Derivative Financial Instruments

We primarily use derivative financial instruments to manage interest rate risk, currency exchange rate risk, and to assist customers with their risk management objectives. Also, in connection with negotiating credit facilities and certain other services, we often obtain equity warrant assets giving us the right to acquire stock in private, venture-backed companies in the technology and life science industries.

Interest Rate Risk

Interest rate risk is our primary market risk and can result from timing and volume differences in the repricing of our interest rate-sensitive assets and liabilities and changes in market interest rates. To manage interest rate risk for our 6.05% Subordinated Notes, we entered into a fixed-for-floating interest rate swap agreement at the time of debt issuance based upon LIBOR with matched-terms. Net cash benefits associated with our interest rate swap is recorded as a reduction in “Interest expense—Borrowings,” a component of net interest income. The fair value of our interest rate swap is calculated using a discounted cash flow method and adjusted for credit valuation associated with counterparty risk. Changes in the fair value of the interest rate swap are reflected in either other assets (if in an asset position) or other liabilities (if in a liability position).

We assess hedge effectiveness under ASC 815, Derivatives and Hedging, using the long-haul method. Any differences associated with our interest rate swap that arise as a result of hedge ineffectiveness is recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income.

Currency Exchange Risk

We enter into foreign exchange forward contracts to economically reduce our foreign exchange exposure risk associated with the net difference between foreign currency denominated assets and liabilities, primarily in Pound Sterling and Euro. We do not designate any foreign exchange forward contracts as derivative instruments that qualify for hedge accounting. Changes in currency rates on foreign currency denominated instruments are included in other noninterest income, a component of noninterest income. We may experience ineffectiveness in the economic hedging relationship, because the instruments are revalued based upon changes in the currency’s spot rate on the principal value, while the forwards are revalued on a discounted cash flow basis. We record forward agreements in gain positions in other assets and loss positions in other liabilities, while net changes in fair value are recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income. Additionally, through our global banking operations we maintain customer deposits denominated in the Euro and Pound Sterling which are used to fund certain loans in these currencies to limit our exposure to currency fluctuations.

Other Derivative Instruments

Equity Warrant Assets

Our equity warrant assets are concentrated in private, venture-backed companies in the technology and life science industries. Most of these warrant agreements contain net share settlement provisions, which permit us to pay the warrant exercise price using shares issuable under the warrant (“cashless exercise”). We value our equity warrant assets using a modified Black-Scholes option pricing model, which incorporates assumptions about the underlying asset value, volatility, and the risk-free rate. We make valuation adjustments for estimated remaining life and marketability for warrants issued by private companies. Equity warrant assets are recorded at fair value in other assets, while changes in their fair value are recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income.

Loan Conversion Options

In connection with negotiating certain credit facilities, we occasionally extend loan facilities which have convertible option features. The convertible loans may be converted into a certain number of shares determined by dividing the principal amount of the loan by the applicable conversion price. Because our loan conversion options have underlying and notional values and had no initial net investment, these assets qualify as derivative instruments. We value our loan conversion options using a modified Black-Scholes option pricing model, which incorporates assumptions about the underlying asset value, volatility, and the risk-free rate. Loan conversion options are recorded at fair value in other assets, while changes in their fair value are recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income.

Other Derivatives

We sell forward and option contracts to clients who wish to mitigate their foreign currency exposure. We economically reduce the currency risk from this business by entering into opposite way contracts with correspondent banks. These relationships do not qualify for hedge accounting. The contracts generally have terms of one year or less, although we may have contracts extending for up to five years. Generally, we have not experienced nonperformance on these contracts, have not incurred credit losses, and anticipate performance by all counterparties to such agreements. Contracts in an asset position are included in other assets and contracts in a liability position are included in other liabilities. The net change in the fair value of these contracts is recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income.

We sell interest rate contracts to clients who wish to mitigate their interest rate exposure. We economically reduce the interest rate risk from this business by entering into opposite way contracts with correspondent banks. We do not designate any of these contracts (which are derivative instruments) as qualifying for hedge accounting. Contracts in an asset position are included in other assets and contracts in a liability position are included in other liabilities. The net change in the fair value of these derivatives is recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income.

Counterparty Credit Risk

We are exposed to credit risk if counterparties to our derivative contracts do not perform as expected. We mitigate counterparty credit risk through credit approvals, limits, monitoring procedures and obtaining collateral, as appropriate. With respect to measuring counterparty credit risk for derivative instruments, we measure the fair value of a group of financial assets and financial liabilities on a net risk basis by counterparty portfolio.

The total notional or contractual amounts, fair value, collateral and net exposure of our derivative financial instruments at June 30, 2014 and December 31, 2013 were as follows:



		June 30, 2014										December 31, 2013
(Dollars in thousands)	Balance Sheet Location	Notional or Contractual Amount		Fair Value			Collateral (1)		Net Exposure (2)			Notional or Contractual Amount		Fair Value			Collateral (1)		Net Exposure (2)
Derivatives designated as hedging instruments:
Interest rate risks:
Interest rate swaps	Other assets	$	45,964	$	5,692		$	3,910	$	1,782		$	45,964	$	6,492		$	5,080	$	1,412
Derivatives not designated as hedging instruments:
Currency exchange risks:
Foreign exchange forwards	Other assets	3,240		198			—		198			140,760		1,423			—		1,423
Foreign exchange forwards	Other liabilities	178,419		(1,545		)	—		(1,545		)	62,649		(634		)	—		(634		)
Net exposure				(1,347		)	—		(1,347		)			789			—		789
Other derivative instruments:
Equity warrant assets	Other assets	182,145		88,905			—		88,905			179,934		103,513			—		103,513
Other derivatives:
Client foreign exchange forwards	Other assets	417,361		10,759			1,000		9,759			424,983		13,673			—		13,673
Client foreign exchange forwards	Other liabilities	347,983		(9,066		)	—		(9,066		)	367,079		(11,549		)	—		(11,549		)
Client foreign currency options	Other assets	4,500		133			—		133			91,854		434			—		434
Client foreign currency options	Other liabilities	4,500		(133		)	—		(133		)	91,854		(434		)	—		(434		)
Loan conversion options	Other assets	1,940		53			—		53			3,455		314			—		314
Client interest rate derivatives	Other assets	310,910		2,239			—		2,239			216,773		1,265			—		1,265
Client interest rate derivatives	Other liabilities	310,910		(2,420		)	—		(2,420		)	216,773		(1,396		)	—		(1,396		)
Net exposure				1,565			1,000		565					2,307			—		2,307
Net				$	94,815		$	4,910	$	89,905				$	113,101		$	5,080	$	108,021


(1)	Cash collateral received from our counterparties in relation to market value exposures of derivative contracts in our favor is recorded as a component of “short-term borrowings” on our consolidated balance sheets.


(2)	Net exposure for contracts in a gain position reflects the replacement cost in the event of nonperformance by all such counterparties. The credit ratings of our institutional counterparties as of June 30, 2014 remain at investment grade or higher and there were no material changes in their credit ratings during the three and six months ended June 30, 2014.

A summary of our derivative activity and the related impact on our consolidated statements of income for the three and six months ended June 30, 2014 and 2013 is as follows:



		Three months ended June 30,						Six months ended June 30,
(Dollars in thousands)	Statement of income location	2014			2013			2014			2013
Derivatives designated as hedging instruments:
Interest rate risks:
Net cash benefit associated with interest rate swaps	Interest expense—borrowings	$	638		$	633		$	1,277		$	1,267
Changes in fair value of interest rate swaps	Net gains on derivative instruments	(13		)	(33		)	(25		)	27
Net gains associated with interest rate risk derivatives		$	625		$	600		$	1,252		$	1,294
Derivatives not designated as hedging instruments:
Currency exchange risks:
(Losses) gains on revaluations of foreign currency instruments	Other noninterest income	$	(685	)	$	(586	)	$	293		$	(7,650	)
Gains (losses) on internal foreign exchange forward contracts, net	Net gains on derivative instruments	538			712			(491		)	6,912
Net (losses) gains associated with currency risk		$	(147	)	$	126		$	(198	)	$	(738	)
Other derivative instruments:
Net gains on equity warrant assets	Net gains on derivative instruments	$	12,329		$	7,190		$	37,702		$	10,695
Gains on client foreign exchange forward contracts, net	Net gains on derivative instruments	$	170		$	124		$	472		$	173
Net (losses) gains on other derivatives (1)	Net gains on derivative instruments	$	(249	)	$	94		$	(716	)	$	572


(1)	Primarily represents the change in fair value of loan conversion options.

Balance Sheet Offsetting

Certain of our derivative and other financial instruments are subject to enforceable master netting arrangements with our counterparties. These agreements provide for the net settlement of multiple contracts with a single counterparty through a single payment, in a single currency, in the event of default on or termination of any one contract. The following table summarizes our assets subject to enforceable master netting arrangements as of June 30, 2014 and December 31, 2013:



								Gross Amounts Not Offset in the Statement of Financial Position But Subject to Master Netting Arrangements
(Dollars in thousands)	Gross Amounts of Recognized Assets		Gross Amounts offset in the Statement of Financial Position			Net Amounts of Assets Presented in the Statement of Financial Position		Financial Instruments			Cash Collateral Received			Net Amount
June 30, 2014
Derivative Assets:
Interest rate swaps	$	5,692	$	—		$	5,692	$	(1,782	)	$	(3,910	)	$	—
Foreign exchange forwards	10,957		—			10,957		(3,633		)	(1,000		)	6,324
Foreign currency options	133		—			133		(133		)	—			—
Client interest rate derivatives	2,239		—			2,239		(559		)	—			1,680
Total derivative assets:	19,021		—			19,021		(6,107		)	(4,910		)	8,004
Reverse repurchase, securities borrowing, and similar arrangements	53,764		—			53,764		(53,764		)	—			—
Total	$	72,785	$	—		$	72,785	$	(59,871	)	$	(4,910	)	$	8,004
December 31, 2013
Derivative Assets:
Interest rate swaps	$	6,492	$	—		$	6,492	$	(1,412	)	$	(5,080	)	$	—
Foreign exchange forwards	15,096		—			15,096		(6,735		)	—			8,361
Foreign currency options	504		(70		)	434		(155		)	—			279
Client interest rate derivatives	1,265		—			1,265		(256		)	—			1,009
Total derivative assets:	23,357		(70		)	23,287		(8,558		)	(5,080		)	9,649
Reverse repurchase, securities borrowing, and similar arrangements	172,989		—			172,989		(172,989		)	—			—
Total	$	196,346	$	(70	)	$	196,276	$	(181,547	)	$	(5,080	)	$	9,649

The following table summarizes our liabilities subject to enforceable master netting arrangements as of June 30, 2014 and December 31, 2013:



								Gross Amounts Not Offset in the Statement of Financial Position But Subject to Master Netting Arrangements
(Dollars in thousands)	Gross Amounts of Recognized Liabilities		Gross Amounts offset in the Statement of Financial Position			Net Amounts of Liabilities Presented in the Statement of Financial Position		Financial Instruments			Cash Collateral Pledged		Net Amount
June 30, 2014
Derivative Liabilities:
Foreign exchange forwards	$	10,611	$	—		$	10,611	$	(6,973	)	$	—	$	3,638
Foreign currency options	133		—			133		—			—		133
Client interest rate derivatives	2,420		—			2,420		(1,861		)	—		559
Total derivative liabilities:	13,164		—			13,164		(8,834		)	—		4,330
Repurchase, securities lending, and similar arrangements	—		—			—		—			—		—
Total	$	13,164	$	—		$	13,164	$	(8,834	)	$	—	$	4,330
December 31, 2013
Derivative Liabilities:
Foreign exchange forwards	$	12,183	$	—		$	12,183	$	(8,282	)	$	—	$	3,901
Foreign currency options	504		(70		)	434		(279		)	—		155
Client interest rate derivatives	1,396		—			1,396		(1,087		)	—		309
Total derivative liabilities:	14,083		(70		)	14,013		(9,648		)	—		4,365
Repurchase, securities lending, and similar arrangements	—		—			—		—			—		—
Total	$	14,083	$	(70	)	$	14,013	$	(9,648	)	$	—	$	4,365