| | | | | | | | Limited partnership | | Company Direct and Indirect Ownership in Limited Partnership |
Managed funds of funds | | |
Strategic Investors Fund, LP | | 12.6 | % |
Capital Preferred Return Fund, LP | | 20.0 | |
Growth Partners, LP | | 33.0 | |
Redwood Evergreen Fund, LP | | 100.0 | |
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Our direct investments in public portfolio companies are valued based on quoted market prices less a discount if the securities are subject to certain security-specific sale restrictions. Gains or losses resulting from changes in the net asset value are recorded as gains on investment securities, net, a component of noninterest income.
Other Investments without a Readily Determinable Fair Value
Our direct investments in private companies do not have a readily determinable fair value. We measure these investments at cost less impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments from the same issuer. Such changes are recognized through earnings. We consider a range of factors when adjusting the fair value of these investments, including, but not limited to, the term and nature of the investment, local market conditions, values for comparable securities, current and projected operating performance, financing transactions subsequent to the acquisition of the investment and a discount for certain investments that have certain security-specific sale restrictions or other features that indicate a discount to fair value is warranted.
Our investments in unconsolidated funds where we do not have the ability to exercise significant influence over their operating and financial policies are valued using the net asset value as obtained from the general partners of the fund investments, because the funds do not have a readily determinable fair value. The general partners of these funds prepare their financial statements using guidance consistent with fair value accounting. We account for differences between our measurement date and the date of the fund investment's net asset value by using the most recent available financial information from the investee general partner, for example September 30th, for our December 31st consolidated financial statements. We adjust the value of our investments for any contributions paid, distributions received from the investment and known significant fund transactions or market events about which we are aware through information provided by the fund managers or from publicly available transaction data during the reporting period. Gains or losses resulting from changes in the net asset value are recorded as gains on investment securities, net, a component of noninterest income.
Equity Method
Our equity method non-marketable securities consist of investments in venture capital and private equity funds, privately-held companies, debt funds, renewable energy investments and joint ventures. Our equity method non-marketable securities and related accounting policies are described as follows:
•Equity securities and investments in limited partnerships, such as preferred or common stock in privately-held companies in which we have the ability to exercise significant influence over the investees' operating and financial policies through voting interests, board involvement or other influence are accounted for under the equity method and
•The Bank's joint venture bank in China (SPD-SVB), for which we have 50 percent ownership, is accounted for under the equity method.
We recognize our proportionate share of the results of operations of these equity method investees in our results of operations, based on the most current financial information available from the investee. We may use the hypothetical liquidation at book value method for investments that involve complex equity structures where liquidation rights are not proportional to the underlying percentage ownership interests.
We review our investments accounted for under the equity method at least quarterly for possible other-than-temporary impairment. Our review typically includes an analysis of facts and circumstances for each investment, the expectations of the investment's future cash flows and capital needs, variability of its business and the company's exit strategy.
For our fund investments, we use the net asset value per share as provided by the general partners of the fund investments. We account for differences between our measurement date and the date of the fund investment's net asset value by using the most recent available financial information from the investee general partner, for example September 30th, for our December 31st consolidated financial statements. We adjust the value of our investments for any contributions paid, distributions received from the investment and known significant fund transactions or market events about which we are aware through information provided by the fund managers or from publicly available transaction data during the reporting period.
We reduce our investment value when we consider declines in value to be other-than-temporary and recognize the estimated loss as a loss on investment securities, a component of noninterest income.
Proportional Amortization Method
In order to fulfill our responsibilities under the CRA, we invest as a limited partner in low income housing partnerships that operate qualified affordable housing projects and generate tax benefits, including federal low income housing tax credits, for investors. The partnerships are deemed to be VIEs because they do not have sufficient equity investment at risk and are structured with non-substantive voting rights. We are not the primary beneficiary of the VIEs and do not consolidate them. Our investments in low income housing partnerships are recorded in non-marketable and other equity securities within our investment securities portfolio on the consolidated balance sheet. As a practical expedient, we amortize the investment in proportion to the allocated tax benefits under the proportional amortization method of accounting and present such benefits net of investment amortization in income tax expense.
Loans
Loans are reported at amortized cost which consists of the principal amount outstanding, net of unearned loan fees. Unearned loan fees reflect unamortized deferred loan origination and commitment fees net of unamortized deferred loan origination costs. In addition to cash loan fees, we often obtain equity warrant assets that give us an option to purchase a position in a client company's stock in consideration for providing credit facilities. The grant date fair values of these equity warrant assets are deemed to be loan fees and are deferred as unearned income and recognized as an adjustment of loan yield through loan interest income. The net amount of unearned loan fees is amortized into loan interest income over the contractual terms of the underlying loans and commitments using the constant effective yield method, adjusted for actual loan prepayment experience, or the straight-line method, as applicable.
Allowance for Credit Losses
The allowance for credit losses for loans considers credit risk and is adjusted by a provision for ECL charged to expense and reduced by the charge-off of loan amounts, net of recoveries. Our allowance for credit losses is an estimate of expected losses inherent with the Company's existing loans at the balance sheet date. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain.
Loan Portfolio Segments and Classes of Financing Receivables
The process to estimate the ECL on loans involves procedures to appropriately consider the unique characteristics of our loan portfolio. Our eight portfolio segments are determined by using the following risk dimensions: (i) underwriting methodology, (ii) industry niche and (iii) life stage. The eight portfolio segments are further disaggregated into eleven classes of financing receivables and represents the level at which credit risk is monitored. Credit quality is assessed and monitored by evaluating various attributes, and the results of those evaluations are utilized in underwriting new loans and in our process to estimate ECL. For further information refer to Note 9—“Loans and Allowance for Credit Losses: Loans and Unfunded Credit Commitments.” The following provides additional information regarding our portfolio segments and classes of financing receivables:
•Global Fund Banking (segment and class) – The vast majority of our GFB portfolio segment consists of capital call lines of credit, the repayment of which is dependent on the payment of capital calls by the underlying limited partner investors in funds managed by certain private equity and venture capital firms.
•Investor Dependent (segment) – Loans are made primarily to technology and life science/healthcare companies. These borrowers typically have modest or negative cash flows and rarely have an established record of profitable operations. Repayment of these loans may be dependent upon receipt by borrowers of additional equity financing from venture capital firms or other investors, or in some cases, a successful sale to a third party or an IPO. This portfolio segment is further disaggregated into two classes of financing receivables:
◦Early-Stage (class) – Loans to pre-revenue, development-stage companies and companies that are in the early phases of commercialization, with revenues of up to $5 million.
◦Growth Stage (class) – Loans to growth-stage enterprises. Within growth-stage enterprises, we consider companies with revenues between $5 million and $15 million, or pre-revenue clinical-stage biotechnology companies, to be Mid Stage, and companies with revenues in excess of $15 million to be Later Stage.
•Cash Flow Dependent and Innovation C&I (segment) – Loans are made primarily to technology and life science/healthcare companies that are not Investor Dependent, for example repayment is not dependent on additional equity financing, a successful sale or an IPO. This portfolio segment consists of two classes of financing receivables:
◦Cash Flow Dependent – SLBO (class) – Loans are typically used to assist a select group of private equity sponsors with the acquisition of businesses, are larger in size and repayment is generally dependent upon the cash flows of the combined entities. Acquired companies are typically established, later-stage businesses of scale and characterized by reasonable levels of leverage with loan structures that include meaningful financial covenants. The sponsor’s equity contribution is often 50 percent or more of the acquisition price.
◦Innovation C&I (class) – Other C&I loans in innovation sectors such as technology and life science/healthcare industries. These loans are dependent on either the borrower’s cash flows or balance sheet for repayment. Cash flow dependent loans require the borrower to maintain cash flow from operations that is sufficient to service all debt. Borrowers must demonstrate normalized cash flow in excess of all fixed charges associated with operating the business. Balance sheet dependent loans include asset-backed loans and are structured to require constant current asset coverage (e.g., cash, cash equivalents, accounts receivable and, to a much lesser extent, inventory) in an amount that exceeds the outstanding debt. The repayment of these arrangements is dependent on the financial condition, and payment ability, of third parties with whom our clients do business.
•Private Bank (segment and class) – Loans to our Private Bank clients who are primarily private equity/venture capital professionals and executives in the innovation companies as well as high net worth clients acquired from Boston Private. We offer a customized suite of private banking services, including mortgages, home equity lines of credit, restricted and private stock loans, personal capital call lines of credit, lines of credit against liquid assets and other secured and unsecured lending products. In addition, we provide owner occupied commercial mortgages to Private Bank clients and real estate secured loans to eligible employees through our EHOP.
•CRE (segment and class) – Generally acquisition financing loans for commercial properties such as office buildings, retail properties, apartment buildings and industrial/warehouse space.
•Other C&I (segment and class) – Loans that include working capital and revolving lines of credit, as well as term loans for equipment and fixed assets. These loans are primarily to clients that are not in the technology and life sciences/healthcare industries. Additionally, this portfolio segment contains commercial tax-exempt loans to not-for-profit private schools, colleges, public charter schools and other not-for-profit organizations.
•Premium Wine and Other (segment) – This portfolio segment consists of two classes of financing receivables:
◦Premium Wine (class) – Loans to wine producers, vineyards and wine industry or hospitality businesses across the Western United States. A large portion of these loans are secured by real estate collateral such as vineyards and wineries.
◦Other (class) – Primarily construction and land loans for financing new developments as well as financing for improvements to existing buildings. These also include our community development loans made as part of our responsibilities under the CRA.
•PPP (segment and class) – Combined loans issued through the PPP. These loans represent clients across all portfolio segments and are guaranteed by the SBA.
We maintain a systematic process for the evaluation of individual loans and portfolio segments for inherent risk of estimated credit losses for loans. At the time of approval, each loan in our portfolio is assigned a credit risk rating. Credit risk ratings are assigned on a scale of 1 to 10, with 1 representing loans with a low risk of nonpayment, 9 representing loans with the highest risk of nonpayment and 10 representing loans which have been charged-off. The credit risk ratings for each loan are monitored and updated on an ongoing basis. This credit risk rating process includes, but is not limited to, consideration of such factors as payment status, the financial condition and operating performance of the borrower, borrower compliance with loan covenants, underlying collateral values and performance trends, the degree of access to additional capital, the presence of credit enhancements such as third party guarantees (where applicable), the degree to which the borrower is sensitive to external factors and the depth and experience of the borrower's management team. Our policies require a committee of senior management to review, at least quarterly, credit relationships with a credit risk rating of 5 through 9 that exceed specific dollar values
Expected Credit Loss Measurement
The methodology for estimating the amount of ECL reported in the ACL is the sum of two main components: (i) ECL assessed on a collective basis for pools of loans that share similar risk characteristics which includes a qualitative adjustment based on management’s assessment of the risks that may lead to a future loan loss experience different from our historical loan loss experience and (ii) ECL assessed for individual loans that do not share similar risk characteristics with other loans. We do not estimate ECL on AIR on loans as AIR is reversed or written off against interest income when the full collection of the AIR related to a loan becomes doubtful, which is when loans are placed on nonaccrual status. AIR on loans totaled $402 million at December 31, 2022, and $171 million at December 31, 2021, and is excluded from the amortized cost disclosures in Note 10—“Loans and Allowance for Credit Losses: Loans and Unfunded Credit Commitments”, as it is included and reported separately within "Accrued interest receivable and other assets" in our consolidated balance sheets.
While the evaluation process of our ACL on loans uses historical and other objective information, the classification of loans and the estimate of the ACL for loans rely on the judgment and experience of our management. A committee comprised of senior management evaluates the appropriateness of the ACL for loans, which includes review of loan portfolio segmentation, quantitative models, internal and external data inputs, economic forecasts, credit risk ratings and qualitative adjustments.
Loans That Share Similar Risk Characteristics with Other Loans
We derive an estimated ECL assumption from a non-discounted cash flow approach based on our portfolio segments discussed above. This approach incorporates a calculation of three predictive metrics: (i) PD, (ii) LGD and (iii) EAD, over the estimated life of the exposure. PD and LGD assumptions are developed based on quantitative models and inherent risk of credit loss, both of which involve significant judgment. Renewals and extensions within our control are not considered in the estimated contractual term of a loan. The quantitative models are based on historical credit loss experience, adjusted for probability-weighted economic scenarios. These scenarios are used to support a reasonable and supportable forecast period of approximately three years for all portfolio segments. To the extent the remaining contractual lives of loans in the portfolio extend beyond the reasonable and supportable period, we revert to historical averages using a method that will gradually trend towards the mean historical loss over the remaining contractual lives of loans, adjusted for prepayments. The macroeconomic scenarios and their weighting are reviewed on a quarterly basis.
We also apply a qualitative factor adjustment to the results obtained through our quantitative ECL models to consider model imprecision, emerging risk assessments, trends and other subjective factors that may not be adequately represented in quantitative ECL models. These adjustments to historical loss information are for asset-specific risk characteristics, and also reflect our assessment of the extent that current conditions and reasonable and supportable forecasts differ from conditions that existed during the period over which historical information was evaluated. These adjustments are aggregated to become our qualitative allocation. Based on our qualitative assessment estimate of changing risks in the lending environment, the qualitative allocation may vary significantly from period to period and may include, but is not limited to, consideration of the following factors:
•Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off and recovery practices not considered elsewhere in estimating credit losses;
•Changes in international, national, regional and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments;
•Changes in the nature and volume of the portfolio and in the terms of loans;
•Changes in the experience, ability and depth of lending management and other relevant staff;
•Changes in the volume and severity of past due loans, the volume of nonaccrual loans and the volume and severity of adversely classified or graded loans;
•Changes in the quality of our loan review system;
•Changes in the value of underlying collateral for collateral-dependent loans;
•The existence and effect of any concentrations of credit, and changes in the level of such concentrations;
•The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in our existing portfolio; and
•The effect of limitations of available data, model imprecision and recent macro-economic factors that may not be reflected in the forecast information.
Loans That Do Not Share Similar Risk Characteristics
We monitor our loan pools to ensure all assets therein continue to share similar risk characteristics with other financial assets inside the pool. Changes in credit risk, borrower circumstances or the recognition of write-offs may indicate that a loan's risk profile has changed, and the asset should be removed from its current pool. For a loan that does not share risk characteristics with other loans, ECL is measured based on the net realizable value, that is, the difference between the discounted value of the expected future cash flows and the amortized cost basis of the loan. When a loan is collateral-dependent and the repayment is expected to be provided substantially through the operation or sale of the collateral, the ECL is measured as the difference between the amortized cost basis of the loan and the fair value of the collateral. The fair value of the collateral will be determined by the most recent appraisal, as adjusted to reflect a reasonable marketing period for the sale of the asset(s) and an estimate of reasonable selling expenses. Collateral-dependent loans will have independent appraisals completed at least annually.
Allowance for Credit Losses: Unfunded Credit Commitments
We maintain a separate ACL for unfunded credit commitments, which is included in other liabilities, and the related ECL in our provision for credit losses. We estimate the amount of expected losses by using historical trends to calculate a probability of an unfunded credit commitment being funded and derive historical lifetime expected loss factors for each portfolio segment similar to our funded loan ECL. The collectively assessed ECL for unfunded credit commitments also includes the same qualitative allocations applied for our funded loan ECL. For unfunded credit commitments related to loans that do not share similar risk characteristics with other loans, where applicable, a separate estimate of ECL will be included in our total ACL on unfunded credit commitments. Loan commitments that are determined to be unconditionally cancellable by the Company do not require an ACL on unfunded credit commitments.
Uncollectible Loans and Write-offs
Our charge-off policy applies to all loans, regardless of portfolio segment. Commercial loans are considered for a full or partial charge-off in the event that principal or interest is over 180 days past due and the loan lacks sufficient collateral and it is not in the process of collection. Consumer loans are considered for a full or partial charge-off in the event that principal or interest is over 120 days past due and the loan lacks sufficient collateral and it is not in the process of collection. We also consider writing off loans in the event of any of the following circumstances: 1) the loan, or a portion of the loan is deemed uncollectible due to: (i) the borrower's inability to make recurring payments, (ii) material changes in the borrower's financial condition, or (iii) the expected sale of all or a portion of the borrower's business is insufficient to repay the loan in full, or 2) the loan has been identified for charge-off by regulatory authorities.
Troubled Debt Restructurings
A TDR arises from the modification of a loan where we have granted a concession to the borrower related to the borrower's financial difficulties that we would not have otherwise considered for economic or legal reasons. These concessions may include: (i) deferral of payment for more than an insignificant period of time that does not include sufficient offsetting borrower concessions, (ii) interest rate reductions, (iii) extension of the maturity date outside of ordinary course extension, (iv) principal forgiveness or (v) reduction of accrued interest.
We use the factors in ASC 310-40, Receivables, Troubled Debt Restructurings by Creditors, in analyzing when a borrower is experiencing financial difficulty, and when we have granted a concession, both of which must be present for a restructuring to meet the criteria of a TDR. If we determine that a TDR exists, we measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, we may also measure impairment based on a loan's observable market price, or the fair value of the collateral less selling costs if the loan is a collateral-dependent loan.
In April 2020, we implemented three loan payment deferral programs targeted to assist borrowers who were the most impacted by the COVID-19 pandemic. These programs included relief for venture-backed, private bank and wine borrowers who met certain criteria. For loans modified under these programs, in accordance with the provisions of Section 4013 of the CARES Act, we elected to not apply TDR classifications to borrowers who were current as of December 31, 2019. In addition, for loans that did not meet the CARES Act criteria, we applied the guidance in an interagency statement issued by bank regulatory agencies. Using this guidance, we may find that borrowers are not experiencing financial difficulty that may
otherwise result in a TDR classification, in accordance with ASC Subtopic 310-40, if loan modifications are performed in response to the COVID-19 pandemic, provide short-term loan payment deferrals (e.g., six months in duration) and are granted to borrowers who were current as of the implementation date of the loan modification program. We evaluated all loans modified under these programs against the CARES Act and interagency guidance, as applicable, and determined the loan modifications would not be considered TDRs. We did not defer interest income recognition during periods of payment deferral, nor did any qualifying modification trigger nonaccrual status.
Nonaccrual Loans
Loans are generally placed on nonaccrual status when they become 90 days past due as to principal or interest payments (unless the principal and interest are well secured and in the process of collection); or when we have determined, based upon currently known information, that the timely collection of principal or interest is not probable.
When a loan is placed on nonaccrual status, the accrued interest and fees are reversed against interest income and the loan is accounted for using the cost recovery method thereafter until qualifying for return to accrual status. For a loan to be returned to accrual status, all delinquent principal and interest must become current in accordance with the terms of the loan agreement and future collection of remaining principal and interest must be deemed probable. We apply a cost recovery method in which all cash received is applied to the loan principal until it has been collected. Under this approach, interest income is recognized after total cash flows received exceed the recorded investment at the date of initial nonaccrual. All of our nonaccrual loans have credit risk ratings of 8 or 9 and are classified under the nonperforming category.
Purchased Credit-Deteriorated Loans
Loans acquired where there is evidence of more than insignificant credit deterioration since origination are classified as PCD. We consider various factors in connection with this determination, including past due or nonaccrual status, credit risk rating declines and any write downs recorded based on the collectability of the asset, among other factors. PCD loans are recorded at their purchase price plus an ECL estimated at the time of acquisition, which represents the amortized cost basis of the asset. The difference between this amortized cost basis and the par value of the loan is the non-credit discount or premium, which is amortized into interest income over the life of the loan. Subsequent increases and decreases in the ACL related to purchased loans is recorded as provision expense.
Premises and Equipment
Premises and equipment are reported at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets or the terms of the related leases, whichever is shorter. The estimated useful lives by asset classification are as follows:
| | | | | | | | |
Leasehold improvements | | Lesser of lease term or asset life |
Furniture and equipment | | 3-7 years |
Computer software | | 3-7 years |
Computer hardware | | 3-5 years |
We capitalize the costs of computer software developed or obtained for internal use, including costs related to developed software, purchased software licenses and certain implementation costs.
Premises and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. For property and equipment that is retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts, and the resulting gain or loss is included in noninterest expense in consolidated net income.
Lease Obligations
We have entered into leases for real estate and equipment. At the inception of the lease, each lease is evaluated to determine whether the lease will be accounted for as an operating or finance lease. We had no finance lease obligations at December 31, 2022, and December 31, 2021. We have made an accounting policy election not to recognize right-of-use assets and lease liabilities that arise from short-term leases for any class of underlying asset. In addition to excluding short-term leases, we have implemented an accounting policy in which non-lease components are not separated from lease components in the measurement of ROU asset and lease liabilities for all lease contracts.
ROU assets represent our right to use an underlying asset for the lease term, and lease liabilities represent our obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at the commencement date based on the present value of lease payments over the lease term. As most of our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at the commencement date in
determining the present value of lease payments. We use the implicit rate when readily determinable. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.
The Company reviews ROU assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. ROU assets are reviewed for recoverability at the lowest level in which there are identifiable cash flows (“asset group”). The carrying amount of an asset group is not considered recoverable if it exceeds the sum of the undiscounted cash flows expected to result from its use and eventual disposition. If the asset group is determined not to be recoverable, then an impairment charge is recognized in the amount by which the carrying amount of the asset group exceeds its fair value. The resulting impairment charge, if any, is allocated to the underlying assets on a pro rata basis using their relative carrying amounts.
Business Combinations
Business combinations are accounted for under the acquisition method of accounting. Acquired assets, including separately identifiable intangible assets, and assumed liabilities are recorded at their acquisition-date estimated fair values. The excess of the cost of acquisition over these fair values is recognized as goodwill. During the measurement period, which cannot exceed one year from the acquisition date, changes to estimated fair values are recognized as an adjustment to goodwill. Certain transaction costs are expensed as incurred.
Goodwill and Other Intangible Assets
Goodwill is not amortized and is subject, at a minimum, to an annual impairment assessment. We may decide to complete a qualitative assessment to determine whether it is more likely than not, that the fair value of a reporting unit is below its carrying amount. As part of this qualitative analysis, we consider macroeconomic factors that might impact the entity’s performance such as changes in interest rates, changes in industry-specific factors and Gross Domestic Product ("GDP"). We also consider the reporting unit's competitive environment, including potential regulatory impact, the political landscape and market pressure. Further, we evaluate entity-specific financial performance of the reporting unit, changes in management or staffing, changes in overall strategy and other factors. If we choose to bypass this qualitative assessment, or we determine it is more likely than not that the fair value of a reporting unit is below its carrying amount, a quantitative assessment will be completed. Should we be required to calculate the fair value of the reporting unit, we would generally apply a discounted cash flow analysis that uses forecasted performance estimates, and a discount rate leveraging a reporting unit specific capital asset pricing model, which in turn uses assumptions related to market performance and various macroeconomic and reporting unit specific risks. We will evaluate goodwill for impairment more frequently if circumstances indicate that the fair value of our reporting units is less than their carrying value, including goodwill.
Intangible assets with finite lives are amortized over their estimated useful lives, and all intangible assets are subject to impairment if events or circumstances indicate that the fair value is less than the carrying amount.
Fair Value Measurements
Our AFS securities, derivative instruments and certain equity securities are financial instruments recorded at fair value on a recurring basis. We make estimates regarding valuation of assets and liabilities measured at fair value in preparing our consolidated financial statements.
Fair Value Measurement-Definition and Hierarchy
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (the “exit price”) in an orderly transaction between market participants at the measurement date. There is a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used for measurement are observable or unobservable and on the significance of those inputs in the fair value measurement. Observable inputs reflect market-derived or market-based information obtained from independent sources, while unobservable inputs reflect our estimates about market data and views of market participants. The three levels for measuring fair value are based on the reliability of inputs and are as follows:
Level 1
Fair value measurements based on quoted prices in active markets for identical assets or liabilities that we have the ability to access. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these instruments does not entail a significant degree of judgment. Assets utilizing Level 1 inputs include U.S. Treasury securities, foreign government debt securities, exchange-traded equity securities and certain marketable securities accounted for under fair value accounting.
Level 2
Fair value measurements based on quoted prices in markets that are not active or for which all significant inputs are observable, directly or indirectly. Below is a summary of the significant inputs used for each class of Level 2 assets and liabilities:
AFS Securities: Valuations for the AFS securities are provided by independent pricing service providers who have experience in valuing these securities and are compared to the average of quoted market prices obtained from independent brokers. We perform a monthly analysis on the values received from third-parties so that the prices represent a reasonable estimate of the fair value. The procedures include, but are not limited to, initial and ongoing review of third-party pricing methodologies, review of pricing trends and monitoring of trading volumes. Additional corroboration, such as obtaining a non-binding price from a broker, may be obtained depending on the frequency of trades of the security and the level of liquidity or depth of the market. Prices received from independent brokers represent a reasonable estimate of the fair value and are validated through the use of observable market inputs including comparable trades, yield curve, spreads and, when available, market indices. If we determine that there is a more appropriate fair value based upon the available market data, the price received from the third party is adjusted accordingly.
U.S. agency debentures: Fair value measurements of U.S. agency debentures are based on the characteristics specific to bonds held, such as issuer name, issuance date, coupon rate, maturity date and any applicable issuer call option features. Valuations are based on market spreads relative to similar term benchmark interest rates, generally U.S. Treasury securities.
Agency-issued MBS: Agency-issued MBS are pools of individual conventional mortgage loans underwritten to U.S. agency standards with similar coupon rates, tenor and other attributes such as geographic location, loan size and origination vintage. Fair value measurements of these securities are based on observable price adjustments relative to benchmark interest rates taking into consideration estimated loan prepayment speeds.
Agency-issued CMO: Agency-issued CMO are structured into classes or tranches with defined cash flow characteristics and are collateralized by U.S. agency-issued mortgage pass-through securities. Fair value measurements of these securities incorporate similar characteristics of mortgage pass-through securities such as coupon rate, tenor, geographic location, loan size and origination vintage, in addition to incorporating the effect of estimated prepayment speeds on the cash flow structure of the class or tranche. These measurements incorporate observable market spreads over an estimated average life after considering the inputs listed above.
Agency-issued CMBS: Fair value measurements of these securities are based on spreads to benchmark interest rates (usually U.S. Treasury rates or rates observable in the swaps market), prepayment speeds, loan default rate assumptions and loan loss severity assumptions on underlying loans.
Derivative assets and liabilities: Fair value measurements of these assets and liabilities are priced based on the following:
•Foreign exchange forward and option contract assets and liabilities are priced based on spot and forward foreign currency rates and option volatility assumptions.
•Interest rate derivative and interest rate swap assets and liabilities are priced considering the coupon rate of the fixed leg of the contract and the variable coupon rate on the floating leg of the contract. Valuation is based on both spot and forward rates on the swap yield curve and the credit worthiness of the contract counterparty.
•Total return swaps are based upon the performance of the reference asset, the variable coupon rate and spread of the floating leg of the contract.
Other equity securities: Fair value measurements of equity securities of public companies are priced based on quoted market prices less a discount if the securities are subject to certain sales restrictions. Certain sales restriction discounts generally range from 10 percent to 20 percent depending on the duration of the sale restrictions, which typically range from three to six months.
Equity warrant assets (public portfolio): Fair value measurements of equity warrant assets of publicly-traded portfolio companies are valued based on the Black-Scholes option pricing model. The model uses the price of publicly-traded companies (underlying stock price), stated strike prices, warrant expiration dates, the risk-free interest rate and market-observable option volatility assumptions.
Level 3
The fair value measurement is derived from valuation techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect our own estimates of assumptions we believe market participants would use in pricing the asset. The valuation techniques are consistent with the market approach, income approach or the cost approach used to measure fair value. Below is a summary of the valuation techniques used for each class of Level 3 assets:
Venture capital and private equity fund investments not measured at net asset value: Fair value measurements are based on consideration of a range of factors including, but not limited to, the price at which the investment was acquired, the term and nature of the investment, local market conditions, values for comparable securities and as it relates to the private company, the current and projected operating performance, exit strategies and financing transactions subsequent to the acquisition of the investment. The significant unobservable inputs used in the fair value measurement include the information about each portfolio company, including actual and forecasted results, cash position, recent or planned transactions and market comparable companies.
Equity warrant assets (public portfolio): Fair value measurements of equity warrant assets of publicly-traded portfolio companies are valued based on the Black-Scholes option pricing model. The model uses the price of publicly-traded companies (underlying stock price), stated strike prices, warrant expiration dates, the risk-free interest rate and market-observable option volatility assumptions. Modeled asset values are further adjusted by applying a discount of up to 20 percent for certain warrants that have certain sales restrictions or other features that indicate a discount to fair value is warranted.
Equity warrant assets (private portfolio): Fair value measurements of equity warrant assets of private portfolio companies are priced based on a Black-Scholes option pricing model to estimate the asset value by using stated strike prices, option expiration dates, risk-free interest rates and option volatility assumptions. Option volatility assumptions used in the Black-Scholes model are based on public market indices whose members operate in similar industries as companies in our private company portfolio. Option expiration dates are modified to account for estimates to actual life relative to stated expiration. Overall model asset values are further adjusted for a general lack of liquidity due to the private nature of the associated underlying company. There is a direct correlation between changes in the volatility and remaining life assumptions in isolation and the fair value measurement while there is an inverse correlation between changes in the liquidity discount assumption and the fair value measurement.
Contingent conversion rights (public portfolio): Fair value measurements of contingent conversion rights of publicly-traded portfolio companies are valued based on the Black-Scholes option pricing model. The model uses the price of publicly-traded companies (underlying stock price), stated strike prices, warrant expiration dates, the risk-free interest rate and market-observable option volatility assumptions. Modeled asset values are further adjusted by applying a discount of up to 20 percent for certain conversion rights that have certain sales restrictions or other features that indicate a discount to fair value is warranted. As sale restrictions are lifted, discounts are adjusted downward to zero once all restrictions expire or are removed.
Contingent conversion rights (private portfolio): Fair value measurements are based on consideration of a range of factors including, but not limited to, actual and forecasted enterprise values, probability of conversion event occurring and limitations and conversion pricing outlined in the convertible debt agreement. Additionally, we have ongoing communication with the portfolio companies and relationship teams to determine whether there is a material change in fair value. We use company provided valuation reports, if available, to support our valuation assumptions. These factors are specific to each portfolio company and a weighted average or range of values of the unobservable inputs is not meaningful.
Fee-based Services Revenue Recognition
Refer to Note 17—“Noninterest Income” for our fee-based services revenue recognition policies for our contracts with customers.
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Our federal, state and foreign income tax provisions are based upon taxes payable for the current year, current year changes in deferred taxes related to temporary differences between the tax basis and financial statement balances of assets and liabilities and a reserve for uncertain tax positions. Deferred tax assets and liabilities are included in the consolidated financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income
taxes. A valuation allowance is provided, when it is determined based upon available evidence, that it is more likely than not that some portion of the deferred tax asset will not be realized.
We file a consolidated federal income tax return, and consolidated, combined, or separate state income tax returns as appropriate. Our foreign incorporated subsidiaries file tax returns in the applicable foreign jurisdictions. Interest and penalties related to unrecognized tax benefits are recorded in other noninterest expense, a component of consolidated net income. We use the deferral method of accounting on investments that generate investment tax credits. Under this method, the investment tax credits are recognized as a reduction to the related asset.
Share-Based Compensation
Generally, for our stock-based awards granted, stock-based compensation expense is amortized on a straight-line basis over the requisite service period, including consideration of vesting conditions and anticipated forfeitures. The service period is reduced for a select number of awards that provide for continued vesting upon retirement if any of the grantees are retirement eligible at the date of grant (or will become retirement eligible during the vesting period). The fair value of stock options is measured using the Black-Scholes option-pricing model, and the fair value for restricted stock awards and restricted stock units is based on the quoted price of our common stock on the date of grant.
Earnings Per Share
Basic earnings per common share is computed using the weighted average number of common stock shares outstanding during the period. Diluted earnings per common share is computed using the weighted average number of common stock shares and potential common shares outstanding during the period. Potential common shares include stock options, ESPP shares and restricted stock units. Potential common shares are excluded from the computation if the effect is antidilutive.
Derivative Financial Instruments
All derivative instruments are recorded on the balance sheet at fair value. The accounting for changes in fair value of a derivative financial instrument depends on whether the derivative financial instrument is designated and qualifies as part of a hedging relationship and, if so, the nature of the hedging activity. Changes in fair value are recognized through earnings for derivatives that do not qualify for hedge accounting treatment, or that have not been designated in a hedging relationship.
Cash Flow Hedges
For derivative instruments that are designated and qualify as a cash flow hedge, changes in the fair value of the derivative are recorded in AOCI and recognized in earnings as the hedged item affects earnings. To qualify for hedge accounting, a derivative must be highly effective at reducing exposure to the hedged risk. Derivative amounts affecting earnings are recognized consistent with the classification of the hedged item. We assess hedge effectiveness on a quarterly basis to ensure all hedges remain highly effective to ensure hedge accounting can be applied. If the hedging relationship no longer exists or no longer qualifies as a hedge, any amounts remaining as gain or loss in AOCI are reclassified into earnings in the line item "loans" as part of interest income, a component of consolidated net income.
Fair Value Hedges
For derivative instruments that are designated and qualify as a fair value hedge, both the changes in the fair value of the derivative and the portion of the fair value adjustments associated with the portfolio attributable to the hedged risk will be recognized into earnings as they occur. To qualify for hedge accounting, a derivative must be highly effective at reducing the hedged risk exposure. Derivative amounts affecting earnings are recognized consistent with the classification of the hedged item. We assess hedge effectiveness on a quarterly basis to ensure all hedges remain highly effective and hedge accounting can be applied. If the hedging relationship no longer exists or no longer qualifies as a hedge, any remaining fair value basis adjustments are allocated to the individual assets in the portfolio and amortized into earnings over a period consistent with the amortization of other discounts and premiums associated with the respective assets.
Net Investment Hedges
For derivative instruments that are designated and qualify as a net investment hedge, the gain or loss from hedge revaluation is recorded in AOCI in the line item "foreign currency translation (losses) gains, net of hedges." We reassess hedge effectiveness at least quarterly. If the hedging relationship no longer exists or no longer qualifies for hedge accounting, any amounts remaining as gains or losses in AOCI are not reclassified into earnings until the sale or liquidation of the associated foreign operation.
Equity Warrant Assets
In connection with negotiated credit facilities and certain other services, we may obtain equity warrant assets giving us the right to acquire stock in primarily private, venture-backed companies in the technology and life science/healthcare industries. We hold these assets for prospective investment gains. We do not use them to hedge any economic risks nor do we use other derivative instruments to hedge economic risks stemming from equity warrant assets.
In general, equity warrant assets entitle us to buy a specific number of shares of stock at a specific price within a specific time period. Certain equity warrant assets contain contingent provisions, which adjust the underlying number of shares or purchase price upon the occurrence of specified future events. Substantially all our warrant agreements qualify as derivatives and are reported at fair value as a component of other assets, on our consolidated balance sheet.
The grant date fair values of equity warrant assets received in connection with the issuance of a credit facility are deemed to be loan fees and recognized as an adjustment of loan yield through loan interest income. Similar to other loan fees, the yield adjustment related to grant date fair value of warrants is recognized over the life of that credit facility. Any changes in fair value after the grant date are recognized as net gains or losses on equity warrant assets, in noninterest income, a component of consolidated net income.
We value our equity warrant assets using a Black-Scholes option pricing model, which incorporates the following significant inputs:
•An underlying asset value, which is estimated based on current information available in valuation reports, including any information regarding subsequent rounds of funding or performance of a company.
•Stated strike price, which can be adjusted for certain warrants upon the occurrence of subsequent funding rounds or other future events.
•Price volatility or risk associated with possible changes in the warrant price. The volatility assumption is based on historical price volatility of publicly traded companies within indices similar in nature to the underlying client companies issuing the warrant. The actual volatility input is based on the mean and median volatility for an individual public company within an index for the past 16 quarters, from which an average volatility was derived.
•Actual data on terminations and exercises of our warrants are used as the basis for determining the expected remaining life of the warrants in each financial reporting period. Warrants may be exercised in the event of acquisitions, mergers or IPOs and alternatively may be cancelled due to events such as bankruptcies, restructuring activities or additional financings. These events may cause the expected remaining life assumption to be shorter than the contractual term of the warrants.
•The risk-free interest rate is derived from the Treasury yield curve and is calculated based on a weighted average of the risk-free interest rates that correspond closest to the expected remaining life of the warrant.
•Other adjustments, including a marketability discount, are estimated based on management's judgment about the general industry environment.
•Number of shares and contingencies associated with obtaining warrant positions such as the funding of associated loans.
When a company in the portfolio completes an IPO, or is acquired, we may exercise these equity warrant assets for shares or cash. In the event of an exercise for common stock shares, the basis or value in the common stock shares is reclassified from other assets to investment securities on the balance sheet on the latter of the exercise date or corporate action date.
The common stock of public companies is classified as non-marketable and other equity securities. Changes in the fair value of the common stock is recorded as gains or losses on investments securities, in noninterest income, a component of consolidated net income. We account for these securities without a readily determinable fair value based on the price at which the investment was acquired plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments, with changes recorded as gains or losses on investment securities, in noninterest income, a component of consolidated net income.
Foreign Exchange Forwards and Foreign Currency Option Contracts
We enter into foreign exchange forward contracts and foreign currency option contracts with clients involved in international activities, either as the purchaser or seller, depending upon the clients' need. We also enter into an opposite-way forward or option contract with a correspondent bank to economically hedge client contracts to mitigate the fair value risk to us from fluctuations in currency rates. Settlement, credit and operational risks remain. We also enter into forward contracts with correspondent banks to economically hedge currency exposure risk related to certain foreign currency denominated assets and liabilities. These contracts are not designated as hedging instruments and are recorded at fair value in our consolidated balance sheets. The contracts generally have terms of one year or less, although we may have contracts
extending for up to five years. Generally, we have not experienced nonperformance on these contracts, have not incurred credit losses and anticipate performance by all counterparties to such agreements. Changes in the fair value of these contracts are recognized in consolidated net income under other noninterest income, a component of noninterest income. Period-end gross positive fair values are recorded in other assets and gross negative fair values are recorded in other liabilities.
Interest Rate Contracts
We sell interest rate contracts to clients who wish to mitigate their interest rate exposure. We economically reduce the interest rate risk from this business by entering into opposite-way contracts with correspondent banks. We do not designate any of these contracts (which are derivative instruments) as qualifying for hedge accounting. Contracts in an asset position are included in other assets and contracts in a liability position are included in other liabilities. The net change in the fair value of these derivatives is recorded through other noninterest income, in noninterest income, a component of consolidated net income.
Changes in Accounting Principles
During 2022, we changed our presentation of derivative asset and liability positions and the related cash collateral in the unaudited interim consolidated balance sheets. The balances are presented net by counterparty when a legally enforceable right of setoff exists under a master netting arrangement in accordance with ASC 815, Derivatives and Hedging. Previously, fair values of derivative positions were reported in the line items “Accrued interest receivable and other assets” and “Other liabilities” gross. The related cash collateral was reported in the line items "Cash and cash equivalents" and "Short-term borrowings". For impact on presentation, please refer to the balance sheet offsetting section of Note 16 – “Derivative Financial Instruments”. This change had no impact on our net income. We concluded that this presentation was preferable as it better reflects the credit risk of derivatives traded under master netting arrangements. This change represents a change in accounting principle under ASC 250, Accounting Changes and Error Corrections, with retrospective application to the earliest period presented.
Reclassifications
Certain prior period amounts have been reclassified to conform to current period presentation to account for the change in presentation of derivative asset and liability positions and the related cash collateral disclosed in the Summary of Significant Accounting Polices in Part 1, Item 1 of this report. These changes are included in our Consolidated Balance Sheets (unaudited) and Consolidated Statements of Cash Flows (unaudited) as well as the Cash and Cash Equivalents, Derivative Financial Instruments and Fair Value of Financial Instruments footnotes.
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