Fifth Third Bank 2012 Annual Report Download - page 117

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
115 Fifth Third Bancorp
12. DERIVATIVE FINANCIAL INSTRUMENTS
The Bancorp maintains an overall risk management strategy that
incorporates the use of derivative instruments to reduce certain risks
related to interest rate, prepayment and foreign currency volatility.
Additionally, the Bancorp holds derivative instruments for the
benefit of its commercial customers and for other business
purposes. The Bancorp does not enter into unhedged speculative
derivative positions.
The Bancorp’s interest rate risk management strategy involves
modifying the repricing characteristics of certain financial
instruments so that changes in interest rates do not adversely affect
the Bancorp’s net interest margin and cash flows. Derivative
instruments that the Bancorp may use as part of its interest rate risk
management strategy include interest rate swaps, interest rate floors,
interest rate caps, forward contracts, options and swaptions. Interest
rate swap contracts are exchanges of interest payments, such as
fixed-rate payments for floating-rate payments, based on a stated
notional amount and maturity date. Interest rate floors protect
against declining rates, while interest rate caps protect against rising
interest rates. Forward contracts are contracts in which the buyer
agrees to purchase, and the seller agrees to make delivery of, a
specific financial instrument at a predetermined price or yield.
Options provide the purchaser with the right, but not the obligation,
to purchase or sell a contracted item during a specified period at an
agreed upon price. Swaptions are financial instruments granting the
owner the right, but not the obligation, to enter into or cancel a
swap.
Prepayment volatility arises mostly from changes in fair value
of the largely fixed-rate MSR portfolio, mortgage loans and
mortgage-backed securities. The Bancorp may enter into various
free-standing derivatives (principal-only swaps, interest rate
swaptions, interest rate floors, mortgage options, TBAs and interest
rate swaps) to economically hedge prepayment volatility. Principal-
only swaps are total return swaps based on changes in the value of
the underlying mortgage principal-only trust. TBAs are a forward
purchase agreement for a mortgage-backed securities trade whereby
the terms of the security are undefined at the time the trade is made.
Foreign currency volatility occurs as the Bancorp enters into
certain loans denominated in foreign currencies. Derivative
instruments that the Bancorp may use to economically hedge these
foreign denominated loans include foreign exchange swaps and
forward contracts.
The Bancorp also enters into derivative contracts (including
foreign exchange contracts, commodity contracts and interest rate
contracts) for the benefit of commercial customers and other
business purposes. The Bancorp may economically hedge significant
exposures related to these free-standing derivatives by entering into
offsetting third-party contracts with approved, reputable
counterparties with substantially matching terms and currencies.
Credit risk arises from the possible inability of counterparties to
meet the terms of their contracts. The Bancorp’s exposure is limited
to the replacement value of the contracts rather than the notional,
principal or contract amounts. Credit risk is minimized through
credit approvals, limits, counterparty collateral and monitoring
procedures.
The Bancorp’s derivative assets contain certain contracts in
which the Bancorp requires the counterparties to provide collateral
in the form of cash and securities to offset changes in the fair value
of the derivatives, including changes in the fair value due to credit
risk of the counterparty. As of December 31, 2012 and 2011, the
balance of collateral held by the Bancorp for derivative assets was
$927 million and $1.2 billion, respectively. The credit component
negatively impacting the fair value of derivative assets associated
with customer accommodation contracts as of December 31, 2012
and 2011 was $18 million and $28 million, respectively.
In measuring the fair value of derivative liabilities, the Bancorp
considers its own credit risk, taking into consideration collateral
maintenance requirements of certain derivative counterparties and
the duration of instruments with counterparties that do not require
collateral maintenance. When necessary, the Bancorp primarily
posts collateral in the form of cash and securities to offset changes
in fair value of the derivatives, including changes in fair value due to
the Bancorp’s credit risk. As of December 31, 2012 and 2011, the
balance of collateral posted by the Bancorp for derivative liabilities
was $785 million and $788 million, respectively. Certain of the
Bancorp’s derivative liabilities contain credit-risk related contingent
features that could result in the requirement to post additional
collateral upon the occurrence of specified events. As of December
31, 2012 and 2011, the fair value of the additional collateral that
could be required to be posted as a result of the credit-risk related
contingent features being triggered was not material to the
Bancorp’s Consolidated Financial Statements. The posting of
collateral has been determined to remove the need for consideration
of credit risk. As a result, the Bancorp determined that the impact of
the Bancorp’s credit risk to the valuation of its derivative liabilities
was immaterial to the Bancorp’s Consolidated Financial Statements.
The Bancorp holds certain derivative instruments that qualify
for hedge accounting treatment and are designated as either fair
value hedges or cash flow hedges. Derivative instruments that do
not qualify for hedge accounting treatment, or for which hedge
accounting is not established, are held as free-standing derivatives.
All customer accommodation derivatives are held as free-standing
derivatives.
The fair value of derivative instruments is presented on a gross
basis, even when the derivative instruments are subject to master
netting arrangements. Derivative instruments with a positive fair
value are reported in other assets in the Consolidated Balance
Sheets while derivative instruments with a negative fair value are
reported in other liabilities in the Consolidated Balance Sheets. Cash
collateral payables and receivables associated with the derivative
instruments are not added to or netted against the fair value
amounts.