DERIVATIVES AND HEDGING

The Company, through its Banner Bank subsidiary, is party to various derivative instruments that are used for asset and liability management and customer financing needs. Derivative instruments are contracts between two or more parties that have a notional amount and an underlying variable, require no net investment and allow for the net settlement of positions. The notional amount serves as the basis for the payment provision of the contract and takes the form of units, such as shares or dollars. The underlying variable represents a specified interest rate, index, or other component. The interaction between the notional amount and the underlying variable determines the number of units to be exchanged between the parties and influences the market value of the derivative contract. The Company obtains dealer quotations to value its derivative contracts.

The Company's predominant derivative and hedging activities involve interest rate swaps related to certain term loans and forward sales contracts associated with mortgage banking activities. Generally, these instruments help the Company manage exposure to market risk and meet customer financing needs. Market risk represents the possibility that economic value or net interest income will be adversely affected by fluctuations in external factors such as market-driven interest rates and prices or other economic factors.

Derivatives Designated in Hedge Relationships

The Company's fixed rate loans result in exposure to losses in value or net interest income as interest rates change. The risk management objective for hedging fixed rate loans is to effectively convert the fixed rate received to a floating rate. The Company has hedged exposure to changes in the fair value of certain fixed rate loans through the use of interest rate swaps. For a qualifying fair value hedge, changes in the value of the derivatives are recognized in current period earnings along with the corresponding changes in the fair value of the designated hedged item attributable to the risk being hedged.

Under a prior program, customers received fixed interest rate commercial loans and Banner Bank subsequently hedged that fixed rate loan by entering into an interest rate swap with a dealer counterparty. Banner Bank receives fixed rate payments from the customers on the loans and makes similar fixed rate payments to the dealer counterparty on the swaps in exchange for variable rate payments based on the one-month LIBOR index. Some of these interest rate swaps are designated as fair value hedges. Through application of the “short cut method of accounting,” there is an assumption that the hedges are effective. Banner Bank discontinued originating interest rate swaps under this program in 2008.

As of September 30, 2018 and December 31, 2017, the notional values or contractual amounts and fair values of the Company's derivatives designated in hedge relationships were as follows (in thousands):



	Asset Derivatives								Liability Derivatives
	September 30, 2018				December 31, 2017				September 30, 2018				December 31, 2017
	Notional/ Contract Amount		Fair Value ⁽¹⁾		Notional/ Contract Amount		Fair Value ⁽¹⁾		Notional/ Contract Amount		Fair Value ⁽²⁾		Notional/ Contract Amount		Fair Value ⁽²⁾
Interest rate swaps	$	4,070	$	257	$	4,350	$	447	$	4,070	$	257	$	4,350	$	447


⁽¹⁾	Included in Loans receivable on the Consolidated Statements of Financial Condition.


⁽²⁾	Included in Other liabilities on the Consolidated Statements of Financial Condition.

Derivatives Not Designated in Hedge Relationships

Interest Rate Swaps: Banner Bank uses an interest rate swap program for commercial loan customers that provides the client with a variable rate loan and enters into an interest rate swap in which the client locks in a fixed rate and the Bank receives a variable rate payment. The Bank offsets its risk exposure by entering into an offsetting interest rate swap with a dealer counterparty for the same notional amount and length of term as the client interest rate swap providing the dealer counterparty with a fixed-rate payment in exchange for a variable-rate payment. These swaps do not qualify as designated hedges; therefore, each swap is accounted for as a free standing derivative.

Mortgage Banking: In the normal course of business, the Company sells originated one- to four-family and multifamily mortgage loans into the secondary mortgage loan markets. During the period of loan origination and prior to the sale of the loans in the secondary market, the Company has exposure to movements in interest rates associated with written interest rate lock commitments with potential borrowers to originate one- to four-family loans that are intended to be sold and for closed one- to four-family and multifamily mortgage loans held for sale that are awaiting sale and delivery into the secondary market. The Company attempts to economically hedge the risk of changing interest rates associated with these mortgage loan commitments by entering into forward sales contracts to sell one- to four-family and multifamily mortgage loans or mortgage-backed securities to broker/dealers as specific prices and dates.

As of September 30, 2018 and December 31, 2017, the notional values or contractual amounts and fair values of the Company's derivatives not designated in hedge relationships were as follows (in thousands):



	Asset Derivatives								Liability Derivatives
	September 30, 2018				December 31, 2017				September 30, 2018				December 31, 2017
	Notional/ Contract Amount		Fair Value ⁽¹⁾		Notional/ Contract Amount		Fair Value ⁽¹⁾		Notional/ Contract Amount		Fair Value ⁽²⁾		Notional/ Contract Amount		Fair Value ⁽²⁾
Interest rate swaps	$	280,872	$	6,128	$	285,047	$	4,636	$	280,872	$	6,128	$	285,047	$	4,636
Mortgage loan commitments	39,104		212		29,739		225		24,926		24		13,763		153
Forward sales contracts	128,902		368		43,069		298		—		—		47,000		48
	$	448,878	$	6,708	$	357,855	$	5,159	$	305,798	$	6,152	$	345,810	$	4,837


⁽¹⁾	Included in Other assets on the Consolidated Statements of Financial Condition, with the exception of certain interest swaps and mortgage loan commitments (with a fair value of $420,000 at September 30, 2018 and $499,000 at December 31, 2017), which are included in Loans receivable.


⁽²⁾	Included in Other liabilities on the Consolidated Statements of Financial Condition.

Gains (losses) recognized in income on derivatives not designated in hedge relationships for the three and nine months ended September 30, 2018 and 2017 were as follows (in thousands):



	Location on Consolidated Statements of Operations	Three Months Ended September 30,						Nine Months Ended September 30,
	Location on Consolidated Statements of Operations	2018			2017			2018			2017
Mortgage loan commitments	Mortgage banking operations	$	(177	)	$	50		$	(13	)	$	235
Forward sales contracts	Mortgage banking operations	325			(398		)	594			(654		)
		$	148		$	(348	)	$	581		$	(419	)

The Company is exposed to credit-related losses in the event of nonperformance by the counterparty to these agreements. Credit risk of the financial contract is controlled through the credit approval, limits, and monitoring procedures and management does not expect the counterparties to fail their obligations.

In connection with the interest rate swaps between Banner Bank and the dealer counterparties, the agreements contain a provision where if Banner Bank fails to maintain its status as a well/adequately capitalized institution, then the counterparty could terminate the derivative positions and Banner Bank would be required to settle its obligations. Similarly, Banner Bank could be required to settle its obligations under certain of its agreements if specific regulatory events occur, such as a publicly issued prompt corrective action directive, cease and desist order, or a capital maintenance agreement that required Banner Bank to maintain a specific capital level. If Banner Bank had breached any of these provisions at September 30, 2018 or December 31, 2017, it could have been required to settle its obligations under the agreements at the termination value. As of September 30, 2018 and December 31, 2017, the termination value of derivatives in a net liability position related to these agreements was $345,000 and $3.7 million, respectively. The Company generally posts collateral against derivative liabilities in the form of cash, government agency-issued bonds, mortgage-backed securities, or commercial mortgage-backed securities. Collateral posted against derivative liabilities was $16.0 million and $16.9 million as of September 30, 2018 and December 31, 2017, respectively.

Derivative assets and liabilities are recorded at fair value on the balance sheet and do not take into account the effects of master netting agreements. Master netting agreements allow the Company to settle all derivative contracts held with a single counterparty on a net basis and to offset net derivative positions with related collateral where applicable.

The following tables illustrate the potential effect of the Company's derivative master netting arrangements, by type of financial instrument, on the Company's Consolidated Statements of Financial Condition as of September 30, 2018 and December 31, 2017 (in thousands):



	September 30, 2018
							Gross Amounts of Financial Instruments Not Offset in the Consolidated Statements of Financial Condition
	Gross Amounts Recognized		Amounts offset in the Statement of Financial Condition		Net Amounts in the Statement of Financial Condition		Netting Adjustment Per Applicable Master Netting Agreements			Fair Value of Financial Collateral in the Statement of Financial Condition			Net Amount
Derivative assets
Interest rate swaps	$	6,385	$	—	$	6,385	$	—		$	—		$	6,385
	$	6,385	$	—	$	6,385	$	—		$	—		$	6,385

Derivative liabilities
Interest rate swaps	$	6,385	$	—	$	6,385	$	—		$	(295	)	$	6,090
	$	6,385	$	—	$	6,385	$	—		$	(295	)	$	6,090

	December 31, 2017
							Gross Amounts of Financial Instruments Not Offset in the Consolidated Statements of Financial Condition
	Gross Amounts Recognized		Amounts offset in the Statement of Financial Condition		Net Amounts in the Statement of Financial Condition		Netting Adjustment Per Applicable Master Netting Agreements			Fair Value of Financial Collateral in the Statement of Financial Condition			Net Amount
Derivative assets
Interest rate swaps	$	5,083	$	—	$	5,083	$	(656	)	$	—		$	4,427
	$	5,083	$	—	$	5,083	$	(656	)	$	—		$	4,427

Derivative liabilities
Interest rate swaps	$	5,083	$	—	$	5,083	$	(656	)	$	(3,467	)	$	960
	$	5,083	$	—	$	5,083	$	(656	)	$	(3,467	)	$	960