DERIVATIVE FINANCIAL INSTRUMENTS

6 Months Ended

Jun. 30, 2023

Derivative Instruments and Hedging Activities Disclosure [Abstract]

The Company is exposed to certain risks 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 may enter 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 as risk management tools by the Company 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 investment securities and borrowings and are not used for trading or speculative purposes.

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 uses interest rate swaps and interest rate caps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of

fixed or variable amounts from a counterparty in exchange for the Company making variable-rate or fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. The Company, however, discontinues cash flow hedge accounting if it is probable the forecasted hedged transactions will not occur in the initially identified time period due to circumstances. Upon discontinuance, the associated gains and losses deferred in AOCI are reclassified immediately into earnings and subsequent changes in the fair value of the cash flow hedge are recognized in earnings. The Company entered into one new interest rate swap designed as a hedging instrument with a notional value of $75.0 million during the three and six months ended June 30, 2023. At June 30, 2023, the Company had three interest rate swaps designated as hedging instruments with a total notional value of $175.0 million for the purpose of hedging the variable cash flows of selected AFS securities or loans or hedging variable cash flows associated with the Company's borrowings compared to two interest rate swaps designated as hedging instruments with a total notional value of $100.0 million at December 31, 2022.

The Company enters into interest rate swap agreements that allow its commercial loan customers to effectively convert a variable-rate commercial loan agreement to a fixed-rate commercial loan agreement. Under these agreements, the Company enters into a variable-rate loan agreement with a customer in addition to an interest rate swap agreement, which serves to effectively swap the customer’s variable-rate loan into a fixed-rate loan. In addition, the Company may enter into interest rate caps that allow its commercial loan customers to gain protection against significant interest rate increases and provide a upper limit, or cap, on the variable interest rate. The Company then enters into a corresponding swap or cap agreement with a third party in order to economically hedge its exposure through the customer agreement. The interest rate swaps and interest rate caps with both the customers and third parties are not designated as hedges and are marked through earnings. At June 30, 2023, the Company had 27 customer and 27 corresponding third-party broker interest rate derivatives not designated as a hedging instrument with an aggregate notional amount of $280.4 million, compared to $268.8 million in notional amount of such derivative instruments at December 31, 2022. The Company entered into two new interest rate swaps with its commercial loan customers and recognized swap fee income of $196 thousand during the three and six months ended June 30, 2023. This is compared to two new interest rate swaps that resulted in swap fee income of $785 thousand during the three months ended June 30, 2022 and five new interest rate swaps that resulted in swap fee income of $1.7 million during the six months ended June 30, 2022. Swap fee income is included in noninterest income in the unaudited condensed consolidated statements of income.

At June 30, 2023 and December 31, 2022, the Company had cash collateral of $5.1 million and $5.4 million with the third parties for certain of these derivatives, respectively. At June 30, 2023 and December 31, 2022, the Company received cash collateral of $8.9 million and $8.5 million from a counterparty for these derivatives, respectively.

The Company also may enter into risk participation agreements with a financial institution counterparty for an interest rate derivative contract related to a loan in which the Company may be a participant or the agent bank. The risk participation agreement provides credit protection to the agent bank should the borrower fail to perform on its interest rate derivative contracts with the agent bank. The Company manages its credit risk on the risk participation agreement by monitoring the creditworthiness of the borrower, which is based on the same credit review process as though the Company had entered into the derivative instruments directly with the borrower. The notional amount of such risk participation agreement reflects the Company’s pro-rata share of the derivative instrument, consistent with its share of the related participated loan. At June 30, 2023 and December 31, 2022, the Company had risk participation agreements with sold protection with a notional value of $32.3 million and $29.0 million, respectively. In addition, the Company had a risk participation with purchased protection with a notional value of $4.9 million at both June 30, 2023 and December 31, 2022. The Company did not enter into any risk participation agreements during the three and six months ended June 30, 2023 compared to one new risk participation agreement with purchased protection during the three and six months ended June 30, 2022. There was no upfront fee on the new risk participation during the three and six months ended June 30, 2022.

As a part of its normal residential mortgage operations, the Company will enter into an interest rate lock commitment with a potential borrower. The Company may enter into a corresponding commitment with an investor to sell that loan at a specific price shortly after origination. In accordance with FASB ASC 820, adjustments are recorded through earnings to account for the net change in fair value of these transactions for the held for sale loans. The fair value of held for sale loans can vary based on the interest rate locked with the customer and the current market interest rate at the balance sheet date.

The following table summarizes the fair value of the Company's derivative instruments at June 30, 2023 and December 31, 2022:


	June 30, 2023					December 31, 2022
	Notional Amount		Balance Sheet Location	Fair Value		Notional Amount		Balance Sheet Location	Fair Value
Derivatives designated as hedging instruments:
Interest rate swaps - balance sheet hedge	$	75,000	Other assets	$	1,389	n/a		Not applicable	n/a
Interest rate swaps - balance sheet hedge	$	100,000	Other liabilities	$	(970)	$	100,000	Other liabilities	$	(973)
Total derivatives designated as hedging instruments				$	419				$	(973)

Derivatives not designated as hedging instruments:
Interest rate swaps	$	134,230	Other assets	$	10,299	$	128,385	Other assets	$	10,437
Interest rate swaps	134,230		Other liabilities	(10,211)		128,385		Other liabilities	(10,262)
Purchased options – rate cap	5,955		Other assets	21		6,000		Other assets	29
Written options – rate cap	5,955		Other liabilities	(21)		6,000		Other liabilities	(29)
Risk participations - sold credit protection	32,312		Other liabilities	(72)		29,019		Other liabilities	(69)
Risk participations - purchased credit protection	4,890		Other assets	14		4,941		Other assets	16
Interest rate lock commitments with customers	2,197		Other assets	67		1,356		Other assets	35
Forward sale commitments	270		Other assets	2		3,483		Other assets	140
Total derivatives not designated as hedging instruments				$	99				$	297

The following tables summarize the effect of the Company's derivative financial instruments on OCI and net income for the three and six months ended June 30, 2023 and 2022:


	Amount of Loss Recognized in OCI on Derivative				Amount of Gain Recognized in OCI on Derivative
	Three Months Ended June 30,				Six Months Ended June 30,
	2023		2022		2023		2022
Derivatives in cash flow hedging relationships:
Interest rate products	$	1,073	$	—	$	1,392	$	—
Total	$	1,073	$	—	$	1,392	$	—


	Amount of Loss Reclassified from AOCI into Income				Amount of Loss Reclassified from AOCI into Income				Location of Loss Recognized from AOCI into Income
	Three Months Ended June 30,				Six Months Ended June 30,
	2023		2022		2023		2022
Derivatives in cash flow hedging relationships:
Interest rate products	$	—	$	—	$	—	$	—	Interest income
Total	$	—	$	—	$	—	$	—


	Amount of Gain (Loss) Recognized in Income				Amount of (Loss) Gain Recognized in Income				Location of Gain (Loss) Recognized in Income
	Three Months Ended June 30,				Six Months Ended June 30,
	2023		2022		2023		2022
Derivatives not designated as hedging instruments:
Interest rate products	$	40	$	93	$	(119)	$	130	Other operating expenses
Risk participation agreements	37		28		27		30		Other operating expenses
Interest rate lock commitments with customers	10		(114)		32		(167)		Mortgage banking activities
Forward sale commitments	(7)		331		(139)		631		Mortgage banking activities
Total	$	80	$	338	$	(199)	$	624

The following table is a summary of components for interest rate swaps designated as hedging instruments at June 30, 2023 and December 31, 2022:


	June 30, 2023		December 31, 2022
Weighted average pay rate	5.07	%	3.81	%
Weighted average receive rate	3.67	%	3.81	%
Weighted average maturity in years	2.4		1.2