Note 15 - Financial Derivatives

9 Months Ended

Sep. 30, 2017

Notes to Financial Statements

Derivative Instruments and Hedging Activities Disclosure [Text Block]

1

5

. Financial Derivatives

It is the policy of the Company

not

to speculate on the future direction of interest rates. However, the Company enters into financial derivatives in order to seek mitigation of exposure to interest rate risks r

elated to our interest-earning assets and interest-bearing liabilities. We believe that these transactions, when properly structured and managed,

may

provide a hedge against inherent interest rate risk in the Company’s assets or liabilities and against risk in specific transactions. In such instances, the Company

may

enter into interest rate swap contracts or other types of financial derivatives. Prior to considering any hedging activities, we seek to analyze the costs and benefits of the hedge in comparison to other viable alternative strategies. All hedges must be approved by the Bank’s Investment Committee.

The Company follows

ASC Topic

815

that establishes accounting and reporting standards for financial derivatives, including certain financial derivatives embedded in other contracts, and hedging activities. It requires the recognition of all financial derivatives as assets or liabilities in the Company’s consolidated balance sheet and measurement of those financial derivatives at fair value. The accounting treatment of changes in fair value is dependent upon whether or

not

a financial derivative is designated as a hedge and, if so, the type of hedge. Fair value is determined using

third

-party models with observable market data. For derivatives designated as cash flow hedges, changes in fair value are recognized in other comprehensive income and are reclassified to earnings when the hedged transaction is reflected in earnings. For derivatives designated as fair value hedges, changes in the fair value of the derivatives are reflected in current earnings, together with changes in the fair value of the related hedged item if there is a highly effective correlation between changes in the fair value of the interest rate swaps and changes in the fair value of the underlying asset or liability that is intended to be hedged. If there is

not

a highly effective correlation between changes in the fair value of the interest rate swap and changes in the fair value of the underlying asset or liability that is intended to be hedged, then only the changes in the fair value of the interest rate swaps are reflected in the Company’s consolidated financial statements.

I

n

May 2014,

Bancorp entered into interest rate swap contracts in the notional amount of

$119.1

million for a period of

ten

years. The objective of these interest rate swap contracts, which were designated as hedging instruments in cash flow hedges, was to hedge on Bancorp’s

$119.1

million of Junior Subordinated Debentures that had been issued to

five

trusts, with the quarterly interest payments throughout the

ten

-year period beginning in

June 2014

and ending in

June 2024,

from the risk of variability of these payments resulting from changes in the

three

-month LIBOR interest rate. Bancorp pays a weighted average fixed interest rate of

2.61%

and receives a variable interest rate of the

three

-month LIBOR at a weighted average rate of

1.32%.

As of

September 30, 2017,

the notional amount of cash flow interest rate swaps was

$119.1

million and their unrealized loss of

$2.3

million, net of taxes, was included in other comprehensive income. The amount of periodic net settlement of interest rate swaps included in interest expense was

$407,000

for the

three

months ended

September 30, 2017

compared to

$588,000

for the same quarter a year ago. For the

nine

months ended

September 30, 2017,

the periodic net settlement of interest rate swaps included in interest expense was

$1.3

million compared to

$1.8

million for the same period in

2016.

As of

September

30,

2017,

the Bank has entered into interest rate swap contracts with various terms from

four

to

eight

years. These interest rate swap contracts are matched to individual fixed-rate commercial real estate loans in the Bank’s loan portfolio. These contracts have been designated as hedging instruments to hedge the risk of changes in the fair value of the underlying commercial real estate loan due to changes in interest rates. The swap contracts are structured so that the notional amounts reduce over time to match the contractual amortization of the underlying loan and allow prepayments with the same pre-payment penalty amounts as the related loan. The Bank pays a weighted average fixed rate of

4.55%

and receives a variable rate at the

one

month LIBOR rate plus a weighted average spread of

293

basis points, or at a weighted average rate of

4.16%.

As of

September 30, 2017,

the notional amount of fair value interest rate swaps was

$510.6

million and their unrealized gain of

$1.9

million was included in other non-interest income. The amount of periodic net settlement of interest rate swaps reducing interest income was

$514,000

for the

three

months ended

September 30, 2017,

compared to

$879,000

for the same quarter a year ago. The amount of periodic net settlement of interest rate swaps reducing interest income was

$1.9

million for the

nine

months ended

September 30, 2017,

compared to

$2.8

million for the same period a year ago. As of

September 30, 2017,

the ineffective portion of these interest rate swaps was

not

significant.

Interest rate swap contracts involve the risk of dealing with institutional derivative counterparties and their ability to meet contractual terms. Institutional counterparties must have a

strong credit profile and be approved by the Company’s Board of Directors. The Company’s credit exposure on interest rate swaps is limited to the net favorable value and interest payments of all swaps by each counterparty. Credit exposure

may

be reduced by the amount of collateral pledged by the counterparty. Bancorp’s interest rate swaps have been assigned by the counterparties to a derivatives clearing organization and daily margin is indirectly maintained with the derivatives clearing organization. Cash posted as collateral by Bancorp related to derivative contracts totaled

$6.3

million as of

September 30, 2017.

The Company enters into foreign exchange forward contracts with

various counterparties to mitigate the risk of fluctuations in foreign currency exchange rates for foreign exchange certificates of deposit or foreign exchange contracts entered into with our clients. These contracts are

not

designated as hedging instruments and are recorded at fair value in our condensed consolidated balance sheets. Changes in the fair value of these contracts as well as the related foreign exchange certificates of deposit and foreign exchange contracts are recognized immediately in net income as a component of non-interest income. Period end gross positive fair values are recorded in other assets and gross negative fair values are recorded in other liabilities. As of

September 30, 2017,

the notional amount of option contracts totaled

$12.3

million with a net negative fair value of

$234,000.

As of

September 30, 2017,

spot, forward, and swap contracts with a total notional amount of

$69.3

million had a positive fair value of

$1.7

million. Spot, forward, and swap contracts with a total notional amount of

$86.6

million had a negative fair value of

$1.1

million as of

September 30, 2017.

As of

December 31, 2016,

the notional amount of option contracts totaled

$12.1

million with a net negative fair value of

$121,000.

As of

December 31, 2016,

spot, forward, and swap contracts with a total notional amount of

$82.4

million had a positive fair value of

$1.3

million. Spot, forward, and swap contracts with a total notional amount of

$89.5

million had a negative fair value of

$3.1

million as of

December 31, 2016.