Derivative Financial Instruments

9 Months Ended

Sep. 30, 2019

Derivative Financial Instruments

Derivative Financial Instruments

15. Derivative Financial Instruments

The Bancorp maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce certain risks related to interest rate, prepayment and foreign currency volatility. Additionally, the Bancorp holds derivative instruments for the benefit of its commercial customers and for other business purposes. The Bancorp does not enter into unhedged speculative derivative positions.

The Bancorp’s interest rate risk management strategy involves modifying the repricing characteristics of certain financial instruments so that changes in interest rates do not adversely affect the Bancorp’s net interest margin and cash flows. Derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, forward starting interest rate swaps, options, swaptions and TBA securities. Interest rate swap contracts are exchanges of interest payments, such as fixed-rate payments for floating-rate payments, based on a stated notional amount and maturity date. Interest rate floors protect against declining rates, while interest rate caps protect against rising interest rates. Forward contracts are contracts in which the buyer agrees to purchase, and the seller agrees to make delivery of, a specific financial instrument at a predetermined price or yield. Options provide the purchaser with the right, but not the obligation, to purchase or sell a contracted item during a specified period at an agreed upon price. Swaptions are financial instruments granting the owner the right, but not the obligation, to enter into or cancel a swap.

Prepayment volatility arises mostly from changes in fair value of the largely fixed-rate MSR portfolio, mortgage loans and mortgage-backed securities. The Bancorp may enter into various free-standing derivatives (principal-only swaps, interest rate swaptions, interest rate floors, mortgage options, TBA securities and interest rate swaps) to economically hedge prepayment volatility. Principal-only swaps are total return swaps based on changes in the value of the underlying mortgage principal-only trust. TBA securities are a forward purchase agreement for a mortgage-backed securities trade whereby the terms of the security are undefined at the time the trade is made.

Foreign currency volatility occurs as the Bancorp enters into certain loans denominated in foreign currencies. Derivative instruments that the Bancorp may use to economically hedge these foreign denominated loans include foreign exchange swaps and forward contracts.

The Bancorp also enters into derivative contracts (including foreign exchange contracts, commodity contracts and interest rate contracts) for the benefit of commercial customers and other business purposes. The Bancorp economically hedges significant exposures related to these free-standing derivatives by entering into offsetting third-party contracts with approved, reputable and independent counterparties with substantially matching terms and currencies. Credit risk arises from the possible inability of counterparties to meet the terms of their contracts. The Bancorp’s exposure is limited to the replacement value of the contracts rather than the notional, principal or contract amounts. Credit risk is minimized through credit approvals, limits, counterparty collateral and monitoring procedures.

The fair value of derivative instruments is presented on a gross basis, even when the derivative instruments are subject to master netting arrangements. Derivative instruments with a positive fair value are reported in other assets in the Condensed Consolidated Balance Sheets while derivative instruments with a negative fair value are reported in other liabilities in the Condensed Consolidated Balance Sheets. Cash collateral payables and receivables associated with the derivative instruments are not added to or netted against the fair value amounts with the exception of certain variation margin payments that are considered legal settlements of the derivative contracts. For derivative contracts cleared through certain central clearing parties who have modified their rules to treat variation margin payments as settlements, the variation margin payments are applied to net the fair value of the respective derivative contracts.

The Bancorp’s derivative assets include certain contractual features in which the Bancorp requires the counterparties to provide collateral in the form of cash and securities to offset changes in the fair value of the derivatives, including changes in the fair value due to credit risk of the counterparty. As of September 30, 2019 and December 31, 2018, the balance of collateral held by the Bancorp for derivative assets was $1.1 billion and $481 million, respectively. For derivative contracts cleared through certain central clearing parties who have modified their rules to treat variation margin payments as settlement of the derivative contract, the payments for variation margin of $748 million and $249 million were applied to reduce the respective derivative contracts and were also not included in the total amount of collateral held as of September 30, 2019 and December 31, 2018, respectively. As of September 30, 2019 and December 31, 2018, the credit component negatively impacting the fair value of derivative assets associated with customer accommodation contracts was $21 million and $3 million, respectively.

In measuring the fair value of derivative liabilities, the Bancorp considers its own credit risk, taking into consideration collateral maintenance requirements of certain derivative counterparties and the duration of instruments with counterparties that do not require collateral maintenance. When necessary, the Bancorp posts collateral primarily in the form of cash and securities to offset changes in fair value of the derivatives, including changes in fair value due to the Bancorp’s credit risk. As of September 30, 2019 and December 31, 2018, the balance of collateral posted by the Bancorp for derivative liabilities was $241 million and $551 million, respectively. Additionally, as of September 30, 2019 and December 31, 2018, $528 million and $23 million, respectively, of variation margin payments were applied to the respective derivative contracts to reduce the Bancorp’s derivative liabilities and were also not included in the total amount of collateral posted. Certain of the Bancorp’s derivative liabilities contain credit risk related contingent features that could result in the requirement to post additional collateral upon the occurrence of specified events. As of September 30, 2019 and December 31, 2018, the fair value of the additional collateral that could be required to be posted as a result of the credit-risk related contingent features being triggered was immaterial to the Bancorp’s Condensed Consolidated Financial Statements. The posting of collateral has been determined to remove the need for further consideration of credit-risk. As a result, the Bancorp determined that the impact of the Bancorp’s credit risk to the valuation of its derivative liabilities was immaterial to the Bancorp’s Condensed Consolidated Financial Statements.

The Bancorp holds certain derivative instruments that qualify for hedge accounting treatment and are designated as either fair value hedges or cash flow hedges. Derivative instruments that do not qualify for hedge accounting treatment, or for which hedge accounting is not established, are held as free-standing derivatives. All customer accommodation derivatives are held as free-standing derivatives.

The following tables reflect the notional amounts and fair values for all derivative instruments included in the Condensed Consolidated Balance Sheets as of:
				Fair Value
		Notional		Derivative	Derivative
September 30, 2019 ($ in millions)		Amount		Assets	Liabilities
Derivatives Designated as Qualifying Hedging Instruments:
Fair value hedges:
Interest rate swaps related to long-term debt	$	2,705		459	3
Total fair value hedges				459	3
Cash flow hedges:
Interest rate floors related to C&I loans		3,000		156	-
Interest rate swaps related to C&I loans		8,000		-	72
Total cash flow hedges				156	72
Total derivatives designated as qualifying hedging instruments				615	75
Derivatives Not Designated as Qualifying Hedging Instruments:
Free-standing derivatives - risk management and other business purposes:
Interest rate contracts related to MSR portfolio		6,420		178	12
Forward contracts related to residential mortgage loans held for sale		2,693		3	5
Swap associated with the sale of Visa, Inc. Class B Shares		2,834		-	146
Total free-standing derivatives - risk management and other business purposes				181	163
Free-standing derivatives - customer accommodation:
Interest rate contracts(a)		71,511		727	169
Interest rate lock commitments		1,096		24	-
Commodity contracts		8,144		368	353
TBA securities		28		-	-
Foreign exchange contracts		13,924		182	151
Total free-standing derivatives - customer accommodation				1,301	673
Total derivatives not designated as qualifying hedging instruments				1,482	836
Total			$	2,097	911

Derivative assets and liabilities are presented net of variation margin of $36 and $621, respectively.

				Fair Value
		Notional		Derivative	Derivative
December 31, 2018 ($ in millions)		Amount		Assets	Liabilities
Derivatives Designated as Qualifying Hedging Instruments:
Fair value hedges:
Interest rate swaps related to long-term debt	$	3,455		262	2
Total fair value hedges				262	2
Cash flow hedges:
Interest rate floors related to C&I loans		3,000		69	-
Interest rate swaps related to C&I loans		8,000		15	27
Total cash flow hedges				84	27
Total derivatives designated as qualifying hedging instruments				346	29
Derivatives Not Designated as Qualifying Hedging Instruments:
Free-standing derivatives - risk management and other business purposes:
Interest rate contracts related to MSR portfolio		10,045		40	14
Forward contracts related to residential mortgage loans held for sale		926		-	8
Swap associated with the sale of Visa, Inc. Class B Shares		2,174		-	125
Foreign exchange contracts		133		4	-
Total free-standing derivatives - risk management and other business purposes				44	147
Free-standing derivatives - customer accommodation:
Interest rate contracts		55,012		262	278
Interest rate lock commitments		407		7	-
Commodity contracts		6,511		307	278
TBA securities		18		-	-
Foreign exchange contracts		13,205		148	142
Total free-standing derivatives - customer accommodation				724	698
Total derivatives not designated as qualifying hedging instruments				768	845
Total			$	1,114	874

Fair Value Hedges

The Bancorp may enter into interest rate swaps to convert its fixed-rate funding to floating-rate. Decisions to convert fixed-rate funding to floating are made primarily through consideration of the asset/liability mix of the Bancorp, the desired asset/liability sensitivity and interest rate levels. As of September 30, 2019, certain interest rate swaps met the criteria required to qualify for the shortcut method of accounting that permits the assumption of perfect offset. For all designated fair value hedges of interest rate risk as of September 30, 2019, that were not accounted for under the shortcut method of accounting, the Bancorp performed an assessment of hedge effectiveness using regression analysis with changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability attributable to the hedged risk recorded in the same income statement line in current period net income.

The following table reflects the change in fair value of interest rate contracts, designated as fair value hedges, as well as the change in fair value of the related hedged items attributable to the risk being hedged, included in the Condensed Consolidated Statements of Income:
			For the three months		For the nine months
	Condensed Consolidated		ended September 30,		ended September 30,
($ in millions)	Statements of Income Caption		2019	2018	2019	2018
Change in fair value of interest rate swaps hedging long-term debt	Interest on long-term debt	$	75	(29)	219	(110)
Change in fair value of hedged long-term debt attributable to the risk being hedged	Interest on long-term debt		(74)	31	(214)	113

The following amounts were recorded in the Condensed Consolidated Balance Sheets related to cumulative basis adjustments for fair value hedges as of:
	Condensed Consolidated
($ in millions)	Balance Sheets Caption		September 30, 2019
Carrying amount of the hedged items	Long-term debt	$	3,455
Cumulative amount of fair value hedging adjustments included in the carrying
amount of the hedged items	Long-term debt		(467)

Cash Flow Hedges

The Bancorp may enter into interest rate swaps to convert floating-rate assets and liabilities to fixed rates or to hedge certain forecasted transactions for the variability in cash flows attributable to the contractually specified interest rate. The assets or liabilities may be grouped in circumstances where they share the same risk exposure that the Bancorp desires to hedge. The Bancorp may also enter into interest rate caps and floors to limit cash flow variability of floating-rate assets and liabilities. As of September 30, 2019, all hedges designated as cash flow hedges were assessed for effectiveness using either regression analysis (quantitative approach) or a qualitative approach. The entire change in the fair value of the interest rate swap included in the assessment of hedge effectiveness is recorded in AOCI and reclassified from AOCI to current period earnings when the hedged item affects earnings. As of September 30, 2019, the maximum length of time over which the Bancorp is hedging its exposure to the variability in future cash flows is 63 months.

Reclassified gains and losses on interest rate contracts related to commercial and industrial loans are recorded within interest income in the Condensed Consolidated Statements of Income. As of September 30, 2019 and December 31, 2018, $519 million and $160 million, respectively, of net deferred gains, net of tax, on cash flow hedges were recorded in AOCI in the Condensed Consolidated Balance Sheets. As of September 30, 2019, $10 million in net unrealized gains, net of tax, recorded in AOCI are expected to be reclassified into earnings during the next 12 months. This amount could differ from amounts actually recognized due to changes in interest rates, hedge de-designations and the addition of other hedges subsequent to September 30, 2019.

During the three and nine months ended September 30, 2019 and 2018, there were no gains or losses reclassified from AOCI into earnings associated with the discontinuance of cash flow hedges because it was probable that the original forecasted transaction would no longer occur by the end of the originally specified time period or within the additional period of time as defined by U.S. GAAP.

The following table presents the pretax net gains (losses) recorded in the Condensed Consolidated Statements of Income and in the Condensed Consolidated Statements of Comprehensive Income relating to derivative instruments designated as cash flow hedges:
		For the three months ended		For the nine months ended
		September 30,		September 30,
($ in millions)		2019	2018	2019	2018
Amount of pretax net gains (losses) recognized in OCI	$	105	(25)	456	(31)
Amount of pretax net gains (losses) reclassified from OCI into net income		5	(2)	2	(2)

Free-Standing Derivative Instruments – Risk Management and Other Business Purposes

As part of its overall risk management strategy relative to its mortgage banking activity, the Bancorp may enter into various free-standing derivatives (principal-only swaps, interest rate swaptions, interest rate floors, mortgage options, TBA securities and interest rate swaps) to economically hedge changes in fair value of its largely fixed-rate MSR portfolio. Principal-only swaps hedge the mortgage-LIBOR spread because these swaps appreciate in value as a result of tightening spreads. Principal-only swaps also provide prepayment protection by

increasing in value when prepayment speeds increase, as opposed to MSRs that lose value in a faster prepayment environment. Receive fixed/pay floating interest rate swaps and swaptions increase in value when interest rates do not increase as quickly as expected.

The Bancorp enters into forward contracts and mortgage options to economically hedge the change in fair value of certain residential mortgage loans held for sale due to changes in interest rates. IRLCs issued on residential mortgage loan commitments that will be held for sale are also considered free-standing derivative instruments and the interest rate exposure on these commitments is economically hedged primarily with forward contracts. Revaluation gains and losses from free-standing derivatives related to mortgage banking activity are recorded as a component of mortgage banking net revenue in the Condensed Consolidated Statements of Income.

In conjunction with the sale of Visa, Inc. Class B Shares in 2009, the Bancorp entered into a total return swap in which the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Class B Shares into Class A Shares. This total return swap is accounted for as a free-standing derivative. Refer to Note 25 for further discussion of significant inputs and assumptions used in the valuation of this instrument.

The net gains (losses) recorded in the Condensed Consolidated Statements of Income relating to free-standing derivative instruments used for risk management and other business purposes are summarized in the following table:
			For the three months		For the nine months
	Condensed Consolidated		ended September 30,		ended September 30,
($ in millions)	Statements of Income Caption		2019	2018	2019	2018
Interest rate contracts:
Forward contracts related to residential mortgage loans
held for sale	Mortgage banking net revenue	$	11	7	6	4
Interest rate contracts related to MSR portfolio	Mortgage banking net revenue		130	(24)	308	(89)
Foreign exchange contracts:
Foreign exchange contracts for risk management purposes	Other noninterest income		2	(1)	(3)	3
Equity contracts:
Swap associated with sale of Visa, Inc. Class B Shares	Other noninterest income		(11)	(17)	(63)	(66)

Free-Standing Derivative Instruments – Customer Accommodation

The majority of the free-standing derivative instruments the Bancorp enters into are for the benefit of its commercial customers. These derivative contracts are not designated against specific assets or liabilities on the Condensed Consolidated Balance Sheets or to forecasted transactions and, therefore, do not qualify for hedge accounting. These instruments include foreign exchange derivative contracts entered into for the benefit of commercial customers involved in international trade to hedge their exposure to foreign currency fluctuations and commodity contracts to hedge such items as natural gas and various other derivative contracts. The Bancorp may economically hedge significant exposures related to these derivative contracts entered into for the benefit of customers by entering into offsetting contracts with approved, reputable, independent counterparties with substantially matching terms. The Bancorp hedges its interest rate exposure on commercial customer transactions by executing offsetting swap agreements with primary dealers. Revaluation gains and losses on interest rate, foreign exchange, commodity and other commercial customer derivative contracts are recorded as a component of corporate banking revenue or other noninterest income in the Condensed Consolidated Statements of Income.

The Bancorp enters into risk participation agreements, under which the Bancorp assumes credit exposure relating to certain underlying interest rate derivative contracts. The Bancorp only enters into these risk participation agreements in instances in which the Bancorp has participated in the loan that the underlying interest rate derivative contract was designed to hedge. The Bancorp will make payments under these agreements if a customer defaults on its obligation to perform under the terms of the underlying interest rate derivative contract. As of September 30, 2019 and December 31, 2018, the total notional amount of the risk participation agreements was $4.3 billion and $4.0 billion, respectively, and the fair value was a liability of $9 million and $8 million at September 30, 2019 and December 31, 2018, respectively, which is included in other liabilities in the Condensed Consolidated Balance Sheets. As of September 30, 2019, the risk participation agreements had a weighted-average remaining life of 3.5 years.

The Bancorp’s maximum exposure in the risk participation agreements is contingent on the fair value of the underlying interest rate derivative contracts in an asset position at the time of default. The Bancorp monitors the credit risk associated with the underlying customers in the risk participation agreements through the same risk grading system currently utilized for establishing loss reserves in its loan and lease portfolio.

Risk ratings of the notional amount of risk participation agreements under this risk rating system are summarized in the following table as of:
		September 30,	December 31,
($ in millions)		2019	2018
Pass	$	4,188	3,919
Special mention		144	79
Substandard		13	4
Total	$	4,345	4,002

The net gains (losses) recorded in the Condensed Consolidated Statements of Income relating to free-standing derivative instruments used for customer accommodation are summarized in the following table:
			For the three months		For the nine months
	Condensed Consolidated		ended September 30,		ended September 30,
($ in millions)	Statements of Income Caption		2019	2018	2019	2018
Interest rate contracts:
Interest rate contracts for customers (contract revenue)	Corporate banking revenue	$	12	7	30	23
Interest rate contracts for customers (credit portion of
fair value adjustment)	Other noninterest expense		(5)	-	(18)	-
Interest rate lock commitments	Mortgage banking net revenue		50	17	108	52
Commodity contracts:
Commodity contracts for customers (contract revenue)	Corporate banking revenue		3	3	6	7
Commodity contracts for customers (credit portion of
fair value adjustment)	Other noninterest expense		-	-	-	(1)
Foreign exchange contracts:
Foreign exchange contracts for customers (contract revenue)	Corporate banking revenue		12	16	36	43
Foreign exchange contracts for customers (contract revenue)	Other noninterest income		7	3	15	8
Foreign exchange contracts for customers (credit portion of
fair value adjustment)	Other noninterest expense		-	-	-	1

Offsetting Derivative Financial Instruments

The Bancorp’s derivative transactions are generally governed by ISDA Master Agreements and similar arrangements, which include provisions governing the setoff of assets and liabilities between the parties. When the Bancorp has more than one outstanding derivative transaction with a single counterparty, the setoff provisions contained within these agreements generally allow the non-defaulting party the right to reduce its liability to the defaulting party by amounts eligible for setoff, including the collateral received as well as eligible offsetting transactions with that counterparty, irrespective of the currency, place of payment or booking office. The Bancorp’s policy is to present its derivative assets and derivative liabilities on the Condensed Consolidated Balance Sheets on a gross basis, even when provisions allowing for setoff are in place. However, for derivative contracts cleared through certain central clearing parties who have modified their rules to treat variation margin payments as settlements, the fair value of the respective derivative contracts are reported net of the variation margin payments.

Collateral amounts included in the tables below consist primarily of cash and highly-rated government-backed securities and do not include variation margin payments for derivative contracts with legal rights of setoff for both periods shown.

The following tables provide a summary of offsetting derivative financial instruments:
		Gross Amount		Gross Amounts Not Offset in the
		Recognized in the		Condensed Consolidated Balance Sheets
		Condensed Consolidated
As of September 30, 2019 ($ in millions)		Balance Sheets(a)		Derivatives	Collateral(b)	Net Amount
Assets:
Derivatives		$	2,073	(550)	(630)		893
Total assets			2,073	(550)	(630)		893
Liabilities:
Derivatives			911	(550)	(18)		343
Total liabilities		$	911	(550)	(18)		343
(a)	Amount does not include IRLCs because these instruments are not subject to master netting or similar arrangements.
(b)	Amount of collateral received as an offset to asset positions or pledged as an offset to liability positions. Collateral values in excess of related derivative amounts recognized in the Condensed Consolidated Balance Sheets were excluded from this table.

		Gross Amount		Gross Amounts Not Offset in the
		Recognized in the		Condensed Consolidated Balance Sheets
		Condensed Consolidated
As of December 31, 2018 ($ in millions)		Balance Sheets(a)		Derivatives	Collateral(b)	Net Amount
Assets:
Derivatives		$	1,107	(410)	(348)		349
Total assets			1,107	(410)	(348)		349
Liabilities:
Derivatives			874	(410)	(123)		341
Total liabilities		$	874	(410)	(123)		341
(a)	Amount does not include IRLCs because these instruments are not subject to master netting or similar arrangements.
(b)	Amount of collateral received as an offset to asset positions or pledged as an offset to liability positions. Collateral values in excess of related derivative amounts recognized in the Condensed Consolidated Balance Sheets were excluded from this table.