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

9 Months Ended

Sep. 30, 2024

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

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

Note 13 – 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 income and 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. The aggregate fair value of the swaps is recorded in other assets or other liabilities with changes in fair value recorded in other comprehensive income, net of tax. The amount included in other comprehensive income would be reclassified to current earnings should all or a portion of the hedge no longer be considered effective. 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 income or 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 income or expense as interest payments are received on the variable rate loan pools or paid on the Company’s fixed-rate borrowings.

Interest rate swaps with notional amounts totaling $300.0 million as of September 30, 2024, and December 31, 2023, were designated as cash flow hedges of certain variable rate commercial and commercial real estate loan pools. Each of these hedges were executed to pay variable and receive fixed rate cash flows. Each of these hedges was determined to be effective during all periods presented and the Company expects the hedges to remain effective during the remaining terms of the swaps.

An interest rate swap with a notional amount of $25.8 million as of September 30, 2024, and December 31, 2023, is designated as a cash flow hedge of junior subordinated debentures and was executed to pay fixed and receive variable rate cash flows. The hedge was determined to be effective during all periods presented and the Company expects the hedge to remain effective during the remaining terms of the swap.

During the next twelve months, the Company estimates that an additional $2.0 million will be reclassified as an increase to interest income and an additional $327,000 will be reclassified as an increase 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 and rate cap agreements with commercial banking customers to facilitate their respective risk management strategies. The notional amounts of interest rate swaps with its loan customers as of September 30, 2024, and December 31, 2023 were $120.5 million and $104.8 million, respectively. The notional amounts of interest rate cap agreements with its loan customers were $32.9 million as of September 30, 2024, and there were no interest rate cap agreements held at December 31, 2023. Those interest rate swaps and rate cap agreements 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.

At September 30, 2024, and December 31, 2023, the Company had $3.6 million and $7.3 million of cash collateral pledged with two correspondent financial institutions, respectively. The Company held $2.6 million and $4.1 million of cash pledged from one correspondent financial institution to support the interest rate swap activity during the periods presented, respectively. No investment securities were required to be pledged to any correspondent financial institution during 2024 through September 30, 2024, or during 2023. The Company offsets derivative assets and liabilities that are subject to a master netting arrangement.

The Company also grants mortgage loan interest rate lock commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan interest rate lock commitments is managed with contracts for future deliveries of loans as well as selling forward mortgage-backed securities contracts. Loan interest rate lock commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The notional amount of these commitments at September 30, 2024, and December 31, 2023 was $18.8 million and $8.4 million, respectively. Commitments to originate residential mortgage loans held-for-sale and forward commitments to sell residential mortgage loans or forward MBS contracts are considered derivative instruments and changes in the fair value are recorded to mortgage banking revenue. Fair values are estimated based on observable changes in mortgage interest rates including mortgage-backed securities prices from the date of the commitment.

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Consolidated Balance Sheets as of September 30, 2024, and December 31, 2023.

Fair Value of Derivative Instruments


					September 30, 2024
	No. of Trans.		Notional Amount $		Balance Sheet Location	Fair Value $		Balance Sheet Location	Fair Value $
Derivatives designated as hedging instruments
Interest rate swap agreements	5		325,774		Other Assets	2,165		Other Liabilities	2,041
Total derivatives designated as hedging instruments						2,165			2,041

Derivatives not designated as hedging instruments
Interest rate swaps with commercial loan customers and rate cap	14		153,443		Other Assets	2,334		Other Liabilities	2,334
Interest rate lock commitments and forward contracts	57		18,816		Other Assets	70		Other Liabilities	-
Other contracts	5		57,184		Other Assets	77		Other Liabilities	14
Total derivatives not designated as hedging instruments						2,481			2,348



					December 31, 2023
	No. of Trans.		Notional Amount $		Balance Sheet Location	Fair Value $		Balance Sheet Location	Fair Value $
Derivatives designated as hedging instruments
Interest rate swap agreements	5		325,774		Other Assets	2,576		Other Liabilities	5,598
Total derivatives designated as hedging instruments						2,576			5,598

Derivatives not designated as hedging instruments
Interest rate swaps with commercial loan customers	17		104,777		Other Assets	2,726		Other Liabilities	2,726
Interest rate lock commitments and forward contracts	24		8,375		Other Assets	(10)		Other Liabilities	-
Other contracts	4		44,790		Other Assets	89		Other Liabilities	-
Total derivatives not designated as hedging instruments						2,805			2,726

Disclosure of the Effect of Fair Value and Cash Flow Hedge Accounting

The fair value and cash flow hedge accounting related to derivatives covered under ASC Subtopic 815-20 impacted Accumulated Other Comprehensive Income (“AOCI”) and the Income Statement. The gain recognized in AOCI on derivatives totaled $88,000 as of September 30, 2024, and the loss recognized in AOCI totaled $3.8 million as of September 30, 2023. The amount of the loss reclassified from AOCI to net interest income on the income statement was $4.8 million for the nine months ended September 30, 2024, and $3.9 million for the nine months ended September 30, 2023.

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.

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

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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 FDIC.

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 September 30, 2024, and December 31, 2023.

The following table is a summary of letter of credit commitments:


		September 30, 2024									December 31, 2023
		Fixed			Variable			Total			Fixed			Variable			Total
Letters of credit:
Borrower:
Financial standby		$	188		$	16,240		$	16,428		$	173		$	16,621		$	16,794
Performance standby			552			10,784			11,336			562			13,689			14,251
			740			27,024			27,764			735			30,310			31,045
Non-borrower:
Performance standby			-			67			67			-			67			67
Total letters of credit		$	740		$	27,091		$	27,831		$	735		$	30,377		$	31,112

Unused loan commitments:		$	153,788		$	623,748		$	777,536		$	140,305		$	694,960		$	835,265

As of September 30, 2024, the Company evaluated current market conditions, including any impacts related to market interest rate changes and unused line of credit utilization trends during the third quarter of 2024, and based on that analysis under the CECL methodology, the Company determined credit losses related to unfunded commitments totaled $2.5 million. The resultant increase in the ACL for unfunded commitments of $2,000 for the third quarter of 2024, compared to the second quarter of 2024, is primarily driven by adjustments to historical benchmark assumptions, such as the funding rates and the period used to forecast those rates within the ACL calculation. The Company will continue to assess the credit risk at least quarterly, and adjust the allowance for unfunded commitments, which is carried within other liabilities on our Consolidated Balance Sheets, as needed, with the appropriate offsetting entry to the provision for credit losses on our Consolidated Statements of Income.