Bank of America 2015 Annual Report Download - page 99

Bank of America 2015 97
We use interest rate derivative instruments to hedge the
variability in the cash flows of our assets and liabilities and other
forecasted transactions (collectively referred to as cash flow
hedges). The net losses on both open and terminated cash flow
hedge derivative instruments recorded in accumulated OCI were
$1.7 billion and $2.7 billion, on a pretax basis, at December 31,
2015 and 2014. These net losses are expected to be reclassified
into earnings in the same period as the hedged cash flows affect
earnings and will decrease income or increase expense on the
respective hedged cash flows. Assuming no change in open cash
flow derivative hedge positions and no changes in prices or interest
rates beyond what is implied in forward yield curves at
December 31, 2015, the pretax net losses are expected to be
reclassified into earnings as follows: $563 million, or 33 percent
within the next year, 37 percent in years two through five, and 20
percent in years six through ten, with the remaining 10 percent
thereafter. For more information on derivatives designated as cash
flow hedges, see Note 2 – Derivatives to the Consolidated Financial
Statements.
We hedge our net investment in non-U.S. operations determined
to have functional currencies other than the U.S. Dollar using
forward foreign exchange contracts that typically settle in less than
180 days, cross-currency basis swaps and foreign exchange
options. We recorded net after-tax losses on derivatives in
accumulated OCI associated with net investment hedges which
were offset by gains on our net investments in consolidated non-
U.S. entities at December 31, 2015.
Mortgage Banking Risk Management
We originate, fund and service mortgage loans, which subject us
to credit, liquidity and interest rate risks, among others. We
determine whether loans will be HFI or held-for-sale at the time of
commitment and manage credit and liquidity risks by selling or
securitizing a portion of the loans we originate.
Interest rate risk and market risk can be substantial in the
mortgage business. Fluctuations in interest rates drive consumer
demand for new mortgages and the level of refinancing activity,
which in turn affects total origination and servicing income.
Hedging the various sources of interest rate risk in mortgage
banking is a complex process that requires complex modeling and
ongoing monitoring. Typically, an increase in mortgage interest
rates will lead to a decrease in mortgage originations and related
fees. IRLCs and the related residential first mortgage LHFS are
subject to interest rate risk between the date of the IRLC and the
date the loans are sold to the secondary market, as an increase
in mortgage interest rates will typically lead to a decrease in the
value of these instruments.
MSRs are nonfinancial assets created when the underlying
mortgage loan is sold to investors and we retain the right to service
the loan. Typically, an increase in mortgage rates will lead to an
increase in the value of the MSRs driven by lower prepayment
expectations. This increase in value from increases in mortgage
rates is opposite of, and therefore offsets, the risk described for
IRLCs and LHFS. Because the interest rate risks of these two
hedged items offset, we combine them into one overall hedged
item with one combined economic hedge portfolio.
Interest rate and certain market risks of IRLCs and residential
mortgage LHFS are economically hedged in combination with
MSRs. To hedge these combined assets, we use certain
derivatives such as interest rate options, interest rate swaps,
forward sale commitments, eurodollar and U.S. Treasury futures,
and mortgage TBAs, as well as other securities including agency
MBS, principal-only and interest-only MBS and U.S. Treasury
securities. During 2015 and 2014, we recorded gains in mortgage
banking income of $360 million and $357 million related to the
change in fair value of the derivative contracts and other securities
used to hedge the market risks of the MSRs, IRLCs and LHFS, net
of gains and losses due to changes in fair value of these hedged
items. For more information on MSRs, see Note 23 – Mortgage
Servicing Rights to the Consolidated Financial Statements and for
more information on mortgage banking income, see Consumer
Banking on page 31.
Compliance Risk Management
Compliance risk is the risk of legal or regulatory sanctions, material
financial loss or damage to the reputation of the Corporation
arising from the failure of the Corporation to comply with the
requirements of applicable laws, rules, regulations and related
self-regulatory organizations’ standards and codes of conduct
(collectively, applicable laws, rules and regulations). Global
Compliance independently assesses compliance risk, and
evaluates FLUs and control functions for adherence to applicable
laws, rules and regulations, including identifying compliance
issues and risks, performing monitoring and independent testing,
and reporting on the state of compliance activities across the
Corporation. Additionally, Global Compliance works with FLUs and
control functions so that day-to-day activities operate in a compliant
manner. For more information on FLUs and control functions, see
Managing Risk on page 47.
The Corporation’s approach to the management of compliance
risk is described in the Global Compliance – Enterprise Policy,
which outlines the requirements of the Corporation’s global
compliance program, and defines roles and responsibilities related
to the implementation, execution and management of the
compliance program by Global Compliance. The requirements work
together to drive a comprehensive risk-based approach for the
proactive identification, management and escalation of
compliance risks throughout the Corporation.
The Global Compliance – Enterprise Policy sets the
requirements for reporting compliance risk information to
executive management as well as the Board or appropriate Board-
level committees with an outline for conducting objective
independent oversight of the Corporation’s compliance risk
management activities. The Board provides oversight of
compliance risk through its Audit Committee and ERC.
Operational Risk Management
The Corporation defines operational risk as the risk of loss
resulting from inadequate or failed internal processes, people and
systems or from external events. Operational risk may occur
anywhere in the Corporation, including third-party business
processes, and is not limited to operations functions. Effects may
extend beyond financial losses and may result in reputational risk
impacts. Operational risk includes legal risk. Successful
operational risk management is particularly important to
diversified financial services companies because of the nature,
volume and complexity of the financial services business.
Operational risk is a significant component in the calculation of
total risk-weighted assets used in the Basel 3 capital calculation
under the Advanced approaches. For more information on Basel
3 Advanced approaches, see Capital Management – Advanced
Approaches on page 53.