NOTE 21 – DERIVATIVE FINANCIAL INSTRUMENTS

As discussed in Note 3, Old National adopted ASU 2017-12 in the first quarter of 2018. This adoption primarily impacted our existing cash flow and fair value hedges related to certain FHLB advances. For cash flow hedges as of the date of adoption, the transition guidance in paragraph 815-20-65-3(d) eliminated the separate measurement of ineffectiveness by means of a cumulative-effect adjustment to accumulated other comprehensive income with a corresponding adjustment to the opening balance of retained earnings. For fair value hedges of interest rate risk, the provisions of paragraph 815-25-35-13 permit Old National to elect to modify the measurement methodology to be based on the benchmark rate component of the contractual coupon cash flows without dedesignation of the hedging relationship. The measurement methodology modification shall be applied as of the hedging relationship’s original inception date. The cumulative effect of applying this election shall be recognized as an adjustment to the basis adjustment of the hedged item recognized on the balance sheet with a corresponding adjustment to the opening balance of retained earnings as of the initial application date.

As part of our overall interest rate risk management, Old National uses derivative instruments, including interest rate swaps, caps, and floors. The notional amount of these derivative instruments was $1.034 billion at June 30, 2018 and $708.5 million at December 31, 2017. These derivative financial instruments at June 30, 2018 consisted of $408.5 million notional amount of receive-fixed, pay-variable interest rate swaps on certain of its FHLB advances and $625.0 million notional amount of pay-fixed, receive-variable interest rate swaps on certain of its FHLB advances. Derivative financial instruments at December 31, 2017 consisted of $33.5 million notional amount of receive-fixed, pay-variable interest rate swaps on certain of its FHLB advances and $675.0 million notional amount of pay-fixed, receive-variable interest rate swaps on certain of its FHLB advances. These hedges were entered into to manage interest rate risk. Derivative instruments are recognized on the balance sheet at their fair value and are not reported on a net basis.

In accordance with ASC 815-20-35-1, subsequent changes in fair value for a hedging instrument that has been designated and qualifies as part of a hedging relationship should be accounted for in the following manner:

Cash flow hedges: changes in fair value will be recognized as a component in other comprehensive income.

Fair value hedges: changes in fair value will be recognized concurrently in earnings.

Consistent with this guidance, as long as a hedging instrument is designated and the results of the effectiveness testing support that the instrument qualifies for hedge accounting treatment, 100% of the periodic changes in fair value of the hedging instrument will be accounted for as outlined above. This is the case whether or not economic mismatches exist in the hedging relationship. As a result, there will be no periodic measurement or recognition of ineffectiveness. Rather, the full impact of hedge gains and losses will be recognized in the period in which the hedged transactions impact earnings.

While separate measurement and presentation of ineffectiveness is being eliminated, paragraph 815-20-45-1A requires the change in fair value of the hedging instrument that is included in the assessment of hedge effectiveness be presented in the same income statement line item that is used to present the earnings effect of the hedged item.

Commitments to fund certain mortgage loans (interest rate lock commitments) and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. These derivative contracts do not qualify for hedge accounting. At June 30, 2018, the notional amount of the interest rate lock commitments was $59.3 million and forward commitments were $76.1 million. At December 31, 2017, the notional amount of the interest rate lock commitments was $29.9 million and forward commitments were $41.2 million. It is our practice to enter into forward commitments for the future delivery of residential mortgage loans to third party investors when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from our commitment to fund the loans.

Old National also enters into derivative instruments for the benefit of its customers. The notional amounts of these customer derivative instruments and the offsetting counterparty derivative instruments were $827.6 million at June 30, 2018. The notional amounts of these customer derivative instruments and the offsetting counterparty derivative instruments were $826.6 million at December 31, 2017. These derivative contracts do not qualify for hedge accounting. These instruments include interest rate swaps, caps, and collars. Commonly, Old National will 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.

Old National enters into derivative financial instruments as part of its foreign currency risk management strategies. These derivative instruments consist of foreign currency forward contracts to accommodate the business needs of its customers. Old National does not designate these foreign currency forward contracts for hedge accounting treatment. The notional amounts of these foreign currency forward contracts and the offsetting counterparty derivative instruments were $2.1 million at June 30, 2018 and $0.8 million at December 31, 2017.

Credit risk arises from the possible inability of counterparties to meet the terms of their contracts. Old National’s exposure is limited to the replacement value of the contracts rather than the notional, principal, or contract amounts. There are provisions in our agreements with the counterparties that allow for certain unsecured credit exposure up to an agreed threshold. Exposures in excess of the agreed thresholds are collateralized. In addition, we minimize credit risk through credit approvals, limits, and monitoring procedures.

Amounts reported in AOCI related to cash flow hedges will be reclassified to interest income or interest expense as interest payments are received or paid on Old National’s derivative instruments. During the next 12 months, we estimate that $2.0 million will be reclassified to interest income and $0.8 million will be reclassified to interest expense.

The following table summarizes the fair value of derivative financial instruments utilized by Old National:


(dollars in thousands)	Balance Sheet Location		Fair Value		Balance Sheet Location		Fair Value
June 30, 2018
Derivatives designated as hedging instruments
Interest rate contracts		Other assets	$	4,871		Other liabilities	$	1,656

Total derivatives designated as hedging instruments			$	4,871			$	1,656

Derivatives not designated as hedging instruments
Interest rate contracts		Other assets	$	8,524		Other liabilities	$	19,148
Mortgage contracts		Other assets		1,537		Other liabilities		352
Foreign currency contracts		Other assets		61		Other liabilities		40

Total derivatives not designated as hedging instruments			$	10,122			$	19,540

Total			$	14,993			$	21,196

December 31, 2017
Derivatives designated as hedging instruments
Interest rate contracts		Other assets	$	3,351		Other liabilities	$	5,351

Total derivatives designated as hedging instruments			$	3,351			$	5,351

Derivatives not designated as hedging instruments
Interest rate contracts		Other assets	$	10,012		Other liabilities	$	10,933
Mortgage contracts		Other assets		747		Other liabilities		—
Foreign currency contracts		Other assets		8		Other liabilities		8

Total derivatives not designated as hedging instruments			$	10,767			$	10,941

Total			$	14,118			$	16,292

The effect of derivative instruments in fair value hedging relationships on the consolidated statements of income for the three and six months ended June 30, 2018 and 2017 were as follows:

(dollars in thousands)

Gain (Loss)
Recognized
in Income on
Related
Hedged
Items

Derivatives in

Fair Value Hedging

Relationships

Location of Gain or

(Loss) Recognized in

in Income on

Derivative

Gain (Loss)
Recognized
in Income on
Derivative

Hedged Items
in Fair Value
Hedging
Relationships

Location of Gain or
(Loss) Recognized in
in Income on Related

Hedged Item

Three Months Ended June 30, 2018

Interest rate contracts

Interest income/(expense)

(944

)

Fixed-rate debt

Interest income/(expense)

934

Three Months Ended June 30, 2017

Interest rate contracts

Interest income/(expense)

Fixed-rate debt

Interest income/(expense)

(25

)

Six Months Ended June 30, 2018

Interest rate contracts

Interest income/(expense)

(1,663

)

Fixed-rate debt

Interest income/(expense)

1,655

Six Months Ended June 30, 2017

Interest rate contracts

Interest income/(expense)

(178

)

Fixed-rate debt

Interest income/(expense)

265

The difference between the gain (loss) recognized in income on derivatives and the gain (loss) recognized in income on the related hedged items represents hedge ineffectiveness. In addition, the net swap settlements that accrue each period are also reported in interest expense.

The effect of derivative instruments in cash flow hedging relationships on the consolidated statements of income for the three and six months ended June 30, 2018 and 2017 were as follows:

Three Months Ended
June 30,

(dollars in thousands)

2018

2017

2018

2017

Derivatives in

Cash Flow Hedging

Relationships

Location of Gain or

(Loss) Reclassified

from AOCI into Income

(Effective Portion)

Gain (Loss)
Recognized in Other
Comprehensive
Income on Derivative
(Effective Portion)

Gain (Loss)
Reclassified from
AOCI into
Income (Effective
Portion)

Interest rate contracts

Interest income/(expense)

1,516

(2,387

)

(10

)

(1,734

)

Six Months Ended
June 30,

(dollars in thousands)

2018

2017

2018

2017

Derivatives in

Cash Flow Hedging

Relationships

Location of Gain or

(Loss) Reclassified

from AOCI into Income

(Effective Portion)

Gain (Loss)
Recognized in Other
Comprehensive
Income on Derivative
(Effective Portion)

Gain (Loss)
Reclassified from
AOCI into
Income (Effective
Portion)

Interest rate contracts

Interest income/(expense)

6,079

(1,807

)

(779

)

(3,533

)

The ineffective portion and amount excluded from effectiveness testing related to derivatives in cash flow hedging relationships was immaterial for the three and six months ended June 30, 2018 and 2017.

The effect of derivatives not designated as hedging instruments on the consolidated statements of income for the three and six months ended June 30, 2018 and 2017 were as follows:


		Three Months Ended June 30,
(dollars in thousands)		2018			2017
Derivatives Not Designated as Hedging Instruments	Location of Gain or (Loss) Recognized in Income on Derivative	Gain (Loss) Recognized in Income on Derivative
Interest rate contracts (1)	Other income/(expense)	$	27		$	13
Mortgage contracts	Mortgage banking revenue		(201	)		451
Foreign currency contracts	Other income/(expense)		6			—

Total		$	(168	)	$	464


		Six Months Ended June 30,
(dollars in thousands)		2018			2017
Derivatives Not Designated as Hedging Instruments	Location of Gain or (Loss) Recognized in Income on Derivative	Gain (Loss) Recognized in Income on Derivative
Interest rate contracts (1)	Other income/(expense)	$	27		$	23
Mortgage contracts	Mortgage banking revenue		437			(1,043	)
Foreign currency contracts	Other income/(expense)		23			—

Total		$	487		$	(1,020	)

(1)	Includes the valuation differences between the customer and offsetting swaps.