Presale Report: ANZ Capital Notes 4 (ANZPG) Where Is the New Issue Premium? Recommendation: Do Not Subscribe

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1 ? Presale Report: ANZ Capital Notes 4 (ANZPG) Where Is the New Issue Premium? Recommendation: Do Not Subscribe Morningstar Research 16 August 2016 John Likos, CFA Senior Credit Analyst, Australia john.likos@morningstar.com Michael Murphy Associate Analyst michael.murphy@morningstar.com Executive Summary Australia and New Zealand Banking Group, or ANZ, will raise AUD 1,000 million with the ability to raise more or less via a new hybrid issue, to be listed on the Australian Securities Exchange, called ANZ Capital Notes 4 (ANZPG). ANZPG will provide additional Tier 1 regulatory capital for ANZ, and its features are compliant with the Australian Prudential Regulation Authority's latest capital adequacy standards (Basel III requirements). ANZPG is a fully paid, noncumulative, convertible, transferrable, redeemable, subordinated, perpetual, unsecured note with a AUD 100 face value and scheduled conversion date of 20 March Scheduled conversion on that date is subject to conversion conditions. ANZPG may be converted earlier as a result of a trigger event or ANZ exercising an option to redeem, transfer or convert the security two years early on 20 March Distributions are discretionary, noncumulative and fully franked with a dividend stopper. Distributions 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 4.70%-4.90% per annum. Using the current 90-day BBSW rate of 1.76%, this equates to a total estimated gross running yield range of 6.46%-6.66% per annum. Key Takeaways We recommend investors do not subscribe to the offer. We consider the pricing to be expensive on a relative basis. Amidst a backdrop of a falling domestic cash rate, hybrid securities have rallied strongly in recent months. However, investors should not assume that this trend will continue unabated. Cash rate expectations have shown in the past that they can change quickly. Our expectation is for final pricing at a trading margin of 4.70% and the issue size to be increased. However, in the absence of a new issue premium, we don't see the rush to commit to an issue priced at fair value on the major bank additional Tier 1 capital curve. Of the longer-dated additional Tier 1 securities, we prefer ANZ Capital Notes 2 (ANZPE), ANZ Capital Notes 3 (ANZPF), CBA PERLS VII (CBAPD) and NAB Capital Notes 2 (NABPD) relative to ANZPG priced at a 4.70% trading margin. Relative to ANZPG s yield to call of 6.46%, ANZPF offers a yield to call of 6.54%, CBAPD 6.43% and NABPD 6.40% all of which have shorter terms to call. Hybrid securities should not be viewed as traditional fixed-income products, nor should they be considered a substitute for low-risk investments such as term deposits. of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information at You should consider the advice in light of these matters and if applicable, the relevant Product 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 14 Recommendation We recommend investors do not subscribe to the offer for ANZPG. We assign ANZPG a medium security investment risk rating, the same as other Basel III-compliant Tier 1 major bank hybrids in our coverage list. The terms and conditions, such as nonviability and capital conversion triggers, in this new breed of hybrid securities make them more equity like and, consequently, riskier than the "old-style" issues. Nevertheless, for investors willing to take a position on the lower end of a company's capital structure, hybrid securities can represent an attractive yield investment. Exhibit 1 highlights the strong performance of major bank hybrids in recent months. This has been driven by investors continuing to seek out yield in an environment of falling benchmark rates. However, we believe that the technical factors at work in supporting hybrid pricing can easily reverse, so we caution investors against becoming too carried away with their expectations. Exhibit 1 Trading Margins of Comparable Tier 1 Capital Securities 7.00% ANZPE ANZPF CBAPD NABPD WBCPE 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Jan-2015 Mar-2015 May-2015 Jul-2015 Sep-2015 Nov-2015 Jan-2016 Mar-2016 May-2016 Jul-2016 Source: Morningstar Investors should consider the risk/reward merits of alternative investment options relative to ANZPG, such as bank deposits, bank equity or other hybrids. Exhibit 2 provides a comprehensive summary of some of the key differences between various ANZ investments. We are comfortable with ANZPG pricing on an absolute basis. An ANZ 5-year term deposit, which has the benefit of a guarantee under the Australian government financial claims scheme, yields approximately 410 basis points less than ANZPG s yield to call, based on the low end of the indicative issue range. Morningstar forecasts indicate a gross yield of about 8.45% on ANZ ordinary shares for fiscal 2017, approximately 200 basis points higher than that of ANZPG's yield to call, based on the low end of the indicative issue range.

3 Page 3 of 14 Exhibit 2 Differences Between ANZPG and Other ANZ Investments Source: Morningstar, ANZ We believe that compared to other outstanding ANZ Tier 1 hybrids, ANZPG is expensive on a relative basis. Exhibit 3 highlights that when plotted at the lower end of the indicative issue range against similar ANZ hybrid securities, it appears expensive on a yield-to-call basis, offering a lower or similar yield to call relative to ANZPF and ANZPE. On this basis, we do not see the need to rush into committing to this issue. Furthermore, as the longest-dated Basel-III Compliant Tier 1 security on the ASX once listed, we would have preferred some new issue premium given the often greater sensitivity of the longer end of the curve to react adversely to negative newsflow. Conversely, the long end of the curve would likely be the greatest beneficiary of positive newsflow.

4 Yield to Reset Morningstar Equity Research 16 August 2016 Page 4 of 14 Exhibit 3 ANZ Credit Securities Yield Curves 7.0% 6.0% AT1 Hybrids Senior Unsecured Term Deposit ANZPD ANZPE ANZPF ANZPG 5.0% 4.0% ANZPC 3.0% 2.0% 1.0% 0.0% Years to Reset Source: Morningstar As domestic additional Tier 1 markets continue to rally, it is worth reminding investors that hybrid securities should not be viewed as traditional fixed-income products, nor should they be considered a substitute for low-risk investments such as term deposits. Therefore, they should offer a yield premium over these lower-risk products. Furthermore, hybrid prices can become volatile in times of distress, similar to shares and unlike traditional senior bonds. In the event of a winding up, ANZPG ranks ahead of ordinary shares, equally with equal-ranking capital securities such as ANZ Capital Notes 3, behind senior creditors, and behind bank deposits and secured debt. Exhibit 4 provides a summary of ANZ's capital structure ranking, highlighting the relatively low position of ANZPG in the event of a winding up, an event we consider highly unlikely.

5 Page 5 of 14 Exhibit 4 Ranking of ANZPG in the Event of a Winding Up of ANZ Source: Morningstar, ANZ Exhibit 5 highlights some comparable Basel III-compliant major bank hybrids as well as ANZPG, which we have included for the purposes of comparison. These are all similar to ANZPG in their Basel III-compliant features, although issuer risk profiles may vary slightly among the major banks. Exhibit 5 highlights that at the lower end of the indicative issue range, the yield to call on ANZPG that is lower than ANZPF, on par with CBAPD and slightly above NABPD and WBCPE. A 10 to 20 basis point new issue premium would have adequately compensated investors in our view for this period of uncertainty leading up to the issue date of 27 September 2016 and the longer term to call on ANZPG.

6 Page 6 of 14 Exhibit 5 Comparable Major Bank Basel III-Compliant Hybrids ANZPG ANZPF CBAPD NABPD WBCPE Name ANZ Capital Notes 4 ANZ Capital Notes 3 CBA PERLS VII NAB Capital Notes 2 Westpac Capital Notes 2 Security Type Mandatory Conversion Mandatory Conversion Mandatory Conversion Mandatory Conversion Mandatory Conversion Issuer ANZ ANZ CBA NAB WBC Issue Size ~AUD 1,000 million AUD 850 million AUD 3,000 million AUD 1,499 million AUD 1,310m Face Value AUD 100 AUD 100 AUD 100 AUD 100 AUD 100 Issue Date 27-Sep-16 5-Mar-15 1-Oct-14 7-Jul Jun-14 Margin above Base Rate 4.70% % 3.60% 2.80% 4.95% 3.05% Base Rate 90-Day BBSW 180-Day BBSW 90-Day BBSW 90-Day BBSW 90-Day BBSW First Call Date 20-Mar Mar Dec-22 7-Jul Sep-22 Mandatory Exchange Date 20-Mar Mar Dec-24 8-Jul Sep-24 Distributions Capital Trigger Event Discretionary, noncumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, noncumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, noncumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, noncumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, noncumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Non-Viability Trigger Event Yes Yes Yes Yes Yes Conversion into ordinary shares Yes Yes Yes Yes Yes Ranking in windup Above ANZ ordinary shares and equal to other preference shares. Above ANZ ordinary shares and equal to other preference shares. Above CBA ordinary shares and equal to other preference shares. Above NAB ordinary shares and equal to other preference shares. Above WBC ordinary shares and equal to other preference shares. Gross Running Yield * 6.46% % 5.91% 5.10% 6.73% 5.26% Gross Yield to Reset * 6.46% % 6.54% 6.43% 6.40% 6.26% Trading Margin * 4.70% % 4.42% 4.47% 4.49% 4.33% * As at 15-Aug-16. ANZPG yields at par value. Source: Morningstar We have been particularly vocal in our views that hybrid securities have offered compelling value in recent months. However, the recent rally has brought to the fore the importance of security selection as investors continue to seek out yield, often unaware of the additional risk they are taking on when changing asset classes. In the case of ANZPG, we would have liked some sort of new issue premium to compensate investors for the uncertainty leading up to the listing date. The lack of a new issue premium and our inability to foresee what will prevail in coming months lead us to prefer alternative shorter-dated securities with immediate price certainty, which we believe offer a more compelling risk/reward equation at this point.

7 Page 7 of 14 The Offer The offer comprises: a reinvestment offer for eligible holders of ANZ CPS2 (ASX ticker: ANZPA); a broker firm offer for clients of eligible brokers; an institutional offer to institutional investors; and a securityholder offer for eligible security holders. This includes a registered holder of ANZ ordinary shares, ANZ CPS2, ANZ CPS3, ANZ CN1, ANZ CN2, ANZ CN3 or ANZ Subordinated Notes at 7:00pm AET on 8 August 2016 and shown on the register to have an address in Australia. The ANZPA Reinvestment Offer The reinvestment offer provides eligible 1 ANZPA holders the opportunity to reinvest some, or all, of their holdings to be bought back early for AUD 100 each on 27 September 2016 and to have the buy-back proceeds applied to application payment for ANZPG. Eligible ANZPA holders will also receive a pro rata dividend for any reinvested holdings, subject to payment tests in the ANZPA terms. In the event of excess demand for the offer, ANZ s current intention is to give preference to ANZPA reinvestment applicants over ANZ securityholder applicants, while still providing a proportion of the available notes to be allocated to ANZ securityholder applicants. Key Differences between ANZPA and ANZPG ANZPG has no fixed maturity date, but is scheduled to convert into equity on 20 March 2026, subject to satisfying certain conditions, with an optional redemption or conversion date on 20 March ANZPA has no fixed maturity date but is scheduled to convert into equity on 15 December 2016, subject to satisfying certain conditions. ANZPG includes a capital trigger and a non-viability trigger. ANZPA doesn't contain either. ANZPA has a 3.10% per annum issue margin, whereas ANZPG has an indicative margin range of 4.70% to 4.90% per annum, with the final margin to be determined under the bookbuild. The significantly higher margin reflects market dynamics and the more equity-like terms ANZPG has relative to ANZPA for investors including the capital and non-viability triggers which make them compliant with the latest prudential rules to qualify as Additional Tier 1 regulatory capital. Further information on the key differences between ANZPA and ANZPG can be found in Section 3.2 of the prospectus. Capital Conservation Buffer As of 1 January 2016, ANZ, along with the other domestic major banks, is required to maintain a capital conservation buffer in the form of common equity Tier 1 capital of 3.5% of risk-weighted assets. On top of the Basel III requirement of maintaining a minimum common equity Tier 1 capital ratio of 4.5%, the total common equity Tier 1 capital requirement is now at least 8.0%. This is a positive for major bank hybrid investors as it increases the margin of safety above the 5.125% capital trigger level and reduces the risk of ANZ being deemed "nonviable" by APRA. The potential 1 Refer to Section for the details of eligibility to participate in the reinvestment offer.

8 Page 8 of 14 downside is distributions may be affected if this new buffer is breached. ANZ's common equity Tier 1 ratio, on a Basel III basis, was 9.7% as at 30 June 2016, representing a healthy buffer above regulatory requirements. However, on a proforma basis as at 30 June 2016, based on credit risk weightings applied to ANZ s Australian residential mortgage lending at the mid-point of APRA s 25%-30% range, ANZ s common equity Tier 1 ratio would be about 9.0%. APRA maintains the discretion to apply an additional countercyclical buffer up to 2.5% of common equity Tier 1 capital. In December 2015, APRA confirmed the countercyclical buffer applicable to Australian exposures will be 0% from January. Further information regarding the Capital Conservation Buffer is available in Section of the prospectus. Security Risks Capital Trigger Risk ANZPG has a capital trigger event clause that requires immediate conversion of some, or all, securities into ordinary shares if ANZ's common equity Tier 1 ratio equals or falls below 5.125%. ANZ's common equity Tier 1 ratio, on a Basel III basis, was 9.7% as at 30 June 2016, representing a healthy buffer above the 5.125% minimum. However, the proforma common equity Tier 1 ratio is expected to be about 9.0% adjusting for APRA s increase in average mortgage risk weightings. This still represents a significant capital cushion over the capital trigger of 5.125%. If a capital trigger event does occur, ANZ must immediately convert such number of ANZPG that is sufficient to return the common equity Tier 1 capital ratio back above 5.125%. Furthermore, if this ratio did fall below 5.125%, ANZPG holders could suffer a capital loss as a result of the maximum conversion number of shares condition, where holders potentially receive ordinary shares worth less than the AUD 100 face value of ANZPG securities. Exhibit 6 ANZ Regulatory Capital Ratios 14.0% APRA Common Equity Tier 1 APRA Tier 1 Basel III Capital Trigger 12.0% 10.0% 8.5% 10.4% 8.8% 10.7% 11.3% 9.6% 9.7% 11.8% 8.0% 6.0% 4.0% 2.0% 0.0% Sep-2013 Sep-2014 Sep-2015 Jun-2016 Source: Morningstar, ANZ.

9 Page 9 of 14 Nonviability Risk ANZPG has a nonviability trigger, which is required by the prudential regulator, APRA, as part of the Basel III reforms. The nonviability trigger gives APRA the discretion to require some, or all, of ANZPG to be converted into ANZ ordinary shares, making ANZPG more equity like than the "old-style" issues issued under the previous, less stringent regulatory framework. Similar to conversion following a capital trigger event, holders could receive ordinary shares worth less than AUD 100. A nonviability trigger event occurs if APRA believes ANZ would become nonviable without a conversion of some, or all, of ANZPG, or a public-sector injection of capital or equivalent support is necessary because without it, ANZ would become nonviable. It should be noted that whether a nonviability 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 ANZ 's capital, liquidity or funding levels. Capital Conservation Buffer Risk As a Domestic Systemically Important Bank, or D-SIB, if ANZ's common equity Tier 1 capital ratio falls into the capital conservation buffer 2, distributions on ANZPG may not be paid. This is because ANZ will only be able to use a certain percentage of its earnings to make discretionary payments such as dividends, hybrid Tier 1 distributions and bonuses. Distributions that are not paid do not accrue and will not subsequently be paid. In the event ANZ s common equity Tier 1 capital ratio falls below 8.0%, we believe management will prioritise coupon payments on AT1 instruments to prevent a dividend stopper on ordinary shares. Furthermore, management has a number of options available to them to strengthen capital including a discounted DRP, share issuance, reducing the dividend and/or not paying staff bonuses. Write-Off Risk If for any reason conversion of notes 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 capital trigger event or nonviability trigger event, then: Those notes will not be converted in respect of such capital trigger event or nonviability trigger event (as the case may be) and 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. Scheduled Conversion Risk A fall in ANZ s share price to below predetermined levels relative to the issue date volume weighted average price, or VWAP, required under the terms of scheduled conversion, would result in ANZPG not being converted on the scheduled conversion date (20 March 2026) and remaining on issue 2 Which is a common equity Tier 1 ratio of at least 8% for the D-SIBs.

10 Page 10 of 14 until the next distribution payment date when the conversion conditions are satisfied. We discuss the relevant VWAPs required under scheduled conversion in the Key Terms section. Credit/Default Risk This is the risk of loss arising from ANZ defaulting on its payments, whether in the form of distribution payments or principal repayment. This is largely offset by ANZ's strong credit profile. Nevertheless, investors should be aware ANZPG is an unsecured, subordinated investment, so in a wind-up scenario, investors will potentially lose all of their investment. Subordination Risk If ANZ issues more equal or higher-ranking securities on the capital structure, ANZPG may become further subordinated. Market Price Risk The market price of ANZPG could decrease below face value, depending on various market-related factors, such as credit spreads, or ANZ's underlying share price performance. Liquidity Risk Hybrids are generally less liquid than the 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. Extension Risk If ANZPG is not called at the first call date (20 March 2024), it may trade like a perpetual security, acknowledging the potential conversion into ordinary shares at the scheduled conversion date. We encourage investors to refer to Section 6 of the prospectus for further detail on the risks associated with investing in ANZPG. Key Dates for the Offer Bookbuild and Announcement of margin: 23 August Offer opens: 24 August Securityholder offer closes: 5:00 pm AET on 19 September Broker firm and institutional offers close: 10:00 am AET on 26 September Issue date: 27 September Commencement of deferred settlement trading: 28 September First distribution payment date: 20 December Optional exchange date: 20 March Scheduled conversion date: 20 March Key Dates for Eligible ANZPA Holders Reinvestment offer record date: 8 August Opening date for the reinvestment offer: 24 August Closing date for the reinvestment offer: 5:00 pm AET on 19 September Reinvestment ANZPA cease trading on ASX (but remain quoted on ASX): 23 September 2016.

11 Page 11 of 14 Reinvestment ANZPA buy-back date and payment date for pro rata dividend on reinvestment ANZPA: 27 September Remaining ANZPA cease trading (but remain quoted on ASX): 29 November 2016 Expected resale of remaining ANZPA to Nominated Purchaser and scheduled quarterly dividend payment date for remaining ANZPA: 15 December 2016 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: ANZ plans to raise AUD 1.0 billion via the issue of 10 million securities with the ability to raise more or less. Cash distribution rate: (90-day BBSW rate + margin) x (1 corporate tax rate). This assumes the ANZPG distribution is fully franked. Margin: The indicative margin range is 4.70% to 4.90% per annum. Frequency of distributions: Quarterly on 20 March, 20 June, 20 September and 20 December. Franking: Distributions are fully franked. If a distribution is not franked, the cash distribution amount will be increased to compensate for any franking shortfall. Distributions: Payment of distributions is discretionary and subject to payment conditions being satisfied, the most material being that payment does not cause ANZ to breach its regulatory capital requirements or become insolvent and APRA not objecting. Distributions are not cumulative, so unpaid distributions do not accumulate. Dividend stopper: If a ANZPG distribution is not paid in full for a distribution payment date, then, ANZ cannot pay dividends on its ordinary shares, undertake a buyback or reduce capital on any ordinary shares until a distribution is paid in full on a subsequent distribution payment period. Term: Perpetual, with a scheduled conversion date of 20 March 2026, or any subsequent distribution payment date, subject to conversion conditions, or if the security is converted earlier as a result of a conversion event or ANZ exercising an option to redeem, resell or convert the security two years early on 20 March Capital classification: Additional Tier 1 regulatory capital. Scheduled Conversion date: If ANZPG has not been converted, resold or redeemed earlier, on 20 March 2026, ANZPG will convert into a variable number of ANZ ordinary shares worth approximately AUD 101 at a 1% discount to the 20 business-day VWAP of ANZ ordinary shares. This is subject to conversion conditions. If these conditions are not satisfied, conversion will be deferred until the next distribution payment date upon which the conditions are met. The scheduled conversion conditions are: First condition: The VWAP of ANZ ordinary shares on the 25th business day before a potential scheduled conversion date is greater than 56% of the issue date VWAP of ANZ ordinary shares; Second condition: The VWAP of ANZ ordinary shares during the 20 business days before a potential scheduled conversion date is greater than 50.51% of the issue date VWAP of ANZ ordinary shares; For example, if the issue date VWAP is AUD 25.00, the relevant VWAP for the first scheduled conversion condition to be satisfied would need to be greater than AUD

12 Page 12 of , and for the second scheduled conversion condition would need to be greater than AUD Capital trigger event: If ANZ determines, or APRA believes, ANZ's common equity Tier 1 ratio is equal to or less than 5.125%, ANZ must convert a sufficient number of ANZPG securities into ANZ ordinary shares to return this ratio above 5.125%. The number of shares on conversion would be based on the VWAP five business days following a capital trigger event. However, conversion following a capital trigger event is not subject to scheduled conversion conditions being satisfied. This means ANZPG holders could receive ANZ ordinary shares worth less than AUD 100. A worked example of this can be found in section of the prospectus. A nonviability trigger event occurs if APRA notifies ANZ it believes that conversion of some, or all, ANZPG (or some action in relation to other ANZ capital instruments) is required, because without it, ANZ would become nonviable; or a public-sector injection of capital is required because without it, ANZ would become nonviable. Following such an event, ANZ must immediately convert such number of ANZPG securities specified by APRA or necessary to satisfy APRA that ANZ will no longer be nonviable. Conversion following this event is not subject to schedule conversion conditions being satisfied. The consequence is similar to conversion following a capital trigger event where ANZPG holders will potentially receive ANZ ordinary shares worth less than AUD 100. Optional exchange: ANZ has the option to redeem, resellor convert some or all ANZPG early on the 20 March ANZ has the right to redeem all ANZPG for tax or regulatory reasons at any time. It should be noted that redemption, resale or conversion, as applicable, is subject to satisfaction of certain conditions and APRA's prior approval. ANZPG 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 ANZPG. Issuer Details Investment Thesis ANZ Bank is one of Australia's four major banks and the largest bank in New Zealand and the Pacific, offering a full range of banking and financial services to the consumer, small business and corporate sectors. There are strong barriers to entry to the Australian and New Zealand banking sectors. All four major banks: ANZ Bank, Commonwealth Bank (ASX:CBA), National Australia Bank (ASX:NAB) and Westpac (ASX:WBC), have superior pricing power, efficient scale, low-cost operations, trusted brands, and very profitable operations. ANZ Bank has a strong domestic franchise and some investors overrate the risks. While Australian residential real estate is expensive and there is some concern about a potential sharp fall in the Australian housing market, we are comfortable these risks are manageable and mitigating factors are in place. Tight underwriting standards, lender's 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 scope for interest-rate cuts by the Australian central bank all reduce potential losses from mortgage lending. House prices are increasing again, but investors who readily compare

13 Page 13 of 14 Australia with the U.S. housing crash miss what are in fact fundamentally different residential real estate markets. A central theme is the likely slower growth in the Australian banking system in coming years. There is a structural shift in the world economy, as economic growth shifts from the west to the east, with ANZ Bank positioned in the right part of the world with a credible plan at the right time. But competition is tough as ANZ Bank competes against large global banks that operated in the region for many decades. A change of CEO in January 2016 prompted a rethink of the strategy, and it appears the super-regional strategy is being de-emphasised as shareholder returns failed to match the levels of major bank peers in Australia. We thought the super-regional strategy would, over time, be successful, but investors have not been patient and returns have disappointed. Progress to date has been good but not good enough. We have always called out the higher risks of the growth strategy, and it appears the experimental nature of the super-regional concept has caught up with reality. Risks arise from increased competition in Asia as international banks target emerging markets for growth. A slowdown in economic growth in the region is an increasing risk. Value destruction may also occur from overpaying for previous acquisitions. The bank's Asian growth emphasises institutional banking, which is capital-intensive because of higher risk weights for this category. Higher regulatory capital levels could subdue ROE unless revenue growth is sufficient to provide offsetting economies of scale. Financial Health The bank is one of the few in the world rated AA- and continues to generate capital organically because of its relatively high return on equity and slower risk-weighted lending growth. In the past three years, the proportion of customer deposits to total funding increased from 50% to 63%, reducing exposure to volatile funding markets. Issuance of covered bonds will incrementally diversify the funding base. Total liquid assets exceed total offshore wholesale debt and, theoretically, ANZ Bank could afford to retire all its offshore wholesale debt in the event these debt markets closed and the maturing debt could not be rolled. This would be disruptive, but at least the bank would be solvent. Economic Moat We assign a wide moat rating to ANZ Bank, mainly because of its sustainable structural advantages of the Australian and New Zealand banking sectors. The wide moat rating recognises the structural and superior 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 and switching costs are the main sources of the wide economic moats for Australia's four major banks. Intangible assets and efficient scale provide important, but less prominent, moat sources. All four Australian major banks have wide moat ratings. The four major banks control more than 90% of the business and consumer lending markets, plus the vast

14 Page 14 of 14 majority of bank deposits. New Zealand is similar. Loan pricing is rational, but intense competition for customer deposits is crimping margins. 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. Foreign banks have not made a serious dent in the domestic majors' market share. The smaller regional banks compete on service and local brand recognition, but face higher funding costs than the majors and have to accept lower profitability to compete on price. The major banks are price-makers, while regional banks tend to follow pricing decisions made by the major banks. Management & Stewardship ANZ Bank s new CEO Shayne Elliot started in the new role on 1 January 2016 and wasted no time making changes to strategy, organisational structure and the senior leadership team. Following these changes, we reduced our stewardship rating to Standard from Exemplary. This was driven by increasing risks and uncertainty around the extent of changes in senior management, corporate vision and strategy. The Morningstar Stewardship rating is based primarily on management skill in allocating shareholder capital rather than on corporate governance measures and values. Despite ANZ Bank being under pressure on a number of corporate governance, regulatory and cultural fronts, corporate governance is only considered in the stewardship rating assessment if it has a demonstrated impact on shareholder value. Stewardship is judged from an equityholder perspective and is determined on an absolute basis. We downgrade the stewardship rating primarily because of uncertainty surrounding management changes rather than high profile corporate governance issues. K