Note 15 – Derivatives, Hedging Activities and Financial Instruments with Off-Balance Sheet Risk

Risk Management Objective of Using Derivatives

The Company is exposed to certain risk arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s loan portfolio.

Cash Flow Hedges of Interest Rate Risk

The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. During 2018, such derivatives were used to hedge the variable cash flows associated with existing variable-rate borrowings.

For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in Accumulated Other Comprehensive Income and subsequently reclassified into interest expense in the same period(s) during which the hedged transaction affects earnings. Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are received on the Company’s variable-rate borrowings. During the next twelve months, the Company estimates that an additional $117,308 will be reclassified as a reduction to interest expense.

Non-designated Hedges

Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings.

Disclosure of Fair Values of Derivative Instruments on the Balance Sheet

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheet as of March 31, 2018 and December 31, 2017.

Fair Value of Derivative Instruments


			Asset Derivatives				Liability Derivatives
			As of March 31, 2018		As of December 31, 2017		As of March 31, 2018		As of December 31, 2017
	Number of Transactions	Notional Amount $	Balance Sheet Location	Fair Value $	Balance Sheet Location	Fair Value $	Balance Sheet Location	Fair Value $	Balance Sheet Location	Fair Value $
Derivatives designated as hedging instruments
Interest Rate Products	1	25,774	Other Assets	-	Other Assets	-	Other Liabilities	7	Other Liabilities	1,287
Total derivatives designated as hedging instruments				-		-		7		1,287

Derivatives not designated as hedging instruments
Interest Rate Products	2	51,548	Other Assets	7	Other Assets	-	Other Liabilities	7	Other Liabilities	1,287
Other Contracts	3	15,908	Other Assets	-	Other Assets	-	Other Liabilities	7	Other Liabilities	13
Total derivatives not designated as hedging instruments				7		-		14		1,301

Disclosure of the Effect of Fair Value and Cash Flow Hedge Accounting on Accumulated Other Comprehensive Income

The table below presents the effect of cash flow hedge accounting on Accumulated Other Comprehensive Income as of March 31, 2018, and December 31, 2017.

The Effect of Fair Value and Cash Flow Hedge Accounting on Accumulated Other Comprehensive Income


Derivatives in Subtopic 815-20 Hedging Relationships		Amount of Gain or (Loss) Recognized in OCI on Derivative			Location of Gain or (Loss) Reclassified from Accumulated OCI into Income		Amount of Gain or (Loss) Reclassified from Accumulated OCI into Income
		Quarter Ended March 31,		Year Ended December 31,			Quarter Ended March 31,		Year Ended December 31,
		2018		2017			2018		2017
Derivatives in Cash Flow Hedging Relationships:

Interest Rate Products	$	1,206	$	(504)	Interest income	$	(74)	$	(211)
Total	$	1,206	$	(504)		$	(74)	$	(211)

Tabular Disclosure of the Effect of Fair Value and Cash Flow Hedge Accounting on the Income Statement

The table below presents the effect of the Company’s derivative financial instruments on the Income Statement as of March 31, 2018, and December 31, 2017.


Location and Amount of Gain or (Loss) Recognized in Income on Fair Value and Cash Flow Hedging Relationships

		Quarter Ended March 31, 2018				Year Ended December 31, 2017
		Interest Income (Expense)		Other Income (Expense)		Interest Income (Expense)		Other Income (Expense)
Total amounts of income and expense line items presented in the
statement of financial performance in which the effects of fair value or
cash flow hedges are recorded	$	(74)	$	-	$	(211)	$	-

The effects of fair value and cash flow hedging:
Gain or (loss) on cash flow hedging relationships in Subtopic 815-20
Interest contracts
Amount of gain or (loss) reclassified from accumulated other		(74)		-		(211)		-
comprehensive income into income

Disclosure of the Effect of Derivatives Not Designated as Hedging Instruments on the Income Statement

The table below presents the effect of the Company’s derivative financial instruments that are not designated as hedging instruments on the Income Statement as of March 31, 2018, and December 31, 2017.


Derivatives Not Designated as Hedging Instruments under Subtopic 815-20

	Location of Gain or (Loss) Recognized in Income on Derivative		Amount of Gain or (Loss) Recognized in Income on Derivative
			Quarter Ended March 31,		Year Ended December 31,
			2018		2017

Interest Rate Products	Other income / (expense)	$	-	$	-
Other Contracts	Other income / (expense)		6		161
Total		$	6	$	161

Fee Income	Other income / (expense)	$	-	$	-

Credit-risk-related Contingent Features

For derivative transactions involving counterparties who are lending customers of the Company, the derivative credit exposure is managed through the normal credit review and monitoring process, which may include collateralization, financial covenants and/or financial guarantees of affiliated parties. Agreements with such customers require that losses associated with derivative transactions receive payment priority from any funds recovered should a customer default and ultimate disposition of collateral or guarantees occur.

Credit exposure to broker/dealer counterparties is managed through agreements with each derivative counterparty that require collateralization of fair value gains owed by such counterparties. Some small degree of credit exposure exists due to timing differences between when a gain may occur and the subsequent point in time that collateral is delivered to secure that gain. This is monitored by the Company and procedures are in place to minimize this exposure. Such agreements also require the Company to collateralize counterparties in circumstances wherein the fair value of the derivatives result in loss to the Company.

Other provisions of such agreements include the definition of certain events that may lead to the declaration of default and/or the early termination of the derivative transaction(s):

if the Company either defaults or is capable of being declared in default on any of its indebtedness (exclusive of deposit obligations), then the Company could also be declared in default on its derivative obligations.

if a merger occurs that materially changes the Company's creditworthiness in an adverse manner.

If certain specified adverse regulatory actions occur, such as the issuance of a Cease and Desist Order, or citations for actions considered Unsafe and Unsound or that may lead to the termination of deposit insurance coverage by the Federal Deposit Insurance Corporation.

As of March 31, 2018, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk, related to these agreements was $0. As of March 31, 2018, the Company has not posted any collateral related to these agreements.

The Bank also issues letters of credit, which are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit are essentially the same as that involved in extending loan commitments to our customers. In addition to customer related commitments, the Company is responsible for letters of credit commitments that relate to properties held in OREO. The following table represents the Company’s contractual commitments due to letters of credit as of March 31, 2018, and December 31, 2017.

The following table is a summary of letter of credit commitments (in thousands):


	March 31, 2018						December 31, 2017
	Fixed		Variable		Total		Fixed		Variable		Total
Letters of credit:
Borrower:
Financial standby	$	292	$	4,152	$	4,444	$	177	$	3,770	$	3,947
Commercial standby		-		354		354		-		354		354
Performance standby		241		7,092		7,333		241		7,594		7,835
		533		11,598		12,131		418		11,718		12,136
Non-borrower:
Performance standby		-		142		142		-		142		142
Total letters of credit	$	533	$	11,740	$	12,273	$	418	$	11,860	$	12,278