Presale Report: NAB Subordinated Notes 2 Bond Like Features Provide Compelling Diversification Benefits Recommendation: Subscribe

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1 ? Presale Report: NAB Subordinated Notes 2 Bond Like Features Provide Compelling Diversification Benefits Recommendation: Subscribe Morningstar Research 23 February 2017 John Likos, CFA Senior Credit Analyst, Australia Executive Summary National Australia Bank, or NAB, will raise AUD 750 million - with the ability to raise more or less via a Tier 2 subordinated note issue, to be listed on the Australian Securities Exchange, called NAB Subordinated Notes 2 (ASX Code: NABPE). NAB is issuing this security to refinance the NAB Subordinated Notes (ASX Code: NABHB) issued by NAB on 18 June 2012 and have a first call date of 18 June APRA has confirmed that the NAB Subordinated Notes 2 will qualify as Tier 2 Capital. NABPE are non-guaranteed, subordinated, unsecured notes, issued by NAB with a AUD 100 face value. They are not deposit liabilities of NAB. NABPE are subject to conversion and write-off on account of a non-viability trigger event. NABPE will mature on 20 September 2028, unless previously redeemed, or purchased by NAB or a related entity and cancelled, or converted or written-off. NAB has the option to redeem the notes on the optional redemption date of 20 September 2023 and on any interest payment date thereafter conditional on APRA's approval. NABPE entitle holders to receive floating rate, cumulative interest. Interest paid on NABPE is not discretionary or deferrable and is not to be franked. Interest will be paid quarterly in arrears, based on the 90-day bank bill swap, or BBSW, rate plus a margin in the indicative range of 2.20%-2.30% per annum. Using the current 90-day BBSW rate of 1.77%, this equates to a total estimated gross running yield range of 3.97%-4.07% per annum. Key Takeaways We recommend investors subscribe to the offer. Our expectation is for final margin to be set at 2.20%, the bottom of the indicative range. We expect demand to be strong as investors seek a more fixed income like exposure than the more commonly issued Additional Tier 1, or AT1, hybrids, issued by the major banks. The security is fairly priced and offers portfolio diversification benefits for retail investors given its lower risk profile relative to AT1 hybrids. We like the more traditional bond like features of NABPE, particularly the fixed September 2028 maturity date, the Event of Default provision, the cumulative nature of interest payments and the higher positioning on the capital structure relative to AT1 hybrid securities. at You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN ("ASXO").

2 Page 2 of 17 Recommendation We recommend investors subscribe to the offer for NABPE. We assign NABPE a low security investment risk rating. This is lower than the Basel III-compliant AT1 major bank hybrids in our coverage list which we assign a medium investment risk rating, reflecting the more equity like features in their terms and conditions, such as the capital trigger and their perpetual nature. Although the capital trigger doesn t exist in the terms and conditions of NBAPE, the non-viability trigger does. This makes NABPE risker than the security it is replacing, NABHB, which doesn t have either trigger. Nevertheless, for investors willing to take an investment position below senior unsecured debt but above AT1 hybrids on NAB s capital structure, NABPE represents an attractive investment. It is worth highlighting some of our preferred bond like features of Tier 2 securities relative to AT1 securities. In particular, we like (i) the fixed 20 September 2028 maturity date of NAPBE; (ii) the cumulative nature of the deferred interest payments of NABPE; (iii) the higher ranking on the capital structure; and (iv) the fact conversion into equity can only take place following a non-viability trigger event. Characteristics such as these go a long way to explaining the premium price of Tier 2 securities relative to AT1 securities. Exhibit 1 Key Characteristics: Tier 1 and Tier 2 Regulatory Capital Additional Tier 1 Tier 2 Interest/distribution payment - Wholly or partially franked - Wholly in Cash Payment deferral - Issuer has full discretion to cancel or alter timing of distributions - Deferred payments are non-cumulative - No, subject to Solvency Condition - Deferred payments are cumulative Term - Perpetual - Fixed Maturity Ranking in a Winding Up - Senior to Ordinary Shares - Senior to Additional Tier 1 and Ordinary Shares Conversion into Ordinary Shares Following scheduled conversion, a capital trigger event, a non-viability trigger event or an acquisition event - Only following a non-viability trigger event Source: Morningstar Event of Default Provision We also like the Event of Default provision in the terms and conditions of NABPE. While AT1 securities provide a dividend stopper to dis-incentivise non-payment of distributions, NABPE goes further to qualify any non-payment of interest or principal as an event of default. In the case of NABPE, an event of default will occur if NAB fails to pay (i) any face value within 7 days of its due date; or (ii) any interest or other amount due in respect of the NABPE within 30 days of its due date. However, to the extent that a payment is not required to be made because of the Solvency Condition, the amount is not due and payable and a payment default cannot occur.

3 Page 3 of 17 Exhibit 2 provides a comprehensive summary of some of the key differences between various NAB investments. Exhibit 2 Differences Between NABPE and Other NAB Investments Term Deposit NAB Subordinated Notes 2 National Income Securities NAB Capital Notes 2 Ordinary Shares ASX Listed (ASX Code) No Yes (NABPE) Yes (NABHA) Yes (NABPD) Yes (NAB) Protection under the Financial Claims Scheme (1) Term Interest, distribution/dividend rate Yes No No No No Often between 1 month and 5 years 11.5 Years (2) 6.5 Years (First Call) Perpetual (2) Perpetual (3) Perpetual Fixed Floating Floating Floating Variable Margin above BBSW Varies 2.20% to 2.30% 1.25% 4.95% N/A Interest/distribution/ dividend payment dates Often at the end of term or per annum Quarterly Quarterly Quarterly Semi-Annually (4) Franking Eligibility No No No (5) Yes Yes Dividend Stopper N/A No Yes Yes N/A Conditions to payment of interest/ distributions/ dividends None, subject to applicable laws and any specific conditions Subject to the Solvency Condition Subject to conditions including the availability of distributable profits and other prudential regulatory tests. Distributions are not cumulative Subject to the discretion of the Directors, and are also only payable if a payment condition does not exist on the distribution payment date. Distributions are not cumulative Subject to the discretion of Directors and applicable laws and regulations Mandatory Conversion into Ordinary Shares Issuer s early redemption option No No No Yes N/A No Yes, with the prior written approval of APRA Yes, with the prior written approval of APRA, at any time on 30 days' notice Yes, with the prior written approval of APRA Loss absorption event No Yes No Yes (6) No Capital Classification None Tier 2 Capital Additional Tier 1 Capital (7) Additional Tier 1 Capital Common Equity Tier 1 Capital No Voting rights No right to vote at general meetings of holders of Ordinary Shares No right to vote at general meetings of holders of Ordinary Shares No right to vote at general meetings of holders of Ordinary Shares, except in limited circumstances No right to vote at general meetings of holders of Ordinary Shares No right to vote at general meetings of holders of Ordinary Shares 1. This is subject to a limit, currently fixed at $250,000 for the aggregate of the customer s accounts with an ADI declared subject to the Financial Claims Scheme. 2. Subject to early Redemption by NAB with the prior written approval of APRA. 3. NAB Capital Notes 2 are scheduled to convert into Ordinary Shares on 8 July 2024, or on the occurrence of certain acquisition events. NAB may also be required to convert NAB Capital Notes 2 as a result of a loss absorption event. In addition, NAB Capital Notes 2 may be converted, redeemed or resold with the prior written approval of APRA on 7 July 2022 or in certain other circumstances. NAB Capital Notes 2 may also be written-off in certain circumstances. 4. There are no fixed dates for payment of ordinary dividends. 5. No frankable distribution is payable on the National Income Securities unless the preference shares forming part of the National Income Securities become fully paid. 6. NAB Capital Notes 2 constitute Additional Tier 1 Capital and provide for a common equity capital trigger event in addition to a non-viability trigger event. A common equity capital trigger event will occur when NAB s Common Equity Tier 1 Ratio as determined by NAB or APRA at any time is equal to or less than 5.125%, calculated on the basis of either or both of the NAB Level 1 Group and the NAB Level 2 Group. 7. The National Income Securities have been classified as Additional Tier 1 Capital under the Basel III Prudential Standards on a transitional basis. Source: Morningstar, NAB We believe NABPE s pricing is attractive on an absolute basis. As Exhibit 3 shows, NABPE is priced in line with NAB s capital structure, offering a premium to both term deposits and senior unsecured debt, but offering a discount to the perpetual National Income Securities (NABHA), NAB s AT1 hybrids and Morningstar s forecast equity dividend yield for NAB for fiscal year 2017.

4 Page 4 of 17 Exhibit 3 NAB Capital Structure Yields 10.00% 9.00% 9.29% 8.00% 7.00% 6.00% 5.69% 5.00% 4.00% 3.00% 2.80% 3.42% 3.97% 4.21% 2.00% 1.00% 0.00% NAB 5 Year Term Deposit NAB Senior Unsecured Note (7 Year) NABPE NABHA (Perpetual) AT1 Hybrid (NABPD) FYE 17 NAB Gross Equity Dividend Yield Source: Morningstar, NAB Exhibit 4 provides a comparison of NABPE's yield to first call relative to the yield curves of alternative credit securities issued by NAB. Not surprisingly, given the more bond like features of NABPE relative to AT1 securities, it is priced closest to the NAB senior unsecured yield curve. Exhibit 4 NAB Credit and Term Deposit Yield Curves (as at 7 February 2017) 6.0% Tier 1 Hybrids Senior Unsecured Term Deposit NABPE 5.0% NABPA NABPC NABPB NABPD 4.0% Yield to Reset 3.0% 2.0% 1.0% 0.0% Years to Reset Source: Morningstar, NAB The listed credit securities market should welcome a security which is more commonplace in the wholesale OTC market. Exhibit 5 provides a comparison of comparable Tier 2 securities, which unlike NABPE, trade over the counter. While NABPE is trading in line with fair value based on this pricing, this must be considered in the context of NABPE being listed and accessible to retail investors while OTC securities are unlisted and available to the wholesale market.

5 Page 5 of 17 There is a scarcity of ASX listed major bank Tier 2 subordinated notes with adequate tenor for retail investors. Currently there are only four such securities on issue, ANZHA, NABHB, WBCHA and WBCHB, all of which have a call date within 2 years with no assurances of listed replacement trades. Of these comparable listed Tier 2 securities, WBCHB is the most similar to NABPE in that it also contains a non-viability trigger, making it Basel III compliant. Exhibit 5 Comparable Over the Counter Tier 2 Major Bank Security Trading Margins (as at 7 February 2017) 250 NABPE 200 WBC ANZ CBA NAB WBC CBA ANZ NAB Basis Points Years to First Call Source: Morningstar, Yieldbroker Winding Up Scenario In the event of a winding up of NAB, NABPE will rank ahead of junior ranking instruments (such as NAB ordinary shares and AT1 hybrids), equally amongst themselves and all other equal ranking instruments, but behind the claims of all senior creditors (which includes depositors). Upon a winding up of NAB, there is a risk that holders will lose some or all of their investment in NABPE. An investor's return in a wind up scenario will be adversely affected if a non-viability trigger event occurs. If NABPE are converted, investors will only be entitled to claim against NAB in a winding up as ordinary shareholders, making their rate of recovery significantly lower than those higher up the capital structure. If NABPE are written off, investors will not have their capital repaid and will not be entitled to any return in a winding up. A winding up scenario of NAB remains extremely unlikely in our view.

6 Page 6 of 17 Exhibit 6 Ranking of NABPE in the Event of a Winding Up of NAB Source: Morningstar, NAB The Offer The offer comprises: the Reinvestment Offer; the Securityholder Offer; the Broker Firm Offer; and the Institutional Offer. The Reinvestment Offer provides eligible holders of NABHB with the opportunity to reinvest some or all their investment into NABPE and maintain an ongoing investment in NAB. The NABHB Reinvestment Offer The reinvestment offer provides eligible NABHB holders with the opportunity to reinvest some or all their NABHB holdings into NABPE. Eligible NABHB holders who successfully participate in the reinvestment offer will also receive accrued NABHB interest of AUD per NABHB in cash for the period from (and including) 18 December 2016 to (but excluding) the issue date of NABPE. This interest is due to be paid on 20 March Investors will receive no further distributions on the reinvested NABHB.

7 Page 7 of 17 You are an eligible NABHB holder if you: were registered as a holder of NABHB at 7:00pm on 3 February 2017; are shown on the NABHB register as having an address in Australia; and are not in the United States or acting as a nominee for, or for the account or benefit of, a US Person or not otherwise prevented from receiving the reinvestment offer or NABPE under the laws of any jurisdiction. Eligible NABHB holders that want to participate in the reinvestment offer and hold 50 or more NABHB securities must apply to reinvest a minimum of 50 securities (AUD 5,000) then additional increments of 10 securities (AUD 1,000). Investors that hold less than 50 NABHB securities must apply to reinvest all their holdings if they want to participate in the reinvestment offer. NABHB holders can also choose to apply for additional NABPE securities. The minimum additional securities that can be applied for are 50 securities (AUD 5,000) then additional increments of 10 securities (AUD 1,000). NABHB holders have to opt in to participate in the reinvestment offer. If they take no action their securities will remain on issue, until expected redemption for cash at face value (AUD 100 per security) plus the applicable interest payment on 18 June NAB has received approval from APRA to redeem the NABHB securities. The Securityholder Offer Investors are eligible to apply under the Securityholder offer if they are a registered holder of NAB ordinary shares, National Income Securities, NAB Subordinated Notes, NAB CPS, NAB CPS II, NAB Capital Notes, or NAB Capital Notes 2 as at 7:00pm on 3 February 2017, with a registered address in Australia. Applications must be made between 16 February 2017 and 10 March The Broker Firm Offer The Broker Firm offer is available to Australian resident clients of a syndicate broker. Applications will only be accepted between 16 February 2017 and 10 March 2017 for applications to reinvest NABHB and between 16 February 2017 and 17 March 2017 for other applications. The Institutional Offer Institutional investors must apply to participate by contacting the arranger. Applications will only be accepted between 16 February 2017 and 17 March Further information on the reinvestment and other offers can be found in Section 3 of the prospectus.

8 Page 8 of 17 Key Differences between NABHB and NABPE The margin applicable to NABHB is 2.75%. The margin for NABPE is expected to be in the range of 2.20% and 2.30%; NABPE are subject to conversion and write-off on account of a non-viability trigger event. NABHB are not subject to such provisions; and in a winding up of NAB, an investor's claim to an amount owing by NAB in connection with NABPE ranks behind claims by holders of NABHB and instruments that rank equally with NABHB. Further information on the key differences between NABHB and NABPE can be found in Section 3.2 of the prospectus. Security Risks Distributions are Subject to the Solvency Condition NAB is not required to make any payment in respect of the NABPE's if, on the day that payment is due, NAB is not, or would not be, solvent. Holders may not take any action to recover an amount that is not required to be paid because of the Solvency Condition. Unpaid amounts will remain a debt owing to the holder by NAB until paid and will be payable on the first business day on which NAB meets the Solvency Condition. Non-viability Risk NABPE has a non-viability trigger, which is required by the prudential regulator, APRA, to qualify as Tier 2 regulatory capital under the latest prudential rules, Basel III. The non-viability trigger gives APRA the discretion to require some, or all, of NABPE to be converted into NAB ordinary shares, making NABPE more equity like than the previous security, NABHB, issued under the previous, less stringent regulatory framework. Following a non-viability event, holders are likely to receive ordinary shares significantly worth less than face value (AUD 100 per security). A non-viability trigger event occurs if APRA believes NAB would become non-viable without a conversion of some, or all, of NABPE, or a public-sector injection of capital or equivalent support is necessary because without it, NAB would become non-viable. It should be noted that whether a non-viability trigger event will occur is at the discretion of APRA and currently there are no precedents for this. APRA may exercise this discretion should it have a concern regarding NAB's capital, liquidity or funding levels. Write-Off Risk If for any reason conversion of notes into NAB ordinary shares does not occur (for example, due to applicable laws, order of a court or action of any government authority) and the ordinary shares are not issued for any reason by 5.00pm on the fifth business day following a non-viability trigger event, then: NABPE will not be converted, redeemed or transferred on any subsequent date. All rights in relation to those notes will be terminated, and holders will lose all of the value of their investment and they will not receive any compensation or unpaid distributions.

9 Page 9 of 17 Reinvestment Risk Subject to the prior written approval of APRA and certain conditions being met, NAB has the right to redeem NABPE for cash at face value (i) on 20 September 2023, the first call date and on any interest payment date after that date up to but excluding the maturity date; and (ii) following the occurrence of a Tax Event or a Regulatory Event. Investors should not assume that APRA s approval, if requested, will be given for any redemption of NABPE. Credit/Default Risk This is the risk of loss arising from NAB defaulting on its payments, whether in the form of interest payments or principal repayment. This is largely offset by NAB's strong credit profile. Nevertheless, investors should be aware NABPE is an unsecured, subordinated investment, so in a wind-up scenario, investors could potentially lose all of their investment. Subordination Risk If NAB issues more equal or higher-ranking securities on the capital structure, NABPE may become further subordinated. Market Price Risk The market price of NABPE could decrease below face value, depending on various market-related factors, such as changes in credit spreads, or NAB's underlying share price performance. Liquidity Risk Listed credit securities such as NABPE are generally less liquid than the ordinary shares in the same company. Low levels of liquidity can make it difficult to buy or sell a security, raising the risk of buying at an inflated price or selling at a capital loss. Investors should read the key risks of NABPE as outlined in Section 7 of the prospectus. Key Dates for the Offer Record Date for Securityholder Offer: 3 February 2017 Announcement of the Offer: 8 February 2017 Lodgement of Prospectus with ASIC: 8 February 2017 Bookbuild: 15 February 2017 Announcement of Margin: 15 February 2017 Offer Opens: 16 February 2017 Reinvestment and Securityholder Offers Close: 10 March 2017 Broker Firm (ex-applications to reinvest NABHB) and Institutional Offers Close: 17 March 2017 Issue of NAB Subordinated Notes 2: 20 March 2017 Commencement of deferred settlement trading: 21 March 2017 Completion of despatch of Holding Statements: 24 March 2017 Commencement of trading on normal settlement basis: 27 March 2017 First Interest Payment Date: 20 June 2017 First Optional Redemption Date: 20 September 2023 Maturity Date: 20 September 2028

10 Page 10 of 17 Key Dates for NABHB Holders Record date for determining eligible NABHB holders for reinvestment Offer (relevant NABHB must also be held on closing date for the reinvestment Offer): 3 February 2017 Opening date for the reinvestment offer: 16 February 2017 Closing date for the reinvestment offer: 10 March 2017 Closing date for broker firm offer (applications to reinvest NABHB): 10 March 2017 Issue of NAB Subordinated Notes 2: 20 March 2017 Quarterly interest payment of $ per NABHB (including reinvested NABHB): 20 March 2017 Expected redemption of NABHB and scheduled quarterly interest payment date for remaining NABHB on issue: 18 June 2017 Key Terms Face value: AUD 100 per security. Minimum subscription amount: AUD 5,000 (50 units). Additional amounts can be bought in increments of AUD 1,000 (10 units). Amount to be raised: NAB plans to raise AUD 750 million via the issue with the ability to raise more or less. Interest Payments: Interest payments are floating, cumulative and payable quarterly in arrears. Interest payments are not franked. Interest is not discretionary or deferrable though payment is subject to a solvency test. Interest Rate for each quarterly Interest payment will be calculated using the following formula: Interest Rate = 90-day Bank Bill Swap Rate + Margin. Margin: The indicative margin range is 2.20% to 2.30% per annum. Frequency of distributions: Quarterly on 20 March, 20 June, 20 September and 20 December. Dividend stopper: There is no dividend stopper provision in NABPE however the solvency test would prevent dividends on ordinary shares being paid Capital classification: Tier 2 regulatory capital. Maturity Date: The maturity date is 20 September Optional Redemption: NAB may, with the prior written approval of APRA, elect to redeem all or some of NABPE on 20 September 2023 and on any interest payment date falling after that date up to but excluding the maturity date; or following the occurrence of a tax or regulatory event. Payment on Optional Redemption: On redemption, for each NABPE that is redeemed, an investor will receive an amount equal to: (i) the face value; plus (ii) any accrued but unpaid interest on NABPE up to the redemption date. Payment is subject to the Solvency Condition and to NABPE not having been redeemed, converted or written-off before that date. Restrictions on Early Redemption: NAB may only elect to redeem NABPE before the maturity date if APRA is satisfied that either (i) the NABPE's to be redeemed are replaced concurrently or beforehand with a capital instrument of the same or better quality and the replacement of the instrument is done under conditions that are sustainable for NAB s income capacity; or (ii) the capital position of NAB will remain adequate after the redemption.

11 Page 11 of 17 Solvency Condition: NAB s obligations to make payments in respect of NABPE (including to pay interest and to repay the face value on maturity) are conditional on: (i) NAB being able to pay its debts as they become due and payable; and (ii) NAB s assets exceeding its liabilities, at the time of the payment and immediately after making the payment (the Solvency Condition ). If the Solvency Condition is not satisfied in respect of a particular payment, that payment will not be made. A failure by NAB to make a payment because of a failure to satisfy the Solvency Condition is not an event of default. However, any unpaid Interest remains a debt payable to investors by NAB and will be payable on the first date on which the Solvency Condition is satisfied. Non-Viability Trigger Event: A non-viability trigger event occurs if APRA notifies NAB it believes that conversion of some, or all, NABPE (or some action in relation to other NAB capital instruments) is required, because without it, NAB would become non-viable; or a public-sector injection of capital is required because without it, NAB would become non-viable. Following such an event, NAB must immediately convert such number of NABPE securities specified by APRA or necessary to satisfy APRA that NAB will no longer be non-viable. If NAB is permitted to convert or write-off a proportion of NABPE, all relevant AT1 Capital instruments will be converted or written-off before any relevant Tier 2 Capital instruments (including NABPE) are converted or written-off. If NAB is permitted to convert only a proportion of NABPE and other relevant Tier 2 Capital instruments following a non-viability trigger event, NAB will endeavour to treat investors on an approximately proportionate basis, but may discriminate to take account of the effect on marketable parcels of NABPE and other logistical considerations. Maximum Conversion Number: The Maximum Conversion Number limits the number of ordinary shares that may be issued on conversion. The Maximum Conversion Number following a nonviability trigger event is broadly the face value (initially AUD 100 per security) divided by 20% of the issue date VWAP. Holders are likely to receive, in the case of a non-viability trigger event, ordinary shares that are worth significantly less than the face value of NABPE and may suffer a significant loss as a consequence. NABPE holders have no right to request or require conversion, redemption or resale of their Notes. We have presented a summary of the key terms. Investors should examine the prospectus in detail if they intend to invest in NABPE.

12 Page 12 of 17 Issuer Details Investment Thesis National Australia Bank is one of four major banks operating in oligopolistic Australia and New Zealand markets. It is Australia's biggest business bank, offering a full range of banking and financial services to the consumer, small business and corporate sectors, with significant operations in New Zealand. We believe commercial banking licences in Australia are very valuable, as all four banks benefit from substantial competitive advantages, resulting from their dominant oligopoly within the regulated industry, extensive pricing power, high barriers to entry, low-cost operations, high-profile brands, and very profitable operations--hence our wide economic moat rating for the firm. National Australia Bank was Australia's leading bank in the 1990s, avoiding the commercial loan disasters that nearly brought down two of its current peers, but a series of slip-ups and disappointments during the decade to 2008 established a hard-to-dislodge reputation as a serial underachiever for the Melbourne-based bank. The ill-fated and expensive "blow-ups" caused top-line management changes on a far-too-regular basis. Disappointingly, the onset of the global financial crisis in 2007 found National Australia Bank wanting, with high exposures to off-balance-sheet special-purpose vehicles--conduits involving structured "assets". Significant loan impairment charges were necessary. The bank's overriding strategic priority is to expand, develop, and leverage its core Australian and New Zealand businesses. The focus is squarely on the profitable Australian franchises, where earnings and return on equity, or ROE, are relatively strong, and further long-term upside potential remains. The need to deliver on its strategy is just as important as transparency about it. Growth opportunities across business banking, retail banking, and wealth management require the support of more favourable economic conditions, stronger equity markets, and a rebound in consumer and business confidence. The powerful banking and wealth management franchise continues to deliver operating momentum, particularly from core retail and business banking operations. The combination of top-line revenue growth and tight cost control will drive better operational efficiency and underpin future profit growth. The price-led, customer-focused retail strategy has been successful in capturing an increasing share of business, particularly at the expense of major bank competitors. The retail growth strategy is providing a larger and more diversified customer base, enabling wealth crossselling and product-upselling opportunities. The extensive marketing campaign, existing distribution network, and increasing reliance on third-party mortgage sales are leading to solid performance. A primary risk that concerns most investors is a potential fall in the Australian housing market. While Australian home prices have been undoubtedly strong for quite a few years, we're comforted by several crucial factors. A combination of factors mitigate potential losses from mortgage lending: tight underwriting standards, lenders' mortgage insurance, low average loan/valuation ratios, a high incidence of loan prepayment, full-recourse lending, a high proportion of variable rate home loans, and the scope for interest rate cuts if deemed necessary by the Reserve Bank of Australia.

13 Page 13 of 17 The sale of 80% of the life insurance business to Nippon Life completed 3 October The life insurance business is managed through MLC Limited and includes AUD 1.8 billion of premiums in force and approximately 1,000 employees. National Australia Bank reported a loss on sale of AUD 1.34 billion. As part of the transaction AUD 1.7 billion in wealth business goodwill was written off. Economic Moat We assign a wide moat to National Australia Bank. The wide moat rating recognises the structural competitive advantages Australia's four major banks possess. The four major banks dominate a regulated and rational oligopoly, bestowing structural advantages that are strong and durable. We believe the economic moats surrounding the major banks are sufficiently wide to ensure global sector-leading returns on equity for the foreseeable future. In our opinion, cost advantage is the main source of the wide economic moats for Australia's four major banks. Switching costs are intangible assets and can provide important, but less prominent, moat sources. Banking in Australia is a highly profitable oligopoly, with the four major banks controlling more than 90% of the business and consumer lending markets, plus the vast majority of bank deposits. National Australia Bank is currently expanding its home loan book above the rate of system growth, with its share of the Australian bank home loan market currently 16%, compared with market heavyweights Commonwealth Bank of Australia at 26% and Westpac Banking Corporation at 25%. Household deposit market share is similar, with Commonwealth Bank leading at 29%, Westpac at 23%, Australia & New Zealand Banking Group at 14%, and National Australia Bank at 14%. Despite dominant market positions, competition is intense between the four major banks. National Australia Bank is a diversified financial services business, benefiting from economies of scale and a sticky customer base. The concentrated industry benefits from high barriers to entry across most segments, making it hard for new entrants to gain any sort of foothold, particularly in retail and business banking. National Australia Bank leverages its strong distribution network, large number of financial advisers, and high-profile MLC investment platform to further expand into the wealth sector. Customer inertia is high, as most customers view the major banks as providing similar levels of service. Most major bank customers have multiple product relationships with their bank, ensuring limited switching because of cost and time pressures. National Australia Bank's focus on deeper customer relationships promotes customer loyalty, reduces switching, and improves profitability. Regulation and highly profitable customer lending reduces risk taking in non-lending asset classes. The concentrated market ensures above-average risk-adjusted returns. Mortgage lending is consistently profitable and accounts for 58% of total loans and 40% of total assets, as at September Pricing can be opaque, as higher advertised rates are discounted for customers, and mortgage interest rate changes tend to be matched by competitors. Standard loans require mortgage lenders' insurance if loan/value ratios, or LVRs, exceed 80%, limiting credit risk on a large portion of higher-lvr loans. Low-doc mortgage loans above 60% LVR require lenders' mortgage insurance, so mortgages resemble a fee-based business with significant operating leverage, and National Australia Bank benefits from its growing market share. Mortgage insurance is paid by

14 Page 14 of 17 borrowers but benefits the bank in the event of a mortgagee-in-possession property sale below the outstanding loan amount. National Australia Bank's Australian mortgage portfolio includes a lower proportion of first-home buyers and low-doc loans compared with its two bigger retail focused peers, Commonwealth Bank of Australia and Westpac. Mortgage insurers in Australia are regulated by APRA, with the two dominant insurers currently rated AA- by S&P. Both insurers regularly stress test their mortgage insurance portfolios and are capitalised to withstand loss severity rates significantly higher than the worst previous experiences. Mortgage insurance covers 100% of the insured loan amount for the loan life. Management & Stewardship We rate the company's stewardship of shareholder capital as Standard. In our view, CEO Andrew Thorburn was a smart appointment when promoted to CEO in August We consider the CEO to be an inspirational leader and a real people person, who is more than capable of running a large and complex major bank. Group strategy remains focused on Australia/New Zealand banking following the demerger of the troubled U.K. assets. Former CEO Cameron Clyne retired on 31 July 2014, after becoming CEO on 1 Jan CEO Andrew Thorburn has made good progress restructuring the group and overhauling and reinvigorating management. Underperforming legacy assets have been disposed and the focus is squarely on business banking, retail banking, and wealth management in Australia and New Zealand. In our opinion, the firm's capital stewardship is Standard. Necessary cultural changes have been implemented as has a more effective risk-management framework. The bank is slowly reestablishing much-needed credibility with investors and the market. K

15 Page 15 of 17 Research Report Disclosure Document Currency This Research Report is current as at the date on the report until it is replaced, updated or withdrawn. Our financial product research may be withdrawn or changed at any time as other information becomes available to us. This report will be updated if events affecting the report materially change. Research Criteria For further information as to: the scope and expertise of our research, the process by which products are selected for coverage, the filters and research methodology applied, and Morningstar s ratings and recommendation scales across credit, equity, ETF, fund, and LIC research, please refer to the Research Overview documents at Material Interests and Conflicts of Interest and How We Manage Them (1) Holding Securities in Product Issuers No material interests are held by us, our staff, or a related company in the financial products that are the subject of the report or the product issuer. Generally, analysts are not permitted to hold securities in entities that they rate, subject to specific waivers by the Morningstar Securities Trading and Disclosure Policy Committee. (2) Fees From Publishing This Report The Morningstar Group and its staff and associates will not receive any direct benefit from the publication of this report. Morningstar does not receive commissions for providing research and does not charge companies to be rated. Where Morningstar provides research it is remunerated by subscribers paying a subscription fee. This fee is variable depending on the client s specific requirements. (3) Who Do We Rate? Morningstar has an associated business, Ibbotson Associates Australia, which provides investment management and consulting services. While the two companies have the same ultimate parent, they have separate reporting lines, and physical and electronic separation of employees and resources. Morningstar avoids any potential conflict of interest by not undertaking or publishing analyst research on Ibbotson s investment products. Morningstar is therefore not affiliated or related to any financial product providers rated by us. (4) Providing Other Services Morningstar may provide a rated product issuer or its related entities with the following services or products for a fee and on an arm s length basis: Software products and licences Research or consulting services Equity, credit and fund data services Licences to republish our ratings and research in their promotional material. (Any licensing agreement takes place after the ratings and research have been completed and published to our clients and the wider marketplace, and the product provider therefore cannot influence the outcomes of our assessments. Licensing negotiations are undertaken by sales employees segregated from research employees.) Event sponsorship Website advertising

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