8. DERIVATIVE AND HEDGING ACTIVITIES

The Corporation is exposed to certain risks arising from both its business operations and economic conditions. The Corporation principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Corporation manages economic risks, including interest rate risk, primarily by managing the amount, source, and duration of its assets and liabilities, and through the use of derivative instruments. Derivative instruments are used to reduce the effects that changes in interest rates may have on net income and cash flows. The Corporation also uses derivative instruments to facilitate transactions on behalf of its customers.

All derivatives are carried on the consolidated balance sheets at fair value and do not take into account the effects of master netting arrangements the Corporation has with other financial institutions. Credit risk is included in the determination of the estimated fair value of derivatives. Derivative assets are classified in the consolidated balance sheets under other assets and derivative liabilities are classified in the consolidated balance sheets under other liabilities. Changes in fair value are recognized in earnings except for certain changes related to derivative instruments designated as part of a cash flow hedging relationship.

The following table presents notional amounts and gross fair values of all derivative assets and derivative liabilities held by the Corporation:


	September 30, 2016						December 31, 2015
	Notional		Fair Value				Notional		Fair Value
(in thousands)	Amount		Asset		Liability		Amount		Asset		Liability
Gross Derivatives
Subject to master netting arrangements:
Interest rate contracts – designated	$	450,000	$	9,938	$	1,167	$	250,000	$	3,178	$	962
Interest rate swaps – not designated		1,614,449		—		91,949		1,262,964		1		50,491
Equity contracts – not designated		1,180		43		—		1,180		18		—

Total subject to master netting arrangements		2,065,629		9,981		93,116		1,514,144		3,197		51,453
Not subject to master netting arrangements:
Interest rate swaps – not designated		1,614,449		90,989		—		1,262,964		49,998		1
Credit risk contracts – not designated		171,072		57		355		114,753		7		133
Equity contracts – not designated		1,180		—		43		1,180		—		18

Total not subject to master netting arrangements		1,786,701		91,046		398		1,378,897		50,005		152

Total	$	3,852,330	$	101,027	$	93,514	$	2,893,041	$	53,202	$	51,605

Derivatives Designated as Hedging Instruments under GAAP

Interest Rate Contracts. The Corporation entered into interest rate derivative agreements to modify the interest rate characteristics of certain commercial loans and three of its FHLB advances from variable rate to fixed rate in order to reduce the impact of changes in future cash flows due to market interest rate changes. These agreements are designated as cash flow hedges (i.e., hedging the exposure to variability in expected future cash flows). The effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income and subsequently reclassified into earnings in the same line item associated with the forecasted transaction when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately.

Following is a summary of key data related to interest rate contracts:


(in thousands)	September 30, 2016		December 31, 2015
Notional amount	$	450,000	$	250,000
Fair value included in other assets		9,938		3,178
Fair value included in other liabilities		1,167		962

The following table shows amounts reclassified from accumulated other comprehensive income (AOCI) for the nine months ended September 30, 2016:


(in thousands)	Total		Net of Tax
Reclassified from AOCI to interest income	$	2,030	$	1,319
Reclassified from AOCI to interest expense		554		360

As of September 30, 2016, the maximum length of time over which forecasted interest cash flows are hedged is seven years. In the twelve months that follow September 30, 2016, the Corporation expects to reclassify from the amount currently reported in AOCI net derivative gains of $1.9 million ($1.2 million net of tax), in association with interest on the hedged loans and FHLB advances. 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, 2016. There were no components of derivative gains or losses excluded from the assessment of hedge effectiveness related to these cash flow hedges. For the nine months ended September 30, 2016 and 2015, there was no hedge ineffectiveness. Also, during the nine months ended September 30, 2016 and 2015, there were no gains or losses from cash flow hedge derivatives reclassified to earnings because it became probable that the original forecasted transactions would not occur.

Derivatives Not Designated as Hedging Instruments under GAAP

Interest Rate Swaps. The Corporation enters into interest rate swap agreements to meet the financing, interest rate and equity risk management needs of qualifying commercial loan customers. These agreements provide the customer the ability to convert from variable to fixed interest rates. The credit risk associated with derivatives executed with customers is essentially the same as that involved in extending loans and is subject to normal credit policies and monitoring. Swap derivative transactions with customers are not subject to enforceable master netting arrangements and are generally secured by rights to non-financial collateral, such as real and personal property.

The Corporation enters into positions with a derivative counterparty in order to offset its exposure on the fixed components of the customer interest rate swap agreements. The Corporation seeks to minimize counterparty credit risk by entering into transactions only with high-quality financial dealer institutions. These arrangements meet the definition of derivatives, but are not designated as hedging instruments under ASC 815, Derivatives and Hedging. Substantially all contracts with dealers that require central clearing (generally, transactions since June 10, 2014) are novated to a SEC registered clearing agency who becomes the Corporation’s counterparty.

Following is a summary of key data related to interest rate swaps:


(in thousands)	September 30, 2016		December 31, 2015
Notional amount	$	1,614,449	$	1,262,964
Fair value included in other assets		90,989		49,999
Fair value included in other liabilities		91,949		50,492

The interest rate swap agreement with the loan customer and with the counterparty is reported at fair value in other assets and other liabilities on the consolidated balance sheets with any resulting gain or loss recorded in current period earnings as other income or other expense.

Credit Risk Contracts. The Corporation purchases and sells credit protection under risk participation agreements to share with other counterparties some of the credit exposure related to interest rate derivative contracts or to take on credit exposure to generate revenue. The Corporation will make/receive payments under these agreements if a customer defaults on its obligation to perform under certain derivative swap contracts.

Risk participation agreements sold with notional amounts totaling $120.5 million as of September 30, 2016 have remaining terms ranging from six months to fourteen years. Under these agreements, the Corporation’s maximum exposure assuming a customer defaults on their obligation to perform under certain derivative swap contracts with third parties would be $0.4 million at September 30, 2016 and $0.1 million at December 31, 2015.

The fair values of risk participation agreements purchased and sold were not material at September 30, 2016 and December 31, 2015.

Counterparty Credit Risk

The Corporation is party to master netting arrangements with most of its swap derivative counterparties. Collateral, usually marketable securities and/or cash, is exchanged between the Corporation and its counterparties, and is generally subject to thresholds and transfer minimums. For swap transactions that require central clearing, the Corporation posts cash to its clearing agency. Collateral positions are valued daily, and adjustments to amounts received and pledged by the Corporation are made as appropriate to maintain proper collateralization for these transactions.

Certain master netting agreements contain provisions that, if violated, could cause the counterparties to request immediate settlement or demand full collateralization under the derivative instrument. If the Corporation had breached its agreements with its derivative counterparties it would be required to settle its obligations under the agreements at the termination value and would be required to pay an additional $1.1 million and $1.3 million as of September 30, 2016 and December 31, 2015, respectively, in excess of amounts previously posted as collateral with the respective counterparty.

The following table presents information about derivative assets and derivative liabilities that are subject to enforceable master netting arrangements as well as those not subject to enforceable master netting arrangements:


(in thousands)	Gross Amount		Gross Amounts Offset in the Balance Sheet		Net Amount Presented in the Balance Sheet
September 30, 2016
Derivative Assets
Subject to master netting arrangements:
Interest rate contracts
Designated	$	9,938		—	$	9,938
Not designated		—		—		—
Equity contracts – not designated		43		—		43
Not subject to master netting arrangements:
Interest rate contracts – not designated		90,989		—		90,989
Credit contracts – not designated		57		—		57

Total derivative assets	$	101,027		—	$	101,027

Derivative Liabilities
Subject to master netting arrangements:
Interest rate contracts
Designated	$	1,167		—	$	1,167
Not designated		91,949		—		91,949
Not subject to master netting arrangements:
Interest rate contracts – not designated		—		—		—
Credit contracts – not designated		355		—		355
Equity contracts – not designated		43		—		43

Total derivative liabilities	$	93,514		—	$	93,514

December 31, 2015
Derivative Assets
Subject to master netting arrangements:
Interest rate contracts
Designated	$	3,178		—	$	3,178
Not designated		1		—		1
Equity contracts – not designated		18		—		18
Not subject to master netting arrangements:
Interest rate contracts – not designated		49,998		—		49,998
Credit contracts – not designated		7				7

Total derivative assets	$	53,202		—	$	53,202


	Gross Amount		Gross Amounts Offset in the Balance Sheet		Net Amount Presented in the Balance Sheet
Derivative Liabilities
Subject to master netting arrangements:
Interest rate contracts
Designated	$	962		—	$	962
Not designated		50,491		—		50,491
Not subject to master netting arrangements:
Interest rate contracts – not designated		1		—		1
Credit contracts – not designated		133				133
Equity contracts – not designated		18		—		18

Total derivative liabilities	$	51,605		—	$	51,605

The following table presents a reconciliation of the net amounts of derivative assets and derivative liabilities presented in the balance sheets to the net amounts that would result in the event of offset:


			Amount Not Offset in the Balance Sheet
(in thousands)	Net Amount Presented in the Balance Sheet		Financial Instruments		Cash Collateral		Net Amount
September 30, 2016
Derivative Assets
Interest rate contracts:
Designated	$	9,938	$	5,578	$	4,360		—
Not designated		—		—		—		—
Equity contracts – not designated		43		43		—		—

Total	$	9,981	$	5,621	$	4,360		—

Derivative Liabilities
Interest rate contracts:
Designated	$	1,167	$	—	$	1,167	$	—
Not designated		91,949		29,605		61,281		1,063

Total	$	93,116	$	29,605	$	62,448	$	1,063

December 31, 2015
Derivative Assets
Interest rate contracts:
Designated	$	3,178	$	1,516	$	1,662		—
Not designated		1		1		—		—
Equity contracts – not designated		18		18		—		—

Total	$	3,197	$	1,535	$	1,662		—

Derivative Liabilities
Interest rate contracts:
Designated	$	962	$	792	$	170	$	—
Not designated		50,491		24,579		24,632		1,280

Total	$	51,453	$	25,371	$	24,802	$	1,280

The following table presents the effect of certain of the Corporation’s derivative financial instruments on the income statement:


		Nine Months Ended September 30,
(in thousands)	Income Statement Location	2016			2015
Interest Rate Contracts	Interest income - loans and leases	$	2,030		$	2,440
Interest Rate Contracts	Interest expense – short-term borrowings		554			115
Interest Rate Swaps	Other income		(467	)		(364	)
Credit Risk Contracts	Other income		(172	)		(180	)

Other

The Corporation has entered into interest rate lock commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans to secondary market investors. These arrangements are considered derivative instruments. The fair values of the Corporation’s rate lock commitments to customers and commitments with investors at September 30, 2016 and December 31, 2015 are not material.