DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

9 Months Ended

Sep. 30, 2023

DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

NOTE 8.           DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

We use derivative instruments to minimize fluctuations in earnings and cash flows caused by interest rate volatility. Our interest rate risk management strategy involves modifying the re-pricing characteristics of certain assets or liabilities so the changes in interest rates do not have a significant effect on net interest income. Thus, all of our derivative contracts are considered to be interest rate contracts.

We recognize our derivative instruments on the consolidated balance sheet at fair value. On the date the derivative instrument is entered into, we designate whether the derivative is part of a hedging relationship (i.e., cash flow or fair value hedge). We formally document relationships between hedging instruments and hedged items, as well as our risk management objective and strategy for undertaking hedge transactions. We also assess, both at the hedge’s inception and on an ongoing basis, whether the derivatives used in hedging transactions are highly effective in offsetting the changes in cash flows or fair values of hedged items. Changes in fair value of derivative instruments that are highly effective and qualify as cash flow hedges are recorded in other comprehensive income or loss.

We offer derivative products in the form of interest rate swaps, to commercial loan customers to facilitate their risk management strategies. These instruments are executed through Master Netting Arrangements (“MNAs”) with financial institution counterparties or Risk Participation Agreements (“RPAs”) with commercial bank counterparties, for which we assume a pro rata share of the credit exposure associated with a borrower's performance related to the derivative contract with the counterparty.

The following tables present information about derivative assets and liabilities at September 30, 2023 and December 31, 2022:

	September 30, 2023
			Weighted
	Notional		Average		Fair Value		Location Fair
	Amount		Maturity		Asset (Liability)		Value Asset
	(in thousands)		(in years)		(in thousands)		(Liability)
Cash flow hedges:
Interest rate swap on wholesale fundings	$	75,000		1.3	$	3,955	Other assets
Interest rate swap on variable rate loans		50,000		2.5		(4,707)	Other liabilities
Total cash flow hedges		125,000				(752)
Fair value hedges:
Interest rate swap on securities		37,190		5.8		5,416	Other assets
Total fair value hedges		37,190				5,416
Economic hedges:
Forward sale commitments		6,425		—		47	Other assets
Customer Loan Swaps-MNA Counterparty		183,510		5.1		(22,226)	Other liabilities
Customer Loan Swaps-RPA Counterparty		119,000		5.4		—	Other liabilities
Customer Loan Swaps-Customer		302,510		5.2		22,226	Other assets
Total economic hedges		611,445				47
Non-hedging derivatives:
Interest rate lock commitments		4,920		0.1		25	Other assets
Total non-hedging derivatives		4,920				25
Total	$	778,555			$	4,736

	December 31, 2022
			Weighted
	Notional		Average		Fair Value		Location Fair
	Amount		Maturity		Asset (Liability)		Value Asset
	(in thousands)		(in years)		(in thousands)		(Liability)
Cash flow hedges:
Interest rate swap on wholesale fundings	$	75,000		2.0	$	4,978	Other assets
Interest rate swap on variable rate loans		50,000		3.2		(4,941)	Other liabilities
Total cash flow hedges		125,000				37
Fair value hedges:
Interest rate swap on securities		37,190		6.6		4,774	Other assets
Total fair value hedges		37,190				4,774
Economic hedges:
Forward sale commitments		—		—		—	Other assets
Customer Loan Swaps-MNA Counterparty		191,987		5.8		(20,287)	Other liabilities
Customer Loan Swaps-RPA Counterparty		113,928		6.0		—	Other liabilities
Customer Loan Swaps-Customer		305,914		5.9		20,287	Other assets
Total economic hedges		611,829				—
Non-hedging derivatives:
Interest rate lock commitments		—		—		—	Other assets
Total non-hedging derivatives		—				—
Total	$	774,019			$	4,811

As of September 30, 2023 and December 31, 2022, the following amounts were recorded on the consolidated balance sheet related to cumulative basis adjustments for fair value hedges:

				Cumulative Amount of Fair
	Location of Hedged Item on	Carrying Amount of Hedged		Value Hedging Adjustment in
	Balance Sheet	Assets		Carrying Amount
September 30, 2023
Interest rate swap on securities	Securities available for sale	$	27,887	$	(9,303)
December 31, 2022
Interest rate swap on securities	Securities available for sale	$	30,045	$	(7,145)

Information about derivative assets and liabilities for the three and nine months ended September 30, 2023 and 2022, follows:

	Three Months Ended September 30, 2023
	Amount of			Amount of
	Gain (Loss)			Gain (Loss)
	Recognized in			Reclassified		Location of	Amount of
	Other		Location of Gain (Loss)	from Other		Gain (Loss)	Gain (Loss)
	Comprehensive		Reclassified from Other	Comprehensive		Recognized in	Recognized
(in thousands)	Income		Comprehensive Income	Income		Income	in Income
Cash flow hedges:
Interest rate swap on wholesale funding	$	(564)	Interest expense	$	—	Interest expense	$	816
Interest rate swap on variable rate loans		48	Interest income		—	Interest income		(578)
Total cash flow hedges		(516)			—			238
Fair value hedges:
Interest rate swap on securities		(2,096)	Interest income		—	Interest income		369
Total fair value hedges		(2,096)			—			369
Economic hedges:
Forward commitments		—	Other income		—	Mortgage banking income		(2)
Total economic hedges		—			—			(2)
Non-hedging derivatives:
Interest rate lock commitments		—	Other expense		—	Mortgage banking income		24
Total non-hedging derivatives		—			—			24
Total	$	(2,612)		$	—		$	629

	Three Months Ended September 30, 2022
	Amount of			Amount of
	Gain (Loss)			Gain (Loss)
	Recognized in			Reclassified		Location of	Amount of
	Other		Location of Gain (Loss)	from Other		Gain (Loss)	Gain (Loss)
	Comprehensive		Reclassified from Other	Comprehensive		Recognized in	Recognized
(in thousands)	Income		Comprehensive Income	Income		Income	in Income
Cash flow hedges:
Interest rate swap on wholesale funding	$	1,262	Interest expense	$	—	Interest expense	$	140
Interest rate swap on variable rate loans		(1,181)	Interest income		—	Interest income		(238)
Total cash flow hedges		81			—			(98)
Fair value hedges:
Interest rate swap on securities		(1,287)	Interest income		—	Interest income		155
Total economic hedges		(1,287)			—			155
Economic hedges:
Forward commitments		—	Other income		—	Mortgage banking income		19
Total economic hedges		—			—			19
Non-hedging derivatives:
Interest rate lock commitments		—	Other income		—	Mortgage banking income		(50)
Total non-hedging derivatives		—			—			(50)
Total	$	(1,206)		$	—		$	26

	Nine Months Ended September 30, 2023
	Amount of			Amount of
	Gain (Loss)			Gain (Loss)
	Recognized in			Reclassified		Location of	Amount of
	Other		Location of Gain (Loss)	from Other		Gain (Loss)	Gain (Loss)
	Comprehensive		Reclassified from Other	Comprehensive		Recognized in	Recognized
(in thousands)	Income		Comprehensive Income	Income		Income	in Income
Cash flow hedges:
Interest rate swap on wholesale funding	$	(786)	Interest expense	$	—	Interest expense	$	2,225
Interest rate swap on variable rate loans		178	Interest income		—	Interest income		(1,575)
Total cash flow hedges		(608)			—			650
Fair value hedges:
Interest rate swap on securities		(1,168)	Interest income		—	Interest income		985
Total fair value hedges		(1,168)			—			985
Economic hedges:
Forward commitments		—	Other income		—	Mortgage banking income		47
Total economic hedges		—			—			47
Non-hedging derivatives:
Interest rate lock commitments		—	Other expense		—	Mortgage banking income		(79)
Total non-hedging derivatives		—			—			(79)
Total	$	(1,776)		$	—		$	1,603

	Nine Months Ended September 30, 2022
	Amount of			Amount of
	Gain (Loss)			Gain (Loss)
	Recognized in			Reclassified		Location of	Amount of
	Other		Location of Gain (Loss)	from Other		Gain (Loss)	Gain (Loss)
	Comprehensive		Reclassified from Other	Comprehensive		Recognized in	Recognized
(in thousands)	Income		Comprehensive Income	Income		Income	in Income
Cash flow hedges:
Interest rate swap on wholesale funding	$	4,058	Interest expense	$	—	Interest expense	$	(1)
Interest rate swap on variable rate loans		(3,489)	Interest income		—	Interest income		(239)
Total cash flow hedges		569			—			(240)
Fair value hedges:
Interest rate swap on securities		(4,761)	Interest income		—	Interest income		(48)
Total economic hedges		(4,761)			—			(48)
Economic hedges:
Forward commitments		—	Other income		—	Mortgage banking income		(7)
Total economic hedges		—			—			(7)
Non-hedging derivatives:
Interest rate lock commitments		—	Other income		—	Mortgage banking income		(283)
Total non-hedging derivatives		—			—			(283)
Total	$	(4,192)		$	—		$	(578)

The effect of cash flow hedging and fair value accounting on the consolidated statements of income for the three and nine months ended September 30, 2023 and 2022:

	Three Months Ended September 30, 2023
	Interest and Dividend Income				Interest Expense
(in thousands)	Loans		Securities and other		Deposits		Borrowings		Non-interest Income
Income and expense line items presented in the consolidated statements of income	$	38,412	$	6,723	$	11,415	$	4,534	$	8,815
The effects of cash flow and fair value hedging:
Gain (loss) on cash flow hedges:
Interest rate swap on wholesale funding		—		—		—		816		—
Interest rate swap on variable rate loans		(578)		—		—		—		—
Gain (loss) on fair value hedges:
Interest rate swap on securities		—		369		—		—		—
	Three Months Ended September 30, 2022
	Interest and Dividend Income				Interest Expense
(in thousands)	Loans		Securities and other		Deposits		Borrowings		Non-interest Income
Income and expense line items presented in the consolidated statements of income	$	27,940	$	5,145	$	1,801	$	1,374	$	8,823
The effects of cash flow and fair value hedging:
Gain (loss) on cash flow hedges:
Interest rate swap on wholesale funding		—		—		—		140		—
Interest rate swap on variable rate loans		(238)		—		—		—		—
Gain (loss) on fair value hedges:
Interest rate swap on securities		—		155		—		—		—

	Nine Months Ended September 30, 2023
	Interest and Dividend Income				Interest Expense
(in thousands)	Loans		Securities and other		Deposits		Borrowings		Non-interest Income
Income and expense line items presented in the consolidated statements of income	$	109,889	$	18,478	$	25,270	$	14,215	$	26,979
The effects of cash flow and fair value hedging:
Gain (loss) on cash flow hedges:
Interest rate swap on wholesale funding		—		—		—		2,225		—
Interest rate swap on variable rate loans		(1,575)		—		—		—		—
Gain (loss) on fair value hedges:
Interest rate swap on securities		—		985		—		—		—
	Nine Months Ended September 30, 2022
	Interest and Dividend Income				Interest Expense
(in thousands)	Loans		Securities and other		Deposits		Borrowings		Non-interest Income
Income and expense line items presented in the consolidated statements of income	$	75,192	$	13,178	$	4,185	$	3,458	$	27,093
The effects of cash flow and fair value hedging:
Gain (loss) on cash flow hedges:
Interest rate swap on wholesale funding		—		—		—		(1)		—
Interest rate swap on variable rate loans		(239)		—		—		—		—
Gain (loss) on fair value hedges:
Interest rate swap on securities		—		(48)		—		—		—

The effect of derivatives not designated as hedging instruments on the consolidated statements of income for the three and nine months ended September 30, 2023 and 2022:

	Location of Gain (Loss) Recognized	Three Months Ended September 30,				Nine Months Ended September 30,
(In thousands)	in Non-interest Income	2023			2022	2023			2022
Derivatives not designated as hedging instruments
Economic hedges:
Forward commitments	Mortgage banking income	$	(2)	$	19	$	47	$	(7)
Non-hedging derivatives:
Interest rate lock commitments	Mortgage banking income		24		(50)		(79)		(283)

Cash flow hedges

Interest rate swaps on wholesale funding

As of September 30, 2023, we have two interest rate swaps on wholesale borrowings to limit our exposure to rising interest rates over a five-year term on 3-month FHLB borrowings or brokered certificates, or a combination thereof at each maturity date.  The first of the two agreements was entered into in November 2019 with a $50.0 million notional amount and pays a fixed interest rate of 1.53%.  A second agreement was entered into in April 2020 with a $25.0 million notional amount and pays a fixed rate of 0.59%. The financial institution counterparty pays us interest on the daily SOFR rate plus 26 basis points. We designated the swaps as cash flow hedges.

Interest rate swap on variable rate loans

We have an interest rate swap that effectively fixes our interest rate on $50 million at the daily SOFR rate plus 11 basis points of based loan assets at 0.806% plus the credit spread on the loans that reprices on weighted average basis. The instrument is specifically designed to hedge the risk of changes in its cash flows from interest receipts attributable to changes in a contractually specified interest rate, on an amount of our variable rate loan assets equal to $50 million. We designated the swap as a cash flow hedge.

Fair value hedges

Interest rate swap on securities

For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative instrument as well as the offsetting loss or gain on the hedged asset or liability attributable to the hedged risk are recognized in current earnings. We utilize interest rate swaps designated as fair value hedges to mitigate the effect of changing interest rates on the fair values of fixed rate callable securities available-for-sale. The hedging strategy on securities converts the fixed interest rates to LIBOR and SOFR based variable interest rates, all securities are expected to convert to SOFR by December 31, 2023. These derivatives are designated as partial term hedges of selected cash flows covering specified periods of time prior to the call dates of the hedged securities. During 2019, we entered into eight swap transactions with a notional amount of $37.2 million designated as fair value hedges. These derivatives are intended to protect against the effects of changing interest rates on the fair values of fixed rate securities.  The fixed rates on the transactions have a weighted average of 1.70%.

Economic hedges

Forward sale commitments

We utilize forward sale commitments on residential mortgage loans to hedge interest rate risk and the associated effects on the fair value of interest rate lock commitments and loans originated for sale. The forward sale commitments are accounted for as derivatives. We typically use a combination of best efforts and mandatory delivery contracts. The contracts are loan sale agreements where we commit to deliver a certain principal amount of mortgage loans to an investor at a specified price on or before a specified date. Generally, we enter into contracts just prior to the loan closing with a customer.

Customer loan derivatives

We enter into customer loan derivatives to facilitate the risk management strategies for commercial banking customers. We mitigate this risk by entering into equal and offsetting loan swap agreements with highly rated third-party financial institutions. The loan swap agreements are free standing derivatives and are recorded at fair value in our consolidated balance sheet. We are party to MNAs with our financial institutional counterparties; however, we do not offset assets and liabilities under these arrangements for financial statement presentation purposes.

The MNAs provide for a single net settlement of all loan swap agreements, as well as collateral or cash funds, in the event of default on, or termination of, any one contract. Collateral is provided by cash or securities received or posted by the counterparty with net liability positions, respectively, in accordance with contract thresholds.

	Gross Amounts Offset in the Consolidated Balance Sheet
	Derivative				Cash Collateral
(in thousands)	Liabilities		Derivative Assets		Pledged		Net Amount
As of September 30, 2023
Customer Loan Derivatives:
MNA counterparty	$	(22,226)	$	22,226	$	—	$	—
RPA counterparty		—		—		—		—
Total	$	(22,226)	$	22,226	$	—	$	—

	Gross Amounts Offset in the Consolidated Balance Sheet
	Derivative				Cash Collateral
(in thousands)	Liabilities		Derivative Assets		Pledged		Net Amount
As of December 31, 2022
Customer Loan Derivatives:
MNA counterparty	$	(20,287)	$	20,287	$	—	$	—
RPA counterparty		—		—		—		—
Total	$	(20,287)	$	20,287	$	—	$	—

Non-hedging derivatives

Interest rate lock commitments

We enter into interest rate lock commitments (“IRLCs”) for residential mortgage loans, which commit us to lend funds to a potential borrower at a specific interest rate and within a specified period of time. IRLCs relate to the origination of residential mortgage loans that are held for sale and are considered derivative financial instruments under applicable accounting guidance. Outstanding IRLCs expose us to the risk that the price of the mortgage loans underlying the commitments may decline due to increases in mortgage interest rates from inception of the rate lock to the funding of the loan. The IRLCs are free standing derivatives, which are carried at fair value with changes recorded in non-interest income in our Consolidated Statements of Income. Changes in the fair value of IRLCs subsequent to inception are based on (i) changes in the fair value of the underlying loan resulting from the fulfillment of the commitment and (ii) changes in the probability when the loan will fund within the terms of the commitment, which is affected primarily by changes in interest rates and the passage of time.