6 million for the six months ended June 30, 2016, $1.8 million for the year ended December 31, 2015, and $0.5 million for the six months ended June 30, 2015.

Other Real Estate Owned

In accordance with the provisions of ASC 360, Property, Plant, and Equipment, other real estate owned (OREO) is carried at the lower of fair value at acquisition date or current estimated fair value, less estimated cost to sell when the real estate is acquired. Estimated fair value of OREO is based on appraisals or evaluations. OREO is classified within Level 3 of the fair value hierarchy. Long-lived assets are subject to nonrecurring fair value adjustments to reflect subsequent partial write-downs that are based on the observable market price or current appraised value of the collateral. Quarter-to-date fair value adjustments on other real estate/assets owned were $0.1 million, $0.5 million, and $0.3 million for the quarters ended June 30, 2016, December 31, 2015, and June 30, 2015, respectively. Year-to-date adjustments were $0.2 million for the six months ended June 30, 2016, $1.7 million for the year ended December 31, 2015, and $0.4 million for the six months ended June 30, 2015.

Our policy for determining the frequency of periodic reviews is based upon consideration of the specific properties and the known or perceived market fluctuations in a particular market and is typically between 12 and 18 months but generally not more than 24 months. Appraisers are selected from the list of approved appraisers maintained by management.

Unobservable (Level 3) Inputs

The following tables present quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements at June 30, 2016 and December 31, 2015.

(in thousands)	Quantitative Information about Level 3 Fair Value Measurements
	Fair Value at June 30, 2016		Valuation Technique(s)	Unobservable Input	Range (Weighted Average)
Mortgage servicing rights	$	2,797	Discount cash flows, computer pricing model	Constant prepayment rate		0.0% - 24.1% (12.9%)
				Probability of default		0.0% - 100.0% (2.8%)
				Discount rate		10.0% - 11.5% (10.1%)

Impaired loans (collateral-dependent)	$	3,973	Market comparable properties	Marketability discount		0.0% - 82.5% (35.9%)

Other real estate/assets owned	$	1,335	Market comparable properties	Comparability adjustments		10.0% - 100.0% (26.4%)

(in thousands)	Quantitative Information about Level 3 Fair Value Measurements
	Fair Value at December 31, 2015		Valuation Technique(s)	Unobservable Input	Range (Weighted Average)
Mortgage servicing rights	$	3,236	Discount cash flows, computer pricing model	Constant prepayment rate		6.1% - 22.4% (10.0%)
				Probability of default		0.0% - 100.0% (2.6%)
				Discount rate		10.0% - 11.5% (10.1%)

Impaired loans (collateral-dependent)	$	3,192	Market comparable properties	Marketability discount		0.0% - 76.7% (26.8%)

Other real estate/assets owned	$	6,798	Market comparable properties	Comparability adjustments		5.0% - 51.8% (11.7%)

Sensitivity of Significant Unobservable Inputs

The following is a discussion of the sensitivity of significant unobservable inputs, the interrelationships between those inputs and other unobservable inputs used in recurring fair value measurement and of how those inputs might magnify or mitigate the effect of changes in the unobservable inputs on the fair value measurement.

Mortgage Servicing Rights

Market value for mortgage servicing rights is derived based on unobservable inputs, such as prepayment speeds of the underlying loans generated using the Andrew Davidson Prepayment Model, FHLMC/FNMA guidelines, the weighted-average life of the loan, the discount rate, the weighted average coupon, and the weighted average default rate. Significant increases (decreases) in either of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for prepayment speeds is accompanied by a directionally opposite change in the assumption for interest rates.

Fair Value of Financial Instruments

The following table presents estimated fair value of CTBI’s financial instruments as of June 30, 2016 and indicates the level within the fair value hierarchy of the valuation techniques.

			Fair Value Measurements at June 30, 2016 Using
(in thousands)	Carrying Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial assets:
Cash and cash equivalents	$	138,650	$	138,650	$	0	$	0
Certificates of deposit in other banks		1,100		0		1,104		0
Securities available-for-sale		579,115		70,282		508,833		0
Securities held-to-maturity		1,661		0		1,662		0
Loans held for sale		1,707		1,742		0		0
Loans, net		2,895,688		0		0		2,897,622
Federal Home Loan Bank stock		17,927		0		17,927		0
Federal Reserve Bank stock		4,887		0		4,887		0
Accrued interest receivable		11,052		0		11,052		0
Mortgage servicing rights		2,797		0		0		2,797

Financial liabilities:
Deposits	$	3,041,983	$	765,467	$	2,284,704	$	0
Repurchase agreements		261,298		0		0		261,287
Federal funds purchased		4,334		0		4,334		0
Advances from Federal Home Loan Bank		999		0		1,084		0
Long-term debt		61,341		0		0		49,073
Accrued interest payable		1,826		0		1,826		0

Unrecognized financial instruments:
Letters of credit	$	0	$	0	$	0	$	0
Commitments to extend credit		0		0		0		0
Forward sale commitments		0		0		0		0

The following table presents estimated fair value of CTBI’s financial instruments as of December 31, 2015 and indicates the level within the fair value hierarchy of the valuation techniques.

(in thousands)			Fair Value Measurements at December 31, 2015 Using
	Carrying Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial assets:
Cash and cash equivalents	$	187,611	$	187,611	$	0	$	0
Certificates of deposit in other banks		3,832		0		3,836		0
Securities available-for-sale		594,936		69,453		525,483		0
Securities held-to-maturity		1,661		0		1,651		0
Loans held for sale		1,172		1,196		0		0
Loans, net		2,837,867		0		0		2,833,267
Federal Home Loan Bank stock		17,927		0		17,927		0
Federal Reserve Bank stock		4,887		0		4,887		0
Accrued interest receivable		12,194		0		12,194		0
Mortgage servicing rights		3,236		0		0		3,236

Financial liabilities:
Deposits	$	2,980,782	$	749,975	$	2,208,120	$	0
Repurchase agreements		251,225		0		0		250,873
Federal funds purchased		3,596		0		3,596		0
Advances from Federal Home Loan Bank		101,056		0		100,905		0
Long-term debt		61,341		0		0		49,073
Accrued interest payable		1,071		0		1,071		0

Unrecognized financial instruments:
Letters of credit	$	0	$	0	$	0	$	0
Commitments to extend credit		0		0		0		0
Forward sale commitments		0		0		0		0

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and cash equivalents – The carrying amount approximates fair value.

Certificates of deposit in other banks – Fair values are based on quoted market prices or dealer quotes for similar instruments.

Securities held-to-maturity – Fair values are based on quoted market prices, if available. If a quoted price is not available, fair value is estimated using quoted prices for similar securities. The fair value estimate is provided to management from a third party using modeling assumptions specific to each type of security that are reviewed and approved by management. Quarterly sampling of fair values provided by additional third parties supplement the fair value review process.

Loans held for sale – The fair value is predetermined at origination based on sale price.

Loans (net of the allowance for loan and lease losses) – The fair value of fixed rate loans and variable rate mortgage loans is estimated by discounting the future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. For other variable rate loans, the carrying amount approximates fair value.

Federal Home Loan Bank stock – The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank.

Federal Reserve Bank stock – The carrying value of Federal Reserve Bank stock approximates fair value based on the redemption provisions of the Federal Reserve Bank.

Accrued interest receivable – The carrying amount approximates fair value.

Deposits – The fair value of fixed maturity time deposits is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities. For deposits including demand deposits, savings accounts, NOW accounts, and certain money market accounts, the carrying value approximates fair value.

Repurchase agreements – The fair value is estimated by discounting future cash flows using current rates.

Federal funds purchased – The carrying amount approximates fair value.

Advances from Federal Home Loan Bank – The fair value of these fixed-maturity advances is estimated by discounting future cash flows using rates currently offered for advances of similar remaining maturities.

Long-term debt – The fair value is estimated by discounting future cash flows using current rates.

Accrued interest payable – The carrying amount approximates fair value.

Commitments to originate loans, forward sale commitments, letters of credit, and lines of credit – The fair value of commitments to originate loans is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of forward sale commitments is estimated based on current market prices for loans of similar terms and credit quality. The fair values of letters of credit and lines of credit are based on fees currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations with the counterparties at the reporting date. The fair values of these commitments are not material.