FAIR VALUE OF FINANCIAL INSTRUMENTS

The following table presents estimated fair values of the Company’s financial instruments as of September 30, 2018 and December 31, 2017, whether or not measured at fair value in the Consolidated Statements of Financial Condition (dollars in thousands):



		September 30, 2018				December 31, 2017
	Level	Carrying Value		Estimated Fair Value		Carrying Value		Estimated Fair Value
Assets:
Cash and cash equivalents	1	$	248,661	$	248,661	$	261,200	$	261,200
Securities—trading	2,3	25,764		25,764		22,318		22,318
Securities—available-for-sale	2	1,412,273		1,412,273		919,485		919,485
Securities—held-to-maturity	2	255,429		250,824		256,793		258,710
Securities—held-to-maturity	3	3,270		3,270		3,478		3,478
Loans held for sale	2	72,850		72,924		40,725		40,923
Loans receivable	3	7,822,519		7,693,348		7,598,884		7,445,990
FHLB stock	3	19,196		19,196		10,334		10,334
Bank-owned life insurance	1	163,265		163,265		162,668		162,668
Mortgage servicing rights	3	14,521		23,890		14,738		19,835
Equity securities	1	416		416		—		—
Derivatives:
Interest rate swaps	2	6,385		6,385		5,083		5,083
Interest rate lock and forward sales commitments	2	580		580		523		523
Liabilities:
Demand, interest checking and money market accounts	2	5,877,590		5,877,590		5,658,994		5,658,994
Regular savings	2	1,627,560		1,627,560		1,557,500		1,557,500
Certificates of deposit	2	1,180,674		1,164,982		966,937		947,517
FHLB advances	2	221,184		221,184		202		202
Other borrowings	2	98,979		98,979		95,860		95,860
Junior subordinated debentures	3	113,110		113,110		98,707		98,707
Derivatives:
Interest rate swaps	2	6,385		6,385		5,083		5,083
Interest rate lock and forward sales commitments	2	24		24		201		201

The Company measures and discloses certain assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (that is, not a forced liquidation or distressed sale). GAAP establishes a consistent framework for measuring fair value and disclosure requirements about fair value measurements. Among other things, the accounting standard requires the reporting entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s estimates for market assumptions. These two types of inputs create the following fair value hierarchy:


•	Level 1 – Quoted prices in active markets for identical instruments. An active market is a market in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.


•	Level 2 – Observable inputs other than Level 1 including quoted prices in active markets for similar instruments, quoted prices in less active markets for identical or similar instruments, or other observable inputs that can be corroborated by observable market data.

•

Level 3 – Unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation; also includes observable inputs from non-binding single dealer quotes not corroborated by observable market data.

The estimated fair value amounts of financial instruments have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize at a future date. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. In addition, reasonable comparability between financial institutions may not be likely due to the wide range of permitted valuation techniques and numerous estimates that must be made given the absence of active secondary markets for certain financial instruments. This lack of uniform valuation methodologies also introduces a greater degree of subjectivity to these estimated fair values. Transfers between levels of the fair value hierarchy are deemed to occur at the end of the reporting period.

Items Measured at Fair Value on a Recurring Basis:

The following tables present financial assets and liabilities measured at fair value on a recurring basis and the level within the fair value hierarchy of the fair value measurements for those assets and liabilities as of September 30, 2018 and December 31, 2017 (in thousands):



	September 30, 2018
	Level 1		Level 2		Level 3		Total
Assets:
Securities—trading
Municipal bonds	$	—	$	100	$	—	$	100
Corporate bonds (Trust Preferred Securities)	—		—		25,664		25,664
	—		100		25,664		25,764
Securities—available-for-sale
U.S. Government and agency obligations	—		136,308		—		136,308
Municipal bonds	—		65,986		—		65,986
Corporate bonds	—		5,040		—		5,040
Mortgage-backed or related securities	—		1,182,518		—		1,182,518
Asset-backed securities	—		22,421		—		22,421
	—		1,412,273		—		1,412,273

Loans held for sale	—		67,128		—		67,128
Equity securities	—		416		—		416

Derivatives
Interest rate swaps	—		6,385		—		6,385
Interest rate lock and forward sales commitments	—		580		—		580
	$	—	$	1,486,882	$	25,664	$	1,512,546

Liabilities:
Junior subordinated debentures, net of unamortized deferred issuance costs	$	—	$	—	$	113,110	$	113,110
Derivatives
Interest rate swaps	—		6,385		—		6,385
Interest rate lock and forward sales commitments	—		24		—		24
	$	—	$	6,409	$	113,110	$	119,519



	December 31, 2017
	Level 1		Level 2		Level 3		Total
Assets:
Securities—trading
Municipal bonds	$	—	$	100	$	—	$	100
Corporate bonds (Trust Preferred Securities)	—		—		22,058		22,058
Equity securities	—		160		—		160
	—		260		22,058		22,318
Securities—available-for-sale
U.S. Government and agency obligations	—		72,466		—		72,466
Municipal bonds	—		68,733		—		68,733
Corporate bonds	—		5,393		—		5,393
Mortgage-backed securities	—		739,557		—		739,557
Asset-backed securities	—		27,758		—		27,758
Equity securities	—		5,578		—		5,578
	—		919,485		—		919,485

Loans held for sale	—		32,392		—		32,392

Derivatives
Interest rate swaps	—		5,083		—		5,083
Interest rate lock and forward sales commitments	—		523		—		523
	$	—	$	957,743	$	22,058	$	979,801

Liabilities:
Junior subordinated debentures, net of unamortized deferred issuance costs	$	—	$	—	$	98,707	$	98,707
Derivatives
Interest rate swaps	—		5,083		—		5,083
Interest rate lock and forward sales commitments	—		201		—		201
	$	—	$	5,284	$	98,707	$	103,991

The following methods were used to estimate the fair value of each class of financial instruments above:

Securities: The estimated fair values of investment securities and mortgaged-backed securities are priced using current active market quotes, if available, which are considered Level 1 measurements. For most of the portfolio, matrix pricing based on the securities’ relationship to other benchmark quoted prices is used to establish the fair value. These measurements are considered Level 2. Due to the continued limited activity in the trust preferred markets that have limited the observability of market spreads for some of the Company’s Trust Preferred Securities (TPS) securities, management has classified these securities as a Level 3 fair value measure. Management periodically reviews the pricing information received from third-party pricing services and tests those prices against other sources to validate the reported fair values.

Loans Held for Sale: Fair values for residential mortgage loans held for sale are determined by comparing actual loan rates to current secondary market prices for similar loans. Fair values for multifamily loans held for sale are calculated based on discounted cash flows using as a discount rate a combination of market spreads for similar loan types added to selected index rates.

Mortgage Servicing Rights: Fair values are estimated based on an independent dealer analysis of discounted cash flows. The evaluation utilizes assumptions market participants would use in determining fair value including prepayment speeds, delinquency and foreclosure rates, the discount rate, servicing costs, and the timing of cash flows. The mortgage servicing portfolio is stratified by loan type and fair value estimates are adjusted up or down based on the serviced loan interest rates versus current rates on new loan originations since the most recent independent analysis.

Junior Subordinated Debentures: The fair value of junior subordinated debentures is estimated using a discounted cash flow approach. The significant inputs included in the estimation of fair value are the credit risk adjusted spread and three month LIBOR. The credit risk adjusted spread represents the nonperformance risk of the liability. The Company utilizes an external valuation firm to assist management in validating the reasonableness of the credit risk adjusted spread used to determine the fair value. The junior subordinated debentures are carried at fair value which represents the estimated amount that would be paid to transfer these liabilities in an orderly transaction amongst market participants. Due to credit concerns in the capital markets and inactivity in the trust preferred markets that have limited the observability of market spreads, management has classified this as a Level 3 fair value measure.

Derivatives: Derivatives include interest rate swap agreements, interest rate lock commitments to originate loans held for sale and forward sales contracts to sell loans and securities related to mortgage banking activities. Fair values for these instruments, which generally change as a result of changes in the level of market interest rates, are estimated based on dealer quotes and secondary market sources.

Off-Balance-Sheet Items: Off-balance-sheet financial instruments include unfunded commitments to extend credit, including standby letters of credit, and commitments to purchase investment securities. The fair value of these instruments is not considered to be material.

Limitations: The fair value estimates presented herein are based on pertinent information available to management as of September 30, 2018 and December 31, 2017. The factors used in the fair values estimates are subject to change subsequent to the dates the fair value estimates are completed, therefore, current estimates of fair value may differ significantly from the amounts presented herein.

Assets and Liabilities Measured at Fair Value Using Significant Unobservable Inputs (Level 3):

The following table provides a description of the valuation technique, unobservable inputs, and qualitative information about the unobservable inputs for certain of the Company's assets and liabilities classified as Level 3 and measured at fair value on a recurring and non-recurring basis at September 30, 2018 and December 31, 2017:



			Weighted Average Rate / Range
Financial Instruments	Valuation Techniques	Unobservable Inputs	September 30, 2018		December 31, 2017
Corporate bonds (TPS securities)	Discounted cash flows	Discount rate	6.40	%	6.69	%
Junior subordinated debentures	Discounted cash flows	Discount rate	6.40	%	6.69	%
Impaired loans	Collateral Valuations	Discount to appraised value	8.5% to 20.0%		8.5% to 20.0%
REO	Appraisals	Discount to appraised value	63.9	%	42.0	%

TPS securities : Management believes that the credit risk-adjusted spread used to develop the discount rate utilized in the fair value measurement of TPS securities is indicative of the risk premium a willing market participant would require under current market conditions for instruments with similar contractual rates and terms and conditions and issuers with similar credit risk profiles and with similar expected probability of default. Management attributes the change in fair value of these instruments, compared to their par value, primarily to perceived general market adjustments to the risk premiums for these types of assets subsequent to their issuance.

Junior subordinated debentures: Similar to the TPS securities discussed above, management believes that the credit risk-adjusted spread utilized in the fair value measurement of the junior subordinated debentures is indicative of the risk premium a willing market participant would require under current market conditions for an issuer with Banner's credit risk profile. Management attributes the change in fair value of the junior subordinated debentures, compared to their par value, primarily to perceived general market adjustments to the risk premiums for these types of liabilities subsequent to their issuance. Future contractions in the risk adjusted spread relative to the spread currently utilized to measure the Company's junior subordinated debentures at fair value as of September 30, 2018, or the passage of time, will result in negative fair value adjustments. At September 30, 2018, the discount rate utilized was based on a credit spread of 400 basis points and three-month LIBOR of 240 basis points.

The following tables provide a reconciliation of the assets and liabilities measured at fair value using significant unobservable inputs (Level 3) on a recurring basis during the three and nine months ended September 30, 2018 and 2017 (in thousands):



	Three Months Ended				Nine Months Ended
	September 30, 2018				September 30, 2018
	Level 3 Fair Value Inputs				Level 3 Fair Value Inputs
	TPS Securities		Borrowings—Junior Subordinated Debentures		TPS Securities		Borrowings— Junior Subordinated Debentures
Beginning balance	$	25,540	$	112,774	$	22,058	$	98,707
Total gains or losses recognized
Assets gains	86		—		3,568		—
Liabilities losses⁽¹⁾	—		336		—		14,403
Ending balance at September 30, 2018	$	25,626	$	113,110	$	25,626	$	113,110

	Three Months Ended				Nine Months Ended
	September 30, 2017				September 30, 2017
	Level 3 Fair Value Inputs				Level 3 Fair Value Inputs
	TPS Securities		Borrowings—Junior Subordinated Debentures		TPS Securities		Borrowings— Junior Subordinated Debentures
Beginning balance	$	21,568	$	96,852	$	21,143	$	95,200
Total gains or losses recognized
Assets gains	107		—		532		—
Liabilities losses	—		428		—		2,080
Ending balance at September 30, 2017	$	21,675	$	97,280	$	21,675	$	97,280

⁽¹⁾The change in fair value on the junior subordinated debentures in 2018 is recorded in other comprehensive income (loss).

The Company has elected to continue to recognize the interest income and dividends from the securities reclassified to fair value from securities available-for-sale as a component of interest income as was done in prior years when they were classified as available-for-sale. Interest expense related to the junior subordinated debentures continues to be measured based on contractual interest rates and reported in interest expense. The change in fair market value on TPS securities and on junior subordinated debentures prior to 2018 has been recorded as a component of non-interest income. Beginning in 2018, the change in fair value of the junior subordinated debentures, which represents changes in instrument specific credit risk, is recorded in other comprehensive income (loss).

Items Measured at Fair Value on a Non-recurring Basis:

The following tables present financial assets measured at fair value on a non-recurring basis and the level within the fair value hierarchy of the fair value measurements for those assets as of September 30, 2018 and December 31, 2017 (in thousands):



	September 30, 2018
	Level 1		Level 2		Level 3		Total
Impaired loans	$	—	$	—	$	1,488	$	1,488
REO	—		—		364		364

	December 31, 2017
	Level 1		Level 2		Level 3		Total
Impaired loans	$	—	$	—	$	6,535	$	6,535
REO	—		—		360		360

The following table presents the losses resulting from non-recurring fair value adjustments for the three and nine months ended September 30, 2018 and 2017 (in thousands):



	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
Impaired loans	$	(102	)	$	(1,584	)	$	(431	)	$	(2,059	)
REO	(27		)	—			(187		)	(256		)
Total loss from non-recurring measurements	$	(129	)	$	(1,584	)	$	(618	)	$	(2,315	)

Impaired loans: Impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of collateral if the loan is collateral dependent. If this practical expedient is used, the impaired loans are considered to be held at fair value. Subsequent changes in the value of impaired loans are included within the provision for loan losses in the same manner in which impairment initially was recognized or as a reduction in the provision that would otherwise be reported. Impaired loans are periodically evaluated to determine if valuation adjustments, or partial write-downs, should be recorded. The need for valuation adjustments arises when observable market prices or current appraised values of collateral indicate a shortfall in collateral value compared to current carrying values of the related loan. If the Company determines that the value of the impaired loan is less than the carrying value of the loan, the Company either establishes an impairment reserve as a specific component of the allowance for loan losses or charges off the impaired amount. These valuation adjustments are considered non-recurring fair value adjustments. The remaining impaired loans are evaluated for reserve needs in homogenous pools within the Company’s methodology for assessing the adequacy of the allowance for loan losses.

REO: The Company records REO (acquired through a lending relationship) at fair value on a non-recurring basis. Fair value adjustments on REO are based on updated real estate appraisals which are based on current market conditions. All REO properties are recorded at the lower of the estimated fair value of the real estate, less expected selling costs, or the carrying amount of the defaulted loans. From time to time, non-recurring fair value adjustments to REO are recorded to reflect partial write-downs based on an observable market price or current appraised value of property. Banner considers any valuation inputs related to REO to be Level 3 inputs. The individual carrying values of these assets are reviewed for impairment at least annually and any additional impairment charges are expensed to operations.