Australian Banks. The chicken or the egg AUSTRALIA. Growth under threat... but undeniable valuation support. Inside

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1 AUSTRALIA Inside The chicken or the egg 2 Earnings/price target changes 4 Margins outlook upside overstated Deteriorating credit quality outlook 17 Attractive valuations... but need to be brave 26 Returns and dividend sustainability 3 Volume growth outlook 33 Expenses outlook 38 Regulation issues 42 Appendices key financial summary 48 ANZ Bank 49 Commonwealth Bank 2 National Australia Bank Westpac 8 21 January 216 Macquarie Securities (Australia) Limited The chicken or the egg Growth under threat... but undeniable valuation support We see near-term downside risk to bank earnings but in our view, this risk has been captured in banks current valuations. Regulatory pressures, which ultimately led to ~$2bn of additional capital across the majors in 21, had a meaningful impact on banks ROEs and earnings growth outlook (impact of dilution). While out-of-cycle mortgage repricing measures provided an offset, our analysis highlights that competitive and market-related pressures have materially reduced the benefit of repricing. The dilution impact, combined with deteriorating credit quality and slowing volume growth suggests that earnings growth across the sector is likely to be negligible in FY16. While this presents a challenging outlook for the sector, we note that emerging valuation support is difficult to ignore. Moreover, we expect banks to further re-price their mortgage books by 1-1bps (not captured in our FY16 forecasts) and believe that the probability of further capital raisings is low. The sector is now trading at a 1 PE rel discount to its 1 year average and continues to offer solid dividend yield support. We are overweight the sector and prefer banks that trade at a reasonable discount to their long-term averages (ie. NAB and ANZ). Margins support is waning... upside from further repricing Prima facie, the underpinning margin drivers are favourable following the mortgage repricing initiatives and large capital raisings in FY1. However, our analysis highlights a number of emerging headwinds in FY16. Namely, we see risk from the widening Bank Bills rate, front book lending competition and deteriorating funding costs. Based on our estimates mortgage repricing should contribute ~9bps to margins but after adjusting for offsets we only expect ~3bps of margin uplift in FY16. In our view the key upside to margins is from further mortgage back book repricing. We believe banks will raise their spreads a further 1-1bps (not captured in our FY16 forecasts at this point). Credit quality is deteriorating but manageable We expect credit quality conditions to deteriorate in FY16 and FY17. The material fall in commodities prices is likely to result in an increased level of provisions and ultimately losses. We increased our BDD charges to non-housing loans to 1bps in FY16 and 9bps in FY17 and are now at the upper end of consensus. We note that our impairment charges across the majors incorporate a ~$1.2b uplift in FY16 and ~$2.3b in FY17 relative to FY1 levels. In our view, this adequately addresses banks $67bn direct exposure to the mining and resources sectors. We don t expect a material deterioration across the broader book, which is underpinned by ongoing favourable credit trends in recent periods. Earnings and recommendation changes We have downgraded our earnings by -13 in FY16 and 3-17 in FY17. While we acknowledge the materiality of downgrades, we believe our forecasts now conservatively capture the competitive landscape and deteriorating credit quality. We have upgraded ANZ to Outperform and downgraded the retail banks to Neutral. Following the 17 outperformance by the retail banks over the last quarter, CBA/WBC now trade at a ~32 premium to ANZ/NAB, which is the largest premium in the last 2 years and above the last peak of 3 in 28. Our new order of preference is NAB, ANZ, CBA and WBC. Please refer to page 63 for important disclosures and analyst certification, or on our website

2 The chicken or the egg Executive summary We see downside risk to banks near-term earnings but in our view this risk has been largely captured in banks current valuations. Following the de-rating over the last six months, the sector is trading at ~1 discount relative to its 1-year historical PE rel and offers a dividend yield of 6.. Moreover, the quantum of de-rating is somewhat masked by the relative outperformance of retail overweight banks. We believe that upside from mortgage repricing (discussed in more detail in this report) is not enough to sustain this relative outperformance. We note that the PE relative premium of CBA and WBC relative to ANZ and NAB has reached ~32, which is the highest level in the last 2 years. Such divergence within the sector was last observed in July/August 28 when CBA/WBC traded at a ~3 premium to ANZ/NAB. It s worth noting that subsequent to July 28, ANZ outperformed peers by ~1 and NAB by ~ in the following six months. We have upgraded ANZ to Outperform and downgraded the retail banks to Neutral. Our order of preference is now for NAB, ANZ, CBA and WBC. Fig 1 Retail banks PE rel to business banks Fig 2 Relative share price performance following August 28 de-rating CBA/WBC PE Rel to ANZ/NAB LT average -1 yr average Maximum 3M 6M 12M Note: Retail banks are CBA and WBC; Business banks are ANZ and NAB Source: IRESS, Macquarie Research, January 216 Note: Relative share price performance to the average of three peers Source: IRESS, Macquarie Research, January 216 Prima facie, the underpinning margin drivers are favourable following mortgage repricing initiatives and large capital raisings in FY1. However, our analysis highlights a number of emerging headwinds in FY16. Namely, we see risk from the widening Bank Bills rate, front book lending competition and deteriorating funding costs. Based on our estimates mortgage repricing should contribute ~9bps to margins but after adjusting for offsets we only expect ~3bps of margin uplift in FY16. We expect CBA to show sector leading margin trends in FY16, followed by WBC, NAB and ANZ. However, the differences amongst banks are not material. The key upside to margins is from further mortgage back book repricing, which we believe is likely, particularly if competitive pressures intensify further. 21 January 216 2

3 Fig 3 FY16f margin movements (bps) BEN BOQ Sector Mortgage repricing Mortgage spreads (excl. repricing benefits) Business spreads Deposit spreads Deposit competition and mix Bills-OIS spread Other (ie. capital, wholesale, etc) Total Source: Company Data, RBA, IRESS, Canstar, Macquarie Research, January 216 Deteriorating credit quality is clearly a risk for banks, especially given their FY1 impairment charges remained low. While we expect impairment charges to rise in the medium term, it is worth noting that the fundamental rationale for low levels of credit losses remains (ie. subdued period of business credit growth since the beginning of the GFC, low interest rate environment, reasonable levels of gearing and high debt serviceability ratios). Nevertheless we recognise the risk to credit quality from deteriorating economic conditions and material declines in commodity prices. As the figure below highlights, banks have $12-2bn in exposure to the resources and mining-related sectors. Although this only represents 1.-2 of their overall books, in absolute terms elevated levels of losses are likely to be material. Based on our assumptions, banks could experience $.-.8bn of losses on this part of their portfolio. While in absolute sense this number appears high, it is worth noting that our current forecasts incorporate a $.7-1.1bn uplift in BDD charges in FY16 and FY17. This suggests that banks can largely accommodate additional losses on their commodities-related exposures within our existing impairment forecasts, assuming credit quality holds up in other parts of their books. Fig 4 Resource and mining related exposures Fig BDD charge expectations vs potential losses $b 2 2. $m Oil & Gas Mining services Iron Ore Coal Other of Group EAD (RHS) FY16 Increase FY17 Increase Potential Losses Note: We have excluded.9 of Energy exposures as these include electricity generation, distribution & supply and gas supply Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January January 216 3

4 Earnings/price target changes Our forecast earnings changes are shown in the following figure. FY16F eps forecast across the major banks has been reduced by -13 in FY16 and FY17F by -18. Changes to price targets reflect our changes to earnings and change in our valuation methodology (we now value banks based on the midpoint of our DCF and PE based valuations). Our earnings changes are largely driven by the following factors: Reduced margins expectations from funding pressures and competitive dynamics; Increase in BDD expectations driven by deteriorating credit environment; and Based on our new forecasts we are 1-3 below consensus in FY16 and 2-3 below consensus in FY17. We understand that our more conservative credit quality assumptions are the prime reason for this difference. Fig 6 Earnings and recommendations revisions BEN BOQ Previous Recommendation Neutral Outperform Outperform Outperform Neutral Neutral New Recommendation Outperform Neutral Outperform Neutral Neutral Neutral Old Price Target ($/share) New Price Target ($/share) FY16F Old EPS (cps) New EPS (cps) Revision () Old Cash Earnings New Cash Earnings Consensus Macquarie rel. to consensus FY17F Old EPS (cps) New EPS (cps) Revision () Old Cash Earnings New Cash Earnings Consensus Macquarie rel. to consensus Source: Factset, Macquarie Research, January 216 We have also reviewed our dividend forecast across the majors. We believe that NAB s dividend is going to be increasingly difficult to sustain and we have incorporated a divided cut and a normalised payout ratio in our forecasts. We believe that the market is fully aware of this issue and the cut is largely expected. We also see a small downside risk to ANZ s dividend and have adjusted our payout ratio to 69, which we believe is sustainable. We note that ANZ may keep its dividend flat for two years and avoid a dividend cut. In our view dividend yields for CBA and WBC are largely sustainable although WBC s dividend growth is likely to lag its earnings as its payout ratio is adjusted to sustainable level. Fig 7 Dividend forecasts (cps) BEN BOQ FY FY FY Source: Macquarie Research, January January 216 4

5 Margins outlook upside overstated In our view, the margins outlook is the key issue for the sector in 216. Prima facie, the underpinning margin drivers are favourable following mortgage repricing initiatives and large capital raisings in FY1. However, in a low growth and low interest rate environment, competitive tensions are likely to build. Moreover, the recent tightening in the wholesale funding markets combined with the need to strengthen the funding base is likely to provide headwinds to banks margins performance in FY16 and beyond. In aggregated terms we see downside risk to bank margins vs current market expectations. In our view, it appears that the market has captured much of the upside to margins from the 21 repricing initiatives, while competitive pressures and higher funding costs haven t been fully reflected in forecasts. Fig 8 Historical net interest margin trends bps H7 2H7 1H8 2H8 1H9 2H9 1H1 2H1 1H11 2H11 1H12 2H12 1H13 2H13 1H14 2H14 1H1 2H1 Source: Company data, Macquarie Research, January 216 While bank margins across the majors normalised from elevated levels observed in the midst of the Global Financial Crisis, overall margin trends were generally favourable in recent years. As the focus shifted away from the funding concerns and asset spread pressures emerged, lower deposit spreads and improving cost of wholesale funding provided relief to bank margins. Moreover, banks have continued to benefit from selected mortgage repricing initiatives. As the figure below highlights, from 28 banks have benefited from improving lending spreads when funding competition intensified and vice versa. We note that banks have generally been effective in managing margins for volume growth and we expect this trend to continue in FY16. Fig 9 Asset and liability repricing measures Fig 1 Margin trends vs volume growth bps 1 18 bps H7 2H7 1H8 2H8 1H9 2H9 1H1 2H1 1H11 2H11 1H12 2H12 1H13 2H13 1H14 2H14 1H1 2H1 1H9 1H96 1H97 1H98 1H99 1H 1H1 1H2 1H3 1H4 1H 1H6 1H7 1H8 1H9 1H1 1H11 1H12 1H13 1H14 1H1 Net repricing Asset repricing Liability repricing System credit growth YoY Majors NIM changes (RHS) Note: Repricing measures are based on the average for the majors Source: Company data, Macquarie Research, January 216 Source: RBA, Company data, Macquarie Research, January January 216

6 On the lending side, a closer look at banks recent pricing experience highlights that banks are generally effective in re-pricing assets when credit conditions deteriorate. As BDDs increased in 2H8, banks lending spreads improved. A similar correlation can be observed when comparing margin trends to the credit cycle. This suggests that banks ability to reprice risk is higher during a period of elevated credit losses. Furthermore, we found that banks were more successful in repricing assets during a period of market share gains. As the figure below highlights, when market share trends start to decline, asset spreads tend to follow. Given we are currently entering a deteriorating credit environment, we expect to see less margin pressure on institutional loans and expect competitive tension to centre on a more profitable retail product where credit conditions remain benign. Fig 11 BDD/GLA vs asset repricing impact Fig 12 Changes in market share vs asset repricing bps bps 1 bps BDD/GLA Asset repricing Asset repricing (RHS) Housing Business Source: Company data, Macquarie Research, January 216 Source: APRA, Company data, Macquarie Research, January 216 At the individual level, WBC has been the biggest beneficiary over the last 12 months from deposit repricing, which ultimately resulted in sector leading margins performance in FY1. We expect those benefits to partially normalise in FY16 and believe WBC s deposit spread performance is likely to lag peers. On a 3-year view CBA has managed its margins better than peers, which was partly a result of the favourable mix impact as CBA gained share in unsecured lending. ANZ underperformed peers, driven by declining lending spreads and less capacity to manage deposit spreads. Fig 13 1-year margin drivers bps Fig 14 3-year margin drivers bps Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January January 216 6

7 In our view, FY16 margin trends are likely to be underpinned by the following themes (which we will explore in more detail in this section of our report): Asset spread benefits from out-of-cycle mortgage repricing and additional capital; Partially offset by ongoing competitive tension in the mortgage front book and competition in SME; Increase in the bank bills to overnight index swap rate is also likely to take ~2bps off banks margins in FY16; and Ongoing benefit from rolling off expensive wholesale funding largely offset with rising wholesale funding costs and ongoing strengthening in banks funding profiles (to meet NSFR and LCR requirements). The prevailing low interest rate environment is also a negative for bank margins. On an aggregated basis, we expect banks to show margin improvement of 1-6bps in FY16. Although this would arguably be a positive outcome for bank earnings, we note that it would not be enough to fully offset the pressure on EPS from dilution and hence we expect relatively subdued earnings per share growth in FY16. The key upside to margins is from further mortgage back book repricing, which we believe is likely, particularly should competitive pressures intensify further. Fig 1 FY16f margin movements (bps) BEN BOQ Sector 2H1 reported margins Mortgage repricing Mortgage spreads (excl. repricing benefits) Business spreads Deposit spreads Deposit competition and mix Bills-OIS spread Other (ie. capital, wholesale, etc) Total Source: Company Data, RBA, IRESS, Canstar, Macquarie Research, January January 216 7

8 Asset spreads underpinned by mortgage repricing Banks benefit from mortgage repricing initiatives (+9bps) Mortgage repricing initiatives in FY1 were arguably the strongest signal that the Australian banking oligopoly lives on and the industry structure remains attractive. Since the start of the GFC, Australian banks were able to increase mortgage spreads by 18bps for owner occupied mortgages and 21bps for investor loans. While positive for profitability and margins in the near term, competition for the front book intensified further in recent periods (we will explore this in more detail). Fig 16 Standard variable spread to cash rate Fig 17 Standard variable discount rate bps 4 bps Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-12 Jan-13 Jan-14 Jan SVR spread to CASH Investor SVR spread Jun-4 Jun- Jun-6 Jun-7 Jun-8 Jun-9 Jun-1 Jun-11 Jun-12 Jun-13 Jun-14 Jun-1 Source: RBA, Macquarie Research, January 216 Source: RBA, Company data, Macquarie Research, January 216 In our view, the key upside to banks margins and the sector s near-term performance is from ongoing mortgage repricing initiatives. We expect the majors to increase their mortgage spreads by an additional 1-1bps. Retail overweight banks (ie. CBA and WBC) and the Regionals (ie. BEN and BOQ) are the bigger beneficiaries from such a move. We have not factored this benefit in our FY16 forecasts given uncertainties around timing and quantum. Fig 18 Earnings benefit from mortgage repricing Earnings uplift () NIM benefit (bps) FY16 earnings ($m) Variable 1bps 1bps 1bps 1bps ANZ 7, CBA 9, NAB 6, WBC 8, BEN BOQ Source: Company data, Macquarie Research, January 216 The figure below outlines the revenue and margin uplift from repricing initiatives and capital raisings. Based on our estimates, banks margins should improve by -13bps in FY16 from initiatives that have already been put in place in FY1. While this is highly positive for the sector, we note that given the high profile nature of these repricing initiatives, the market is relatively well aware of the benefit and the upside should have been captured in consensus estimates. It is also worth noting that overall, repricing benefits will be impacted by the recent customer shift from investor to owner occupied segments and $2-3bn of offset accounts (our numbers are adjusted for these factors). 21 January 216 8

9 Fig 19 Revenue and margins uplift from repricing and capital raising initiatives Revenue impact from SVR repricing and capital raisings ($m) 2H1 1H16 2H16 ANZ CBA NAB WBC BEN BOQ Margin impact (bps) ANZ CBA NAB WBC BEN BOQ Source: Macquarie Research, January 216 Diminishing risk from Insto lending but SME loans remain competitive (-2bps) Increasing competition in business lending (both at the Institutional and SME level) has been highlighted in recent years as the key driver for margin pressure. The excess in global liquidity has resulted in intensifying competition to deploy funding with lending spreads for BBB debt narrowing from 3bps in 211 to 14bps in 214. As the figures below highlight, tighter credit conditions should result in diminishing margin pressures for the majors. We expect margin pressure in Institutional lending to normalise. As funding conditions tighten and credit quality conditions deteriorate, we expect to see more rational pricing at the larger end of the lending spectrum. While this also suggests that SME margins could also improve, we are less optimistic on that part of banks balance sheets. It is worth noting that at current pricing levels, SME business remains attractive and with NAB looking to revive its franchise suggests that spreads in SME are likely to remain competitive. Our analysis of lending spreads suggests that the impact from institutional business should be negligible in FY16, while competition in SME lending is likely to take ~2bps off group margins. We have assumed a greater impact on NAB s margins since their SME book is a larger part of its overall mix and given NAB s recent efforts to revive this part of its franchise. Fig 2 Lending spreads Fig 21 AUD investment grade corporate bond spreads Jun-4 Dec-4 Jun- Dec- Jun-6 Dec-6 Jun-7 Dec-7 Jun-8 Dec-8 Jun-9 Dec-9 Jun-1 Dec-1 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-1 bps Small Business Large Business AA A BBB Source: RBA, Macquarie Research, January 216 Source: Bloomberg, Macquarie Research, January January 216 9

10 Increased competition in mortgages (-2bps) Mortgages remain a highly attractive product for the majors. Following the repricing initiatives in FY1, the majors were able to partially neutralise the impact of additional capital and mortgage remains a high ROE product. While the back book repricing is undeniably beneficial, it is worth noting that the front book competition continues to intensify (particularly in the owner occupied space). As the figure below highlights, the majors have gradually started losing market share in mortgages from their peak levels in 211. Furthermore, recent regulatory changes suggest that standardised banks are likely to compete more aggressively in this category. We expect bank returns in mortgages to continue to decline in the medium term as a result of this competitive tension. As we capture margin benefits from repricing separately, we expect mortgage competition to take ~2bps off banks margins in FY16, and on an aggregated basis, mortgage spreads to provide 3-9bps margin benefits. Fig 22 Major bank housing lending market share Fig 23 Mortgage discounts () 2 () 8 bps Nov 8 Nov 9 Nov 1 Nov 11 Nov 12 Nov 13 Nov 14 Nov Majors (RHS) Other (LHS) Other domestic (LHS) Jun-4 Jun- Jun-6 Jun-7 Jun-8 Jun-9 Jun-1 Jun-11 Jun-12 Jun-13 Jun-14 Jun-1 Source: APRA, Macquarie Research, January 216 Source: RBA, Macquarie Research, January January 216 1

11 Funding costs Pressure is emerging from the short end of the curve (-2bps) The short end of the curve has widened in recent months. The spread between three month Bank Bill rate and the Overnight Index Swap (OIS) increased by ~1bps in the last two months. While some of the increase could be attributed to seasonal factors, it appears that there are also some structural elements. Under the new LCR rules banks wholesale funding with less than one month maturity is required to be largely offset with liquids and hence isn t valuable to the issuer. This suggests that banks that are reliant on bank bills are essentially required to raise more paper to achieve the same funding task. In our view, this would arguably incentivise banks to offer wholesale deposit products with a 3-days redemption notification clause, which they are able to price at a more attractive spread (given diminished liquidity cost). Reduced demand for bank bills arguably drives up the price. While this in itself may not be detrimental to banks margins (as banks issue less of more expensive short term paper), on an aggregated basis banks short term wholesale funding costs continue to rise (including the cost of wholesale deposits with redemption clause and cost of wholesale funding, which has BBSW as a reference rate). Assuming the increase in pricing is structural and the spread normalises at ~2bps (relative to the long term average of ~1bps and current spread of ~3bps), we estimate this to have ~2bps impact on margins in FY16 (although there is an offset in deposit spreads and bills linked businesses). Given institutional and business lending is largely priced of bank bills rates, banks with more meaningful business lending portfolios should get a more meaningful offset to rising bills rates. Fig 24 3m BBSW to OIS spread (June YE) 6 bps Fig 2 3m BBSW to OIS spread (Sept YE) bps Note: Horizontal lines represent average spread in the half Source: IRESS, RBA, Macquarie Research, January 216 Note: Horizontal lines represent average spread in the half Source: IRESS, RBA, Macquarie Research, January 216 Deposit cost outlook not overly supportive (-2bps) While banks were able to largely fund their growth using deposits in a subdued volume growth environment, as credit growth picked up in the last 12 months, banks increasingly needed to rely on wholesale markets. As the figure below highlights, over the past 12 months, banks' lending growth grew in excess of core deposit growth (household and nonfinancial corporates) by ~$4-1bn. In 21, WBC had the largest deposit gap, which could explain its superior deposit performance. We expect WBC to focus more on its deposit gathering in FY16, which is likely to result in deposit spread pressures. 21 January

12 Fig 26 Banks funding gap Total funding gap Retail funding gap Retail + Business funding gap Growth in total deposits vs growth in GLA (A$bn) Growth in housing deposits vs growth in housing lending (A$bn) Growth in housing, bus.& personal deposits vs household & corp. lending (A$bn) 1m 3m 6m 12m 1m 3m 6m 12m 1m 3m 6m 12m ANZ 3 (3) (4) (1) (2) (4) (7) (13) 1 (2) (12) CBA (1) (6) (9) (1) (1) (1) () 1 () (2) (6) (7) NAB (2) (2) (7) (8) (2) (2) (2) (7) () 1 () (4) WBC () (12) (1) (27) (3) (2) () (7) (2) (4) (9) (1) BEN () 1 () BOQ () () () (1) (1) () (2) (2) SUN (1) (1) (1) (3) () (2) () () () MQG (6) (6) (7) (9) () () (1) () (7) (6) (6) (1) AMP () () () () () () (1) Total ADI (13) (33) (47) (6) (9) (1) (19) (34) (13) (31) (3) Source: APRA, Macquarie Research, January 216 Moreover, with wholesale funding costs tightening in recent periods and the regulator s increased focus on the quality of funding, we expect competition for deposits to intensify throughout FY16. This will likely put pressure on bank margins in FY16 and beyond. We note that current analysis of deposit spread changes is impacted by increases in wholesale funding costs discussed earlier. As the figure below highlights, the cost of term deposits (including special term deposits) continued to decline. However, while the earlier benefit to rates has been a result of lower deposit costs, in recent periods the reduction in spreads has been largely driven by an increase in the reference rate (ie. Bank Bills). This suggests that while deposit profitability is likely to improve, there is an offsetting cost to banks (discussed earlier). Fig 27 Term deposit spreads Fig 28 Special deposit spreads (-7M duration) 3 bps Feb-2 Nov-2 Aug-3 May-4 Feb- Nov- Aug-6 May-7 Feb-8 Nov-8 Aug-9 May-1 Feb-11 Nov-11 Aug-12 May-13 Feb-14 Nov-14 Aug BEN BOQ Special rate 3 month 1 year Average spread (Mar1-Sep1) Dec-1 Change Note: We have compare the current spread to the 3m average spread Source: RBA, IRESS, Macquarie Research, January 216 Note: Spreads are calculated as advertised special rates less three months bank bills rate. Source: IRESS, Company data, Macquarie Research, January 216 Conversely, competition for at call deposits appears to have intensified. While headline rates continued to decline, special offers increasingly favour bank customers. As the figure below highlights, the special online deposit rates generally increased from what were already attractive rates. All of the majors (excluding ANZ) currently offer a 1bps premium to the cash rate on their online deposits. While these offers are only available to new customers, it is generally reflective of the prevailing level of discretionary discounting. In our view, this should result in a twofold impact on banks. First, their deposit margins are likely to be impacted by ongoing pricing tension. Secondly, given the online rates are now materially better than term deposit rates, customers are more likely to switch to online deposits, suggesting a possible margin impact from the mix changes. In aggregate, we expect deposit costs to take off 1-4bps from FY16 margins across the majors. 21 January

13 Fig 29 Online deposit spreads Fig 3 Special offers for online deposit (spreads)..3.1 bps Dec-3 Sep-4 Jun- Mar-6 Dec-6 Sep-7 Jun-8 Mar-9 Dec-9 Sep-1 Jun-11 Mar-12 Dec-12 Sep-13 Jun-14 Mar-1 Dec BEN BOQ Average spread (Mar1-Sep1) Dec-1 Change Note: Spreads are calculated as one year swap rate less the advertised one year deposit rate. Source: RBA, IRESS, Macquarie Research, January 216 Note: Spreads are calculated as one year swap rate less the advertised one year deposit rate. Source: Company data, IRESS, Macquarie Research, January 216 Long-term wholesale funding costs appear to be bottoming out While funding costs were a forefront issue between 27 and 213, in more recent periods liability repricing turned into a tailwind for bank earnings. With an abundance of global liquidity, wholesale funding costs for highly rated Australian bank paper narrowed materially. In FY14 spreads on unsecured three-year paper narrowed to ~6bps, while spreads on secured paper narrowed to ~3-4bps. While the current level of funding spreads is above 214 levels, we don t see a material headwind from wholesale funding costs as banks continue to roll-off funding raised prior to 213. Albeit it is worth noting that the tailwind from wholesale funding costs improvement is also likely to diminish in FY16. Fig 31 Wholesale funding costs bps Jun-9 Jun-1 Jun-11 Jun-12 Jun-13 Jun-14 Jun-1 Snr Unsec Covered Bond Source: Bloomberg, Yieldbroker, Macquarie Research, January 216 Note: We have used the average traded price of two yr covered bonds issued by CBA and WBC Fig 32 Indicative long term wholesale funding costs bps margin to BBSW yr 2 yr 3 yr 4 yr yr 1H16f 2H1 2H14 2H13 2H12 Note: 1H16f is based on Macquarie s estimates. Previous periods are based on CBA s data Source: CBA, Macquarie Research, January 216 The cost of USD and GBP swaps has also narrowed over the past 12 months, albeit JPY swap costs remain very high. As the figure below highlights, Australian banks continue to largely rely on the Australian, USA and European markets for their wholesale funding requirements, with Australia representing around a third of their wholesale funding base. 21 January

14 Fig 33 Swap costs/basis spread (vs AUD) Fig 34 Australian banks debt by issued currency bps Dec-8 Apr-9 Aug-9 Dec-9 Apr-1 Aug-1 Dec-1 Apr-11 Aug-11 Dec-11 Apr-12 Aug-12 Dec-12 Apr-13 Aug-13 Dec-13 Apr-14 Aug-14 Dec-14 Apr-1 Aug-1 Dec-1 USD GBP EUR JPY H12 2H12 1H13 2H13 1H14 2H14 1H1 2H1 Australia/NZ USA Europe & UK Asia Other Source: Bloomberg, Macquarie Analysis Debt Markets, January 216 Source: Company data, Macquarie Research, January 216 Australian banks also continued to issue covered bonds at a relatively measured pace. As the figure below highlights, the utilisation of covered bonds is currently ~4 across the majors. Covered bonds are generally a cheaper source of funding and while it makes sense for banks to retain flexibility should funding conditions tighten, we see scope to replace some of the unsecured funding with covered bonds. It is also worth noting that while there is a P&L benefit of using covered bonds, there is an implicit balance sheet cost. Our estimates suggest that at capacity banks would utilise 1-2 of their outstanding mortgages on covered bonds. Combining this with internal securitisation suggests that 2-4 of Australian mortgages would be encumbered at full capacity. Fig 3 Australian Covered Bonds Fig 36 Covered Bonds relative to Australian mortgages $bn Issued (LHS) Capacity utilised (RHS) Capacity as of Aust. Mort. Issued as of Aust. mort. Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 Regulatory burden remains a longer-term headwind While banks have materially improved their funding profiles in the last years, we continue to expect ongoing competition for core deposits as banks pursue a more sustainable funding base (particularly should lending growth conditions improve). As the figures below highlight, banks core deposits composition improved from ~3 of their funding base in 27 to ~4 currently. Additionally, their reliance on short-term wholesale funding diminished (note the split between ST and LT wholesale funding doesn t account for term debt with less than one year maturity remaining). 21 January

15 Fig 37 Banks funding composition (Deposits) Fig 38 Banks funding composition Core deposits Other Deposits ST Wholesale LT Wholesale Equity Note: Core deposits are household and non-financial business deposits Source: ABS, Macquarie Research, January 216 Note: Term funding with maturity of less than one year is included in LT wholesale category Source: ABS, Macquarie Research, January 216 Across the majors, deposits now account for -63 of their funding bases. However, deposit mix varies materially. CBA has the highest proportion of retail deposits while NAB has a bigger share of domestic business/institutional deposits (NAB doesn t disclose the split). ANZ is most exposed to offshore institutional deposits, which are arguably less stable. We expect banks to increasingly focus on the higher quality deposits, which are generally more expensive, while lower quality deposits and short-term wholesale funding is likely to diminish over time as a proportion of the overall funding base. Fig 39 Major banks funding composition Fig 4 Deposit composition by business unit Aus/NZ deposits Offshore deposits ST LT Core tier one equity Retail Business Insto NZ APEA Insto APEA retail Other Source: Company data, Macquarie Research, January 216 Note: NAB business deposits include institutional Source: Company data, Macquarie Research, January 216 It is also worth noting that while wholesale funding conditions improved materially in the last few years, banks haven t utilised the opportunity to materially lengthen the duration of their funding bases nor increase the proportion of term debt. In hindsight, this may have been a forgone opportunity as the cost for wholesale funding started to rise from FY14 levels. Over time, we expect banks to increase their proportion of term funding relative to short-term funding and lengthen the duration of their term funding portfolio. 21 January 216 1

16 Fig 41 Weighted maturity profile of term funding Fig 42 ST funding to total wholesale debt Year FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY1 2 2H1 1H11 2H11 1H12 2H12 1H13 2H13 1H14 2H14 1H1 2H1 Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January January

17 Deteriorating credit quality outlook Impairment charges rose modestly in FY1 (excluding NAB), providing a small headwind to banks earnings growth. While in FY13 and FY14 impairment charges contributed ~2 to banks cash NPAT growth, higher BDD charges took ~1 off banks earnings in FY1. NAB was the exception with falling BDDs contributing ~1 to its FY1 earnings, which was predominantly driven by NAB s change in its accounting treatment for provisioning. Fig 43 Impairment expense Fig 44 Contribution to earnings growth from BDDs $m Sector (ex NAB) Sector (ex NAB) Source: Company data, Macquarie Research, January 216 Source: RBA, Company data, Macquarie Research, January 216 Although this trend suggests that banks have reduced their reliance on provision releases, we note that at ~41bps to non-housing loans, BDD charges remain ~4 below the through-thecycle average of ~7bps. This suggests that normalisation to mid-cycle levels takes ~ off banks earnings. While we don t expect BDD charges to revert to mid-cycle levels in the next two years, given the challenging economic conditions and reduced scope for ongoing material write-backs, we believe the risk from BDDs remains tilted to the downside. Moreover, following the sizable deterioration in commodity prices, we expect banks to increasingly provide for their commodities related direct and indirect exposures. Fig 4 BDD to Non Housing Loans through the cycle bps Fig 46 BDD charge to Non Housing Loans bps Majors Average Trough 1H12 2H12 1H13 2H13 1H14 2H14 1H1 2H1 Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 While improving credit quality (a significant reductions in impaired assets) justifies write-backs and recoveries, as banks work through their non-performing portfolios, the scope of ongoing write-backs diminishes. As the figure below highlights, the level of non-performing assets on the balance sheet has generally been a good guide for capacity of future write-backs. With the ongoing level of asset quality improvement observed over the last year, we expect to see further reductions in the level of write-backs over the next 24 months. 21 January

18 Fig 47 Impaired assets to Non Housing Loans Fig 48 Recoveries vs. gross non performing loans bps 3 $bn 7 $mn H12 2H12 1H13 2H13 1H14 2H14 1H1 2H1 Sector average impaired assets (1yr lagged) Sector average recoveries & write-backs (RHS) Source: Company data, Macquarie Research, January 216 Note: Sector average excludes NAB Source: Company data, Macquarie Research, January 216 Given the differences in disclosures of write-backs and recoveries, we compare individual banks recoveries to their own long-term history rather than to peers. As the figure below highlights, banks current level of write-backs and recoveries is above their long-term averages (NAB discloses write-backs differently to peers). We note that normalisation in the level of write-backs to long-term average rates would result in a 6-1bps uplift in banks BDD charges and would reduce bank earnings by 1-3. It is also worth noting that at the trough of the credit cycle, the level of write-backs and recoveries is 6-7 below normalised levels, although those periods are also often associated with very benign credit conditions. Fig 49 Impact of write-backs and recoveries normalisation on bank earnings $m FY1 recoveries and write-backs Recoveries and write-backs LT average (1 years) Implied BDD uplift from normalising recoveries BDD uplift to non housing loans (bps) Implied increase in FY1 BDD charge Impact on FY1 earnings Source: Company data, Macquarie Research, January 216 While improving credit quality arguably justifies write-backs and reductions in specific provisions, ongoing reductions in collective provisions are less clear cut. Should economic conditions remain challenging, we believe it will be increasingly difficult for banks to continue to run-off their collective provision coverage. As the figure below highlights, CP coverage fell again in FY1 by -1bps, providing an ~2 boost to earnings. 21 January

19 Fig Economic growth and unemployment rate Fig 1 Collective provisions to credit RWA bps Mar-8 Mar-82 Mar-84 Mar-86 Mar-88 Mar-9 Mar-92 Mar-94 Mar-96 Mar-98 Mar- Mar-2 Mar-4 Mar-6 Mar-8 Mar-1 Mar-12 Mar-14 Mar-16 4 Unemployment Real GDP growth (RHS) 1H12 2H12 1H13 2H13 1H14 2H14 1H1 2H1 Source: RBA, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 Fig 2 Impact of CP releases on BDDs and earnings Bps FY14 Collective provisions to Credit RWA FY1 Collective provisions to Credit RWA Implied BDD uplift to maintain CP coverage ($mn) na 224 Required BDD uplift to maintain coverage (bps) 6 14 na 11 Impact on FY1 BDD charge na 3 Impact on FY1 earnings 2 2 na 2 Source: Company data Macquarie Research, January 216 Near-term downside risk from resources related exposures In our view, the key near-term risk to credit quality is from deteriorating economic conditions and a material decline in commodity prices. As the figures below highlight, commodity prices have declined by ~33 since September 21 and the level of credit spreads spiked. As the viability of exposed companies is questioned, banks will be required to make provisions for their exposures. Should the current level of pricing be sustained, we expect a material increase in the level of defaults for exposures within this segment. Fig 3 Iron ore and oil prices Fig 4 Energy yield index A$ Iron Ore Brent Crude HY Energy HY Ex-Energy IG Energy Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January January

20 As the figure below highlights, banks each have a $1-2bn exposure to the resources and mining related sectors. Although this only represents 1.-2 of their overall books, in absolute terms elevated levels of losses are likely to be material. Based on our assumptions (outlined below), banks could experience $.-.8bn of direct losses on this part of their portfolio. While in absolute sense this number appears high, it is worth noting that our current forecast incorporates an $.7-1.1bn uplift in BDD charges in FY16 and FY17. This suggests that banks can largely accommodate additional losses on their direct commodities related exposures within our existing impairment forecasts, assuming losses within other parts of their portfolios remain contained. Fig Resource and mining related exposures Fig 6 BDD charge expectations vs potential losses $b $m Oil & Gas Mining services Iron Ore Coal Other of Group EAD (RHS) FY16 Increase FY17 Increase Potential Losses Note: We have excluded.9 of Energy exposures as these include electricity generation, distribution & supply and gas supply Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 The figure below outlines a potential loss scenario based on the stressed loss rate assumptions. We apply 1 probability of default to banks Oil & Gas and Iron Ore exposures and 3 loss rate on their Mining services exposures. We note that in the context of the overall portfolio, which includes exposure to high quality names, these probabilities of default are high. Our overall loss assumption of 4bps for Oil, Gas and Iron ore and 12 for Mining services is also high relative to the current level of losses across the mining and agriculture books of ~8bps and 7 year history of 44bps. We haven t taken additional provisions for banks coal exposures given the price trends in that space have been subdued for some time and we expect banks to have been providing for these exposures in the past. We also note that there is likely to be an indirect impact on banks portfolios (ie. service industries, etc), which we haven t quantified in this analysis. Fig 7 Mining/resources exposures and potential loss scenario Oil & Gas Iron Ore Mining services Coal Other Exposures ($b) ANZ CBA NAB WBC Assumptions: Probability of Default Loss Given Default Loss rate Potential Losses ($b) Total ANZ CBA NAB WBC Total Note: We have assumed ANZ s mining exposures were split evenly between iron ore and others as this split wasn t disclosed. We have also included CBA s resource ports and transport exposure in mining services. Source: Macquarie Research, January January 216 2

21 Key drivers of impairment charge forecasts While our analysis doesn't bode well for the BDDs outlook, we expect a gradual rise in impairment changes rather than a material spike in FY16. We believe the remaining pipeline of write-backs and recoveries will continue to provide a cushioning, albeit a diminishing, impact. Furthermore, spikes in impairment charges generally occur following a period of buoyant economic activity and strong credit growth. As the figures below highlight, business credit growth remained weak and credit standards were generally conservative between 21 and 213. Fig 8 Business credit growth Fig 9 BDD/NHL to yr rolling business credit growth bps Periods preceding spikes in BDDs Business Credit growth Growth in Bus. Credit/GDP BDD/NH Loans (LHS) Δ in Bus Credit Growth (yr rolling, 1 yr lagged) () Source: Company data, Macquarie Research, January 216 Source: RBA, Company data, Macquarie Research, January 216 Given banks reliance on the broader economy, we expect to see a correlation between economic trends and banks credit quality. As the figures below highlight, the relationship between credit quality and GDP growth as well as changes in the level of unemployment has been relatively strong. Based on the prevailing economic forecasts, it appears that credit quality should remain broadly stable in 216, albeit there are arguably downside risks to economic forecasts. Fig 6 BDD/NHL to real GDP Fig 61 BDD/NHL to change in unemployment rate bps bps BDD to NHL YoY GDP growth (RHS) BDD to NHL Unemployment rate change (RHS) Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 From a bottom-up perspective we look at both insolvency and bankruptcy rates as well as the overall level of gearing across households and businesses. Although insolvencies and company administrations data is generally a lagging indicator, it is a good gauge to the prevailing conditions. As the figures below highlight, the number of incorporated companies going into external administration, as well as the number of business related insolvencies, has generally been improving from 21. In 21 the level of administrations and insolvencies started to rise, albeit in absolute terms, numbers remain relatively low. 21 January

22 Fig 62 Companies entering administration (monthly) Fig 63 Business related bankruptcies (quarterly) # 1,2 1, Food /accom Agri Construction 1,8 1,7 1,6 1, 1,4 1,3 1,2 1,1 1, Energy/water Media/Telco Manufacturing Mining Other services Rental services Dec-4 Jun- Dec- Jun-6 Dec-6 Jun-7 Dec-7 Jun-8 Dec-8 Jun-9 Dec-9 Jun-1 Dec-1 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-1 Trade Transport/storage Other/Unknown Business-related bankruptcy YoY change Source: Company data, Macquarie Research, January 216 Source: RBA, Company data, Macquarie Research, January 216 Drilling down into the individual states and industries, it appears that deterioration is relatively broad based with WA, NT and QLD more impacted (arguably as a result of greater exposure to mining). Similarly, the deterioration in credit quality appears to impact most industry groups, rather than being contained to the mining sector as it was 12 months ago. This suggests that a slowdown in the mining sector is having a broader base impact, although it s worth noting that the overall number of insolvencies remains low. Fig 64 Change in administrations by state Fig 6 Change in administrations by industry NSW VIC QLD SA WA TAS NT ACT AUS 3m 6m 12m Source: Company data, Macquarie Research, January 216 Note: Calculations are based on 3m rolling average 3m 6m 12m Source: RBA, Company data, Macquarie Research, January 216 Note: Calculations are based on 3m rolling average The figure below provides a snapshot of banks industry lending breakdown. Agricultural and mining exposures account for 3- of total exposures, albeit we understand agricultural exposures tend to dominate these figures. Across the majors, ANZ appears more exposed to the mining sector, showing the strongest level of growth in its book in FY January

23 Fig 66 Banks industry exposures of total exposures YoY change Mortgages Other Personal Agri & Mining Business Services Construction Energy/Utilities Entertainment Financials & Insurance Government Manufacturing Property Services Trade Transport Other Total Source: Company data, Macquarie Research, January 216 The low level of interest rates and modest gearing levels are ultimately supportive for the credit quality outlook. As the figures below highlight, the level of gearing within the listed corporate space remains relatively low. Combining this with record low levels of interest rates leaves corporate ability to service their debt at a healthy level. As a result we expect FY16 credit quality problems to be driven by specific issues or industries rather than a broad based credit quality deterioration across the entire book. Fig 67 ratios BDD expense vs listed corporate gearing Fig 68 Listed and Unlisted corporations debt servicing ratios bps F BDD expense Gearing (1yr lagged) All businesses Listed corps Unincorp bus. Source: Company data, RBA, Macquarie Research, January 216 Source: Company data, RBA, Macquarie Research, January 216 On the retail lending side, while households continued to borrow throughout the downturn, their balance sheets have been boosted by the recent increases in house prices and the significant reductions in the level of interest rates. Based on the current interest rate of 2, household interest payments to disposable income in aggregate terms is ~ below the 2 year average. Although we recognise that focusing on averages could be misleading, overlaying this data with the declining personal bankruptcy rates, gives us near-term comfort with respect to credit outlook in the retail space. 21 January

24 Fig 69 Interest payments to disposable income Fig 7 Personal bankruptcy rates Mar-77 Nov-78 Jul-8 Mar-82 Nov-83 Jul-8 Mar-87 Nov-88 Jul-9 Mar-92 Nov-93 Jul-9 Mar-97 Nov-98 Jul- Mar-2 Nov-3 Jul- Mar-7 Nov-8 Jul-1 Mar-12 Nov-13 bps Housing debt Household debt # of bankruptcies/population YoY growth (RHS) Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 Normalised level of BDDs We expect BDD charges to revert to more normal levels over the medium term and we use a normalised level of BDDs for our bank valuation purposes. The figure below provides a snapshot of the lending book exposures across the majors. Assuming a long-term loss rate for each portfolio, we derive a normalised BDD charge on both the GLA and NHL basis (summarised in the bottom two rows). Fig 71 Lending book split () and implied long-term loss rates Australia Housing Consumer Business Margin lending Institutional NZ Housing Consumer Business Institutional Offshore Housing Non Housing Implied LT BDD charge to GLA (bps) Implied LT BDD charge to NHL (bps) Source: Macquarie Research, January 216 Note: Assumed loss rates for Housing bps; Consumer 1bps; Business 6bps; Margin Lending bps and Institutional bps. We assumed higher loss rates for offshore exposures 21 January

25 Sensitivity to bank earnings from stressed impairment charges Although we don t see this as a likely scenario, in the figure below we provide sensitivity analysis to the rising BDD charges in FY16. Should BDD charges return to the 28 peak level of 17bps to non housing loans, this would imply an earnings reduction for CBA and WBC of ~2 and an ~3 reduction in earnings for ANZ and NAB. Should write-off levels reach the 1991 peak level, this would imply a 4-6 reduction to earnings. While these numbers are clearly disastrous for banks share-prices, we note that even in the highly unlikely event of an early 9s level of losses, banks continue to be profitable. Fig 72 Impact on FY16 earnings from differing levels of BDD charges Impairment Sensitivity FY16f earnings FY16f NHL FY16f BDD charge ANZ 7, ,86 1, CBA 9,6 233,74 1, NAB 6,878 2,63 1, WBC 8,43 226, Note: WBC BDD expense is grossed up for charges taken through revenue line Source: Macquarie Research, January January 216 2

26 Attractive valuations... but need to be brave While the Australian banking sector had a challenging six months (~1 reduction in valuations), in a relative sense underperformance has been muted. Moreover, within the global context, Australian banks absolute performance was largely consistent with offshore peers and in relative terms Australian banks outperformed most jurisdictions, with Canada being the only exception. Fig 73 Bank absolute total performance Fig 74 Banks relative total performance Index AU Banks US Banks Australia US Asia ex Japan Banks Europe Banks Asia ex Japan Europe Canada Banks Canada Source: Factset, Macquarie Research, January 216 Source: Factset, Macquarie Research, January 216 Absolute PE in line with long term but relative PE highlights value On an absolute prospective PE basis, the bank sector appears fair valued; at 11.x it is trading broadly in line with its long-term average of ~12x. However, at current levels bank multiples are at their lowest levels since 212. On a relative basis the sector is trading at just.72x relative to All Industrials, which is in-line with its long-term average (since 1992) and ~1 below the 1 year average. Fig 7 Average 1 year forward PE of the majors Fig 76 Bank prospective PE rel to All Industrials (ex banks) x Jan-96 Dec-96 Nov-97 Oct-98 Sep-99 Aug- Jul-1 Jun-2 May-3 Apr-4 Mar- Feb-6 Jan-7 Dec-7 Nov-8 Oct-9 Sep-1 Aug-11 Jul-12 Jun-13 May-14 Apr Jan-4 Aug-4 Mar- Oct- May-6 Dec-6 Jul-7 Feb-8 Sep-8 Apr-9 Nov-9 Jun-1 Jan-11 Aug-11 Mar-12 Oct-12 May-13 Dec-13 Jul-14 Feb-1 Sep-1 Avg Majors 1yr fwd PE LT average Bank PE rel LT average yr average Source: Factset, Macquarie Research, January 216 Source: Factset, Macquarie Research, January 216 The quantum of the recent sector de-rating is somewhat masked by the relative outperformance of retail overweight banks. We note that the PE relative premium of CBA and WBC relative to ANZ and NAB has reached ~32, which is the highest level in the last 2 years. Such divergence within the sector was last observed in July/August 28 when CBA/WBC traded at ~3 discount to ANZ/NAB. We note that subsequently to July 28, ANZ outperformed peers by ~1 and NAB by ~ in the following six months. 21 January

27 Fig 77 Retail banks PE rel to business banks Fig 78 Relative share price performance following August 28 de-rating CBA/WBC PE Rel to ANZ/NAB LT average -1 yr average Maximum 3M 6M 12M Note: Retail banks are CBA and WBC; Business banks are ANZ and NAB Source: IRESS, Macquarie Research, January 216 Note: Relative share price performance to the average of three peers Source: IRESS, Macquarie Research, January 216 Given investors increasing focus on yields, we find it useful to compare banks to high yielding industrials (aggregate of telecommunication, utilities, transport, staples and REITs). Relative to these stocks, banks are trading at an ~26 discount vs the long-term discount of ~1 and the 1-year discount of ~19. On this basis banks are ~-1 undervalued relative to high yield industrials. Fig 79 Banks to high yielding industrials Fig 8 Banks PE rel to high yielding industrials x Jan-4 Aug-4 Mar- Oct- May-6 Dec-6 Jul-7 Feb-8 Sep-8 Apr-9 Nov-9 Jun-1 Jan-11 Aug-11 Mar-12 Oct-12 May-13 Dec-13 Jul-14 Feb-1 Sep-1 Avg Majors High Yield Industrials Jan-4 Aug-4 Mar- Oct- May-6 Dec-6 Jul-7 Feb-8 Sep-8 Apr-9 Nov-9 Jun-1 Jan-11 Aug-11 Mar-12 Oct-12 May-13 Dec-13 Jul-14 Feb-1 Sep-1 Banks PE rel to High Y LT average yr average Source: Factset, Macquarie Research, January 216 Source: Factset, Macquarie Research, January 216 Dividend yield attraction remains particularly relative to bonds Banks current dividend yield of ~6. is largely in-line with the sector s five year average and above the long-term average yield of ~.8. We note that prior to the GFC, the bank sector average yield was ~. On a relative basis to the industrials, the banks yield premium has widened to ~1., which is well above the long-term average of ~1 premium. 21 January

28 Fig 81 Banks sector dividend yield Fig 82 Bank sector yield less All Industrials (ex banks) Majors Div Yield Long term year av. Spread Long term year av. Source: Factset, Macquarie Research, January 216 Source: Factset, Macquarie Research, January 216 Banks real valuation advantage is relative to bond yields. On a grossed-up basis, banks offer a 6. premium vs ~3.24 LT average. This is also reinforced by the historical relationship between banks' relative performance and bond yields. As the figure below highlights, current valuations appear relatively attractive relative to prevailing bond yields. Fig 83 Banks prospective yield (grossed up) minus ten year bond yield Fig 84 Bank relative performance vs 1yr bond yield Index Spread to 1Y (gross) Long term year av. Bank Index performance vs All Ords (LHS) 1-year bond yield (inverted RHS) Source: Factset, Macquarie Research, January 216 Source: IRESS, Macquarie Research, January 216 Not surprisingly, this yield attractiveness should appeal to retail investors. On a grossed-up basis, banks offer an ~.8 yield premium to prevailing special deposit rates. This compares to a five-year average of a 4.6 premium and long-term average of January

29 Fig 8 Bank yields vs special deposit rates Fig 86 Grossed up bank yields vs special deposits Special Deposit Rates Majors Div Yield Spread Long term average year average Source: Factset, Macquarie Research, January 216 Source: Factset, Macquarie Research, January 216 Fig 87 Australian banks valuation summary Current (x) LT average (x) 1yr average (x) LT Discount/ 1yr Discount/ premium () premium () Absolute Banks forward PE Banks dividend yield Relative Banks PE rel to All Ind ex Banks Banks yield less All Ind ex Banks Banks gross div less 1yr bond rate Source: Macquarie Research, January January

30 Returns and dividend sustainability How sustainable are the yields? Dividend attractiveness is only justifiable if dividends can be sustained. Although a material reduction in bank earnings (ie. substantial deterioration in the credit cycle) would result in a dividend cut, we believe banks should largely be able to maintain their dividends. Albeit their ability to grow dividends is low as over time payout ratios will need to be adjusted downwards (a result of dividend growth lagging earnings growth). In our view, NAB s dividend is most at risk and we have assumed a more normal payout ratio for NAB in our forecasts, which resulted in a dividend cut. The figure below highlights, on a proforma basis, banks core tier one capital ratios adjusted for various known movements in capital. We estimate that the sector s current core tier one ratio is ~9. Fig 88 Proforma core tier one capital FY1 RWA 41, ,91 399,78 38,8 Additional weightings on mortgages from 2H16 24,467 43,23 33,876 44,963 Proforma RWA 426,44 411, ,634 43,43 FY1 core tier one capital 38,26 33,398 4,937 34,69 Capital raisings since balance date,17 3,497 Proforma core tier one capital 38,26 38,41 4,937 37,66 Proforma core tier one ratio Corporate activity Divestments (Esanda/MLC).2. NAB estimated impact from demerger* -. Implied proforma core tier one WM instruments (FY16-FY18) Implied proforma core tier one post WM *Note: NAB s impact of demerger is based on NAB s disclosure Source: Company data, Macquarie Research, January 216 Our capital modelling scenario analysis in the figure below incorporates a relatively conservative approach to potential further changes to capital. We expect RWA on mortgages to increase by a further ~ from the ~2 level announced and implemented by APRA in 21; Although APRA s treatment for non-housing related exposures is arguably already more conservative, implementation of new framework is likely to result in RWA increases relating to the non-housing part of the book. While estimating the impact of these changes is inherently difficult (given lack of granular disclosure), for illustrative purposes we assume that RWA is likely to increase by ~$1bn for each one of the majors; We assume that core tier one capital ratios will settle at ~9. by FY18 (with a risk of settling at ~1 by 22); Risk weighted asset growth (balance sheet growth) remains one of the key drivers for the additional capital requirements over the next three years, with ~6 p.a. in our numbers; and We have assumed constant DRP participation of 2 for each of the majors (this can be managed through the use of discounts). Based on our inputs, the retail banks current capital positions appear broadly adequate, with the business banks a little short. We expect the banks to continue to run discounted DRP programmes, targeting a participation ratio of 2-3 in order to meet their capital requirements, depending on the level of balance sheet growth. 21 January 216 3

31 Fig 89 Core tier one capital position and potential capital shortfall by FY18 Future capital considerations Additional RWA on mortgages 11,6 19,19 12,98 18,139 Additional RWA on non-mortgage risk weights 1, 1, 1, 1, Balance sheet growth FY1-FY18 8,331 74,171 74,69 81,9 FY18 implied RWA 33,29 19,624 48,789 17,772 Required capital ratio Implied capital requirement,663 49,364 4,67 49,188 Current proforma capital 38,92 36,13 3,37 37,66 Capital generated through organic earnings 6,791 7,171 4,843 6,423 Capital generated through disc. DRP (3) 4,139,781 4,1 4,888 Implied capital shortfall , Source: Factset, Company data, Macquarie Research, January 216 We expect to see normalisation within the regulatory regime requirements by FY18 and hence our sustainable payout ratio analysis is built on the basis that capital ratios will level out at Within that setting, the key component to ongoing divided sustainability for banks is around their growth aspirations and DRP usage. Given the elevated level of gearing within the housing sector, we expect credit growth for the majors to run at ~6 from FY18 and beyond (ie. broadly in-line with nominal GDP). We expect Australian banks to continue to offer DRP programmes. While dilutive, DRPs offer banks an efficient mechanism of transferring franking credits to their domestic shareholders. We expect banks to remove DRP discounts and participation ratios should settle at ~1. We have normalised FY18 consensus earnings for the through-the-cycle BDD charge of ~77bps to non-housing loans. Based on this analysis, we estimate that current payout ratios across the sector (excluding NAB) are largely sustainable and 1-2 overstated should banks decide to fully neutralise their DRPs. As a result, we expect banks to look to maintain their current dividends unless their growth rates materially exceed nominal GDP or franking credits become a constraining factor. Following NAB s decision to divest its insurance business, its FY1 dividend payout ratio appears high. We have reduced NAB s divided to its sustainable payout ratio in FY16 and beyond. Fig 9 Bank dividend sustainability on steady state basis from FY18 FY18 Cash earnings 8,132 1,2 7,19 8,974 RoIC Normalised RoIC for BDDs Balance sheet growth Implied sustainable payout ratio Implied sustainable payout ratio with ongoing DRP (1 part. rate) FY16 payout ratio Dividend downside risk assuming no DRP Dividend downside risk with DRP Current Dividend Yield Implied yield at sustainable payout ratio Source: Factset, Company data, Macquarie Research, January January

32 Our dividend sustainability sensitivity analysis tests against possible core tier one requirements and RWA growth parameters. As the figure below highlights, balance sheet growth is in fact a more important driver for dividend sustainability. We note that banks payout ratios are 2-3 overstated under the 9 credit growth and 1 core tier one scenario. This suggests that banks are going to find it increasingly challenging to grow balance sheets well above the nominal GDP level and maintain their dividends. Fig 91 Sustainable payout ratio sensitivities to growth and CET1 requirements from FY18 with 1 DRP participation ANZ sustainable payout ratio CBA sustainable payout ratio NAB sustainable payout ratio WBC sustainable payout ratio Source: Macquarie Research, January January

33 Volume growth outlook Credit growth continued to improve in FY1 underpinned by buoyant growth in investor housing lending and stronger growth in business loans. While business credit growth continued showing signs of improvement, it appears that it s driven by larger end institutional lending, which is not as profitable for Australian banks. While we see scope for a mediumterm recovery in business credit growth, particularly given favourable interest rate conditions, it appears that businesses are reluctant to borrow given the broader macro concerns. We see downside risk to credit growth in FY16 as housing growth slows. Fig 92 3m rolling annualised credit growth () (1) (1) (2) Jan- Jan-3 Jan-6 Jan-9 Jan-12 Jan-1 Source: RBA, Macquarie Research, January 216 Total Housing Business Housing credit outlook slowing Housing credit growth has been underpinned by strong demand from investors, the buoyant property market and robust turnover rates. In large part, those trends appear to be unwinding going into FY16, suggesting that housing credit growth is likely to moderate in FY16 and beyond. More restrictive lending criteria in the investment segment following regulatory intervention ultimately resulted in a reduction in the investor segment growth rate while underlying owner occupied housing growth (ie. excluding the effect of switching) remained benign. Fig 93 YoY housing credit growth Fig 94 Growth in housing approvals Jan- Jan-3 Jan-6 Jan-9 Jan-12 Jan Jan-199 Apr-1991 Jul-1992 Oct-1993 Jan-199 Apr-1996 Jul-1997 Oct-1998 Jan-2 Apr-21 Jul-22 Oct-23 Jan-2 Apr-26 Jul-27 Oct-28 Jan-21 Apr-211 Jul-212 Oct-213 Jan-21 Owner-occupier Investor Investor limit Owner-occupier Investor Note: Growth rate was derived using RBA s monthly growth figures, which normalise for the impact of recent switching between investor and owneroccupier loans Source: RBA, Macquarie Research, January 216 Note: YoY growth in the 3m rolling average of the $-value of approvals Source: ABS, Macquarie Research, January January

34 A slowdown in investor demand has also resulted in the slowing property price appreciation and a material reduction in clearance rates. With a risk of property price declines in 216 (Macquarie s economics team is currently forecasting an ~ decline in property prices in 216 and a further 2. decline by March 217), there is downside risk for growth in demand for new credit. Fig 9 Auction clearance rates and turnover Fig 96 Growth in house prices vs credit growth # 36, 34, 32, 3, 28, 26, 24, 22, 2, Jun-3 Feb-4 Oct-4 Jun- Feb-6 Oct-6 Jun-7 Feb-8 Oct-8 Jun-9 Feb-1 Oct-1 Jun-11 Feb-12 Oct-12 Jun-13 Feb-14 Oct-14 Jun-1 Turnover Clearance Rates (RHS) Jan-94 Jan-9 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan- Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-12 Jan-13 Jan-14 Jan-1 Jan-16 YoY Credit Growth YoY Price Growth (3m lagged) Note: Calculations are an aggregate of Sydney, Melbourne, Brisbane, Adelaide and Perth Source: APM, Macquarie Research, January 216 Source: APM, RBA, Macquarie Research, January 216 While demand for new credit is likely to fall, repayment rates should remain at elevated levels in an environment of low interest rates. As the figure below highlights, we believe the level of repayments has increased in recent periods driven by the prevailing low interest rate environment. This creates downside risk for system volume growth in FY16 and FY17. This, coupled with ongoing market share losses, suggests a challenging outlook for housing credit for the majors. We expect the majors to grow housing books by ~ in FY16 and ~4 in FY17, while the regionals should deliver 1-2 additional growth in this part of the book as they regain share. Fig 97 Major bank housing lending market share Fig 98 Monthly repayments vs cash rate () 2 16 () Nov 8 Nov 9 Nov 1 Nov 11 Nov 12 Nov 13 Nov 14 Nov 1. 8 Majors (RHS) Other (LHS) Other domestic (LHS) Monthly repayments (approvals less growth) Cash rate Source: APRA, Macquarie Research, January 216 Source: ABS, RBA, Macquarie Research, January January

35 Business credit growth outlook likely to remain benign While both the banks and the market have been looking for a rebound in business credit for some time, the improvement has been stubbornly slow. While we see scope for business growth recovery in the medium term, particularly given the favourable interest rate environment, it appears that businesses are reluctant to materially increase their borrowings given the broader macro concerns. As the figures below highlight, both economic growth expectations as well as business sentiment remains weak. Fig 99 GDP vs credit growth Fig 1 Business sentiment & capex vs credit growth Jan-8 Sep-81 May-83 Jan-8 Sep-86 May-88 Jan-9 Sep-91 May-93 Jan-9 Sep-96 May-98 Jan- Sep-1 May-3 Jan- Sep-6 May-8 Jan-1 Sep-11 May-13 Jan-1 GDP growth (nominal) Bus credit growth Source: ABS, RBA, Macquarie Research, January / Index Jan-9 Mar-91 May-92 Jul-93 Sep-94 Nov-9 Jan-97 Mar-98 May-99 Jul- Sep-1 Nov-2 Jan-4 Mar- May-6 Jul-7 Sep-8 Nov-9 Jan-11 Mar-12 May-13 Jul-14 Sep-1 Bus credit growth Bus sentiment (12m lagged) Capex growth (12m lagged) Source: RBA, NAB, Melbourne Institute, Macquarie Research, January 216 In addition, as the figures below show, business credit has generally responded well to improving profitability trends for businesses and corporates. With a weak business earnings outlook and lack of material investment initiatives, it's difficult to see fundamental reasons for business credit to rebound in FY16. We note a potential area of growth is arguably from ongoing strength in M&A activity and if businesses change their long-term assumptions around interest rates and sustainable level of gearing (arguably with lower cost of funding, additional gearing may be justified for stable businesses). Fig 11 Business profits and credit index Fig 12 Credit growth by sector Index Dec- Sep-1 Jun-2 Mar-3 Dec-3 Sep-4 Jun- Mar-6 Dec-6 Sep-7 Jun-8 Mar-9 Dec-9 Sep-1 Jun-11 Mar-12 Dec-12 Sep-13 Jun-14 Mar-1 Dec-1 Comp gross profit Un-incorp gross profit Bus credit Macq. Estimate (comp gp) YoY growth 3yr CAGR Source: ABS, RBA, Macquarie Research, January 216 Source: RBA, Macquarie Research, January 216 Turning to gearing and debt servicing ratios suggests that there is capacity to increase debt from current levels for the listed companies. However the gearing level for all businesses appears to remain at higher levels relative to the period between 1997 and 2. While businesses capacity to survive this debt is materially higher due to the low level of interest rates, we believe business would be looking for an improvement in macroeconomic conditions to get the confidence to take on more debt. 21 January 216 3

36 Fig 13 Gearing ratios (all businesses and listed) Fig 14 Listed and Unlisted corporations debt servicing ratios Index () Private non-financial corporations Listed companies All businesses Listed corps Unincorp bus. Note: Private non-financial corporations level of gearing is defined as debt to equity ratio, adjusted for price changes ( Sep 199 base). For listed companies gearing ratios are calculated as book value of debt to equity Source: ABS, Macquarie Research, January 216 Source: RBA, Macquarie Research, January 216 As the figures below highlight, the majors delivered -12 growth in business lending. However, this appears to be weighted towards lower margins institutional lending. Looking at the split between the categories suggests that business and corporate lending grew by 4-8, while growth in the institutional segment was Fig 1 FY1 lending growth across key categories Fig 16 growth FY1 business vs Institutional volume ANZ CBA WBC Housing Business Personal Business Insto Source: APRA, Macquarie Research, January 216 Note: We have only used Australian institutional loans for ANZ Source: Company data, Macquarie Research, January 216 Similar to housing lending, after a period of market share gain between 28 and 212, the majors market share in business lending declined. Japanese and Chinese banks were largely responsible for taking market share over the last three years. Although a material deterioration in the credit cycle is likely to slow aspirations from these players, in the absence of significant loan losses we expect them to continue to see the Australian market as attractive. 21 January

37 Fig 17 banks) Business lending market shares (Australian Fig 18 banks) Business lending market shares (foreign () 1 () 78 () Nov 8 Nov 9 Nov 1 Nov 11 Nov 12 Nov 13 Nov 14 Nov 1 Majors (RNS) Other domestic (LHS) Nov 8 Nov 9 Nov 1 Nov 11 Nov 12 Nov 13 Nov 14 Nov 1 European Banks Asian Banks Japanese Banks US Banks Source: APRA, Macquarie Research, January 216 Source: APRA, Macquarie Research, January January

38 Expenses outlook Following a period of significant efficiency improvements between 199 and 29, banks' expense-to-income ratios have remained broadly flat. This was largely a result of the majors ongoing investment despite the slower revenue environment (arguably a result of underinvestment in earlier years). While we continue to believe banks have more scope to reduce inefficiencies and lower their costs-to-income ratios over the longer term, in the near term we believe it s unlikely. In our view, medium-term expense growth will be impacted by banks need to continue to invest in productivity initiatives and technology. Furthermore, cost pressures are likely to crystallise from higher amortisation expenses. Our analysis highlights that current reported cash costs underestimate the full nature of banks investment spends and additional cost of amortisation combined with more conservative recognition of cost will add 1-2 to banks cost growth. Fig 19 Sector expense to income ratio Fig 11 Sector expense to GLA ratio FY9 FY96 FY97 FY98 FY99 FY FY1 FY2 FY3 FY4 FY FY6 FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY1 1 FY9 FY96 FY97 FY98 FY99 FY FY1 FY2 FY3 FY4 FY FY6 FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY1 Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 On an underlying adjusted basis (excluding the impact of FX and acquisitions/divestments), banks expense growth has hovered at around 3-4pa. Over the last three years banks have delivered cost growth of ~3pa, while over the seven year period expense growth was ~4 pa across the sector. We note the following trends from the figures below: CBA and WBC delivered broadly consistent expense growth over the period (4- CAGR). ANZ s average growth rate of ~6.4pa was impacted by the period when expenses grew by ~9 pa as ANZ aggressively pursued its Asian expansion strategy. In more recent periods, ANZ s expense growth was more controlled. NAB s expense performance was sector leading over the last -7 years, which provided support to its earnings in a slow revenue growth environment. We estimate NAB achieved ~2pa underlying expense growth over that period. While at face value this was a positive outcome, and was partly a reflection of NAB s cost base being elevated relative to peers, we note that low expense growth could potentially also be a sign of underinvestment (relative to peers). We believe there is some evidence of both of these drivers in NAB s cost performance, which we expect to continue to unwind in FY January

39 Fig 111 Expense growth (ex one-offs and FX) Fig 112 Expense index (implied from annual growth) FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY1 Index FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY1 Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 As the figures below highlight, between 28 and 212 banks have reported material noncash expenses and significantly increased their capitalised balances in order to contain cost growth. Although in more recent periods banks have reduced reliance on non-cash expenses, between FY8 and FY12 non-cash expenses accounted for of banks overall expense bases with ANZ and NAB being more aggressive than peers. Similarly, in the last five years, banks capitalised balances (ex write-offs) increased by ~1 across the majors. Fig 113 Below the line adjustments ( of expenses) Fig 114 Capitalised software balances $m 12 3, , 2, 2, 2,893 2,89 2,6 1,64 4 1, 2 1, -2 FY8 FY9 FY1 FY11 FY12 FY13 FY14 FY1 - FY1 FY11 FY12 FY13 FY14 FY1 Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 Moreover, a sharp increase in capitalised balances appears somewhat understated as a result of impairment charges that banks have recognised in that period. While some impairments to capitalised software were taken above the line, we note that between 27 and 21, $-m of software write-downs have been reported below the line. ANZ and WBC appear to be more aggressive than peers in taking impairment to capitalised software balances below the line. Adjusting for below the line impairments, between FY1 and FY1 capitalised expenses for the major increased by 162 (ANZ), 18 (CBA), 27 (NAB) and 132 (WBC). 21 January

40 Fig 11 Capitalised software impairments (27-21) Fig 116 Capitalised software balances adjusted for write-offs $m $m 3, 3, 2, 3,189 2,196 2,96 2,293 2, 4 1, , - Total written-off (27-1) Written-off below the line - FY1 FY11 FY12 FY13 FY14 FY1 Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 While the growth in capitalised balances has led to higher amortisation expenses (up 84 between FY1-FY1), we note that this increase hasn t been consistent across the majors. NAB appears to be an outlier with the average amortisation period increasing to 6.6 years from 3. years five years ago. This implies that NAB has a more aggressive capitalisation policy, while WBC has the most conservative recognition schedule. Although NAB s longer amortisation schedule is arguably justifiable by the scope of its core upgrade programme (note CBA s average amortisation period peaked at 7.1 years in FY13), it does put ongoing pressure on NAB s future expense growth. Fig 117 Average amortisation period Fig 118 P&L software amortisation expense yrs FY1 FY11 FY12 FY13 FY14 FY1 - FY1 FY11 FY12 FY13 FY14 FY1 Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 Looking specifically at the investment spend figures, it's worth noting upfront that banks disclosure is not fully comparable and somewhat opaque. However, based on the information provided we draw the following conclusions: Investment spend (in terms of the overall amount) has been broadly consistent across the banks ($1.-1.4b per year); Over the last three years, ANZ reduced its spend by ~3 from a sector leading position to being a sector laggard. NAB increased the overall amount by ~$1m per year in the last two years. CBA and WBC have largely maintained their investment spend profiles, although WBC has announced a $2m p.a. increase from 21; While overall investment spend is over $1b for each of the majors, the expensed amount is materially below that figure ($28-76m); 21 January 216 4

41 P&L expensed portion of the investment spend has fallen materially for ANZ and increased for CBA and WBC, although WBC s recent changes may have been impacted by changes to its capitalised balances in FY1; and NAB doesn t disclose the split between expensed and capitalised amounts, and hence comparisons are difficult. Fig 119 Investment spend Fig 12 Proportion of investment spend capitalised $b FY11 FY12 FY13 FY14 FY1 4 FY1 FY11 FY12 FY13 FY14 FY1 ANZ CBA WBC Source: Company data, Macquarie Research, January 216 Source: Company data, Macquarie Research, January 216 While we recognise the business rationale in capitalising costs, particularly related to infrastructure related spending, we expect additional cost pressure for the banks as amortisation charges increase in the future (assuming banks don t write-off their capitalised balances). In that regard we believe the current P&L expense underestimates the full extent of banks cash investment. Moreover, this is amplified by the high capitalisation rates. The figure below summarises the difference between cash investment spend and the estimated P&L charge. We estimate that banks expenses are understated by $1-m, translating to a 1- reduction to major banks cash earnings. It is also worth noting that CBA has largely completed its core upgrade project and its P&L expense is the highest amongst peers. In addition, looking at the investment spend breakdown, it appears NAB s investment in its core systems is reducing its ability to invest in productivity initiatives. However, we note there are definitional differences and some of NAB s infrastructure expenses would be equivalent to productivity allocation across its peers. Fig 121 Investment spend table Total Investment Spend 997 1,246 1,38 1,2 Investment Spend Expensed Software amortisation expense Total expense through P&L Required investment 1,3 1, 1,2 1,3 Implied shortfall (assuming $1.2bn average requirement) Implied downside to FY16f earnings Investment spend breakdown: Productivity and Growth Risk and Compliance Infrastructure 1 Branches Source: Macquarie Research, January January

42 Regulation issues Regulatory pressures had a material impact on the sector s performance in 21. In aggregate the majors raised ~$2bn of new equity. While additional capital requirements were well anticipated by the market, the timing took the market by surprise. APRA s accelerated approach in raising risk weights on mortgages ahead of Basel announcements was not well anticipated by both the banks and the market. Since then, the tone around additional capital requirements from the regulator has arguably moderated. It appears that while the regulator is of the view that additional capital is needed to achieve unquestionably strong status, recent capital raising initiatives combined with the conservative capital settings should allow the banks to meet ongoing capital build-up. Our central case around capital is underpinned by the following assumptions: Measured capital accumulation with reduced payout ratios, discounted DRPs and subdued balance sheet growth; and Ongoing build-up of other forms of capital (ie. tier one, tier two and TLAC instruments). In our view, the key risk to our thesis is from one of the banks rushing to raise equity ahead of requirements. An environment of uncertainty creates a classical prisoner s dilemma situation, where there is a risk of one or two players raising equity early and hence pushing others to raise capital ahead of the required timeframe. While the share prices are depressed, we believe this risk is diminished, yet ongoing uncertainty around capital requirements will weigh on banks share prices in the medium term. Basel and APRA to remain busy in but is it time to consolidate? A recent press release from the Basel Committee coupled with comments from regulators suggests that perhaps there is light emerging at the end of the regulatory tunnel. In January 216 the Basel Committee announced that it would complete its work to address the problem of excessive variability in risk-weighted assets by the end of 216. The key take away in our view was that...the Committee will focus on not significantly increasing overall capital requirements. This follows recent comments made by FSB Chairman Mark Carney that there is no Basel IV... There is no big wave of additional capital. This programme will include the following elements: consultation on the removal of internal model approaches for certain risks (such as the removal of the Advanced Measurement Approach for operational risk); and consultation on setting additional constraints on the use of internal model approaches for credit risk, in particular through the use of floors. The Group of Central Bank Governors and Heads of Supervision will then review the Committee s proposals on the risk-weighted framework and the design and calibration of capital floors towards the end of 216. In December, the Basel Committee released their latest revision to standardised risk weights, which arguably left the market with many unanswered questions. In our view, the key aspects of further regulatory changes are likely going to be centred on the mortgage floors for the advance banks. Non-mortgage risk weights Basel initially proposed an approach that removed all references to external credit ratings and would assign risk weightings based on a limited number of alternative risk drivers (ie. capital adequacy and asset quality for bank exposures; revenue and leverage for corporate exposures). After respondents to the first consultative document expressed concerns around the removal of all references to external credit ratings, the Committee decided to reintroduce the use of ratings, in a non-mechanistic manner, for exposures to banks and corporates. The revised proposal also includes alternative approaches for jurisdictions that do not allow the use of external ratings for regulatory purposes. We continue to believe that with limited granularity of disclosure around the non-mortgage part of the book it is difficult to quantify the impact. 21 January

43 Mortgage risk weights The decision by the Committee to not use a debt service coverage ratio and stick with loan-to-value as the main risk driver should be welcomed by banks. However, there is still an element of uncertainty around what the final impact will be. This is particularly the case with investment properties that are materially dependent on rental income, which could attract significant risk-weighting increases. Fig 122 Standardised bank mortgage risk weight settings LVR APRA s current position Standard eligible mortgages Riskweight (no LMI) Riskweight (with LMI) Non-standard eligible mortgages Riskweight (no LMI) Riskweight (with LMI) DSC <3 Dec-14 Other Basel proposals Not materially dependent on rent Dec-1 Materially dependent on rent > Source: APRA, BIS, Macquarie Research, December 21 While the impact on capital for the regionals will depend on the interpretation of cash flow dependency and usage of LMI, we highlight the range of capital outcomes in the table below. We note that ultimately it will be up to the domestic regulator to define materiality. Our base case expectation is for risk weightings on the investment book portfolios to rise but overall impact for standardised banks to be manageable (ie. broadly neutral overall capital impact). We also note that although there are a relatively high proportion of investor loans in Australia, given the existence of negative gearing it can be argued that Australian investors may rely on cash flows from their properties less than in other jurisdictions. Fig 123 Mortgage book risk weightings scenario analysis Current Proposed - LMI, No Investor impact Proposed - No LMI, No Investor impact Proposed - LMI, 2 of Investor impacted Proposed - No LMI, 2 of Investor impacted BEN BOQ Source: Company data, Macquarie Research, December 21 Capital floor for Advanced Banks While the Basel standardised rules only directly impact the regional banks, the likely implementation of capital floors for the advanced banks suggests the majors will be indirectly affected by capital changes. We expect the majors to have a blended risk weighting on mortgages at ~3 (up from 2 currently). However, we expect the majority of the increase to be driven by the investor part of the book and banks with smaller investor lending books are likely to have lower capital requirements than peers (ie. CBA). It is also worth noting that banks should have more capacity to re-price investor loans and arguably profitability of this segment shouldn t be materially affected by changes. 21 January

44 Fig 124 Investor loan split and YoY growth in investor loans as at Nov BEN BOQ -1 Investor Split Investor YoY growth (RHS) APRA growth limit (RHS) Source: APRA, Company data, Macquarie Research, January 216 We note during the year several investor customers switched to owner-occupiers, which is less likely to have occurred for NAB as they repriced interest-only loans, instead of investor Staged IRB accreditation and decoupling of operational risk In December 21 APRA confirmed that they are open to an ADI adopting a staged approach to accreditation, subject to certain criteria, in response to a recommendation from the Financial System Inquiry. This is a clear positive for the regional banks, with both BEN and SUN having begun the process several years ago and BOQ having already put some of the building blocks in place albeit at an earlier stage of the process. APRA s long-standing policy position is that ADIs seeking IRB accreditation must: be capable of modelling all material credit portfolios; and meet accreditation requirements for all such portfolios before models can be used for regulatory capital purposes. Staged accreditation will allow an ADI to use advanced models for some credit portfolios so long as: a credible plan is presented for all material credit portfolios to be accredited; APRA is confident that all credit portfolios will achieve accreditation in no more than two years; The initial accreditation should cover the larger part of the ADI s aggregate credit exposure; Selection must not be motivated by cherry-picking to arbitrage between advanced and standardised; A significant portion (at APRA s discretion but at least ) of any expected capital benefit would only become available after obtaining complete accreditation; and Accreditation approval can be withdrawn if APRA forms the view the final accreditation will exceed two years. We estimate the capital benefit for the regional banks should they obtain advanced accreditation to be ~8-1bps assuming their average mortgage risk weights move to 3 from current levels. We would expect BEN to receive at least of this benefit in , with the rest to potentially follow in 218 should they receive accreditation for non-mortgages. BOQ will likely take a little longer given they aren t as far down the path to accreditation. It is also unlikely that BOQ will be able to achieve the same average risk weight as BEN given their higher starting point but the benefit is clearly there for the future. 21 January

45 Fig 12 CET1 benefit from obtaining accreditation (3 mortgage risk weights) Mortgage riskweights $b Mortgage Exposures $b Av. mortgage risk-weight RWA reduction $b CET1 benefit BEN BOQ Source: Company data, Macquarie Research, January 216 Additionally, APRA is prepared to consider, that an ADI be accredited to use the IRB approach for credit risk without an accredited AMA model for operational risk, which was another barrier for the regionals to achieve accreditation. Overall, we believe these changes are favourable for the regionals, which underpins our positive stance on that fragment of the market. How strong is unquestionably strong? In July 21, APRA released its International Capital Comparison study in response to the first ( top quartile ) recommendation of the FSI and concluded that the banks were short ~7bps CET1 (June 14) to top quartile. APRA also confirmed that it fully supports the FSI's recommendation that Australian ADIs should be unquestionably strong. However it does "not intend to tightly tie that definition to a benchmark based on the capital ratios of foreign banks". Since the balance date used in APRA s study, we estimate the top quartile of global Tier 1 ratios has increased by 2-3bps using a selection of 184 Macquarie stocks under coverage as a proxy. Fig 126 Global capital ratio increases since APRA s study Tier 1 ratio Jun-14 Jun-1 YoY change Mean Top quartile average th percentile Median th percentile Bottom quartile average Source: Macquarie Research, January 216 Note: Data obtained from Macquarie Global Database using 184 of banks under coverage and we have compared with Jun-14, which was the balance date used by APRA Over a similar 12 month period, we calculate that the majors have increased their CET1 ratios by 1-166bps through both organic and inorganic means, with the ~$2bn of capital raised by the sector the major contributor. This would suggest that the major banks now sit near the bottom of the top quartile. Fig 127 The majors increased their CET1 ratios by 1-166bps in FY1 CET1 FY14 FY1 pro-forma YoY change ANZ CBA NAB WBC Source: Macquarie Research, January 216 Note: FY1 pro-forma numbers include the impact of capital raisings and asset sales/divestment. We have not included the impact of increased mortgage risk weights to allow for comparability with global peers Now that much of the heavy lifting on capital is done, we do not envisage a material capital call on the sector, although recognise that there is still some work to be done. We are of the view that this will be done in an orderly manner (discounted DRPs) with APRA suggesting in 21 that higher capital levels should be manageable provided ADIs continue to sensibly accumulate capital. 21 January 216 4

46 LCR rules have been met... although not without costs Banks continued to increase their overall liquidity positions ahead of LCR implementation in 21. In 2H1, LCRs ranged between We expect banks to target range and to that extent do not see this as a material near-term issue for the banks. It is worth noting that LCR rules had a material impact on banks margins (discussed in more detail the margins outlook section of this report). Fig 128 Liquid assets Fig 129 LCR (Current and previous) $b H1 2H1 1H1 2H1 1H1 2H1 1H1 2H HQLA CLF 1H1 2H1 Source: Company data, Macquarie Research, January 216 Source: RBA, Company data, Macquarie Research, January 216 Net Stable Funding Ratio (NSFR) and Total Loss Absorbent Capital (TLAC) As we highlighted in the funding sector of this report, stability and quality of funding is likely to continue to impact the cost of banks funding. Furthermore we expect APRA to formalise its views on TLAC implementation. In aggregate terms, we expect banks to materially increase their overall capital ratios through issuance of qualifying tier one, tier two and potentially tier three (TLAC) instruments. We estimate that banks will be required to issue ~$2bn of TLAC instruments by January 219 and an additional $7-8bn by January 222. We note that these estimates are based on the harmonised approach to capital and if APRA chooses to apply its definition of capital, the implied task for banks is ~$1bn per bank higher. On a five year view we expect banks overall level of loss absorbent capital to settle at ~18. We expect this to be achieved through 9-1 core tier one capital, 2-3 tier one; 2-3 tier two and 2-3 tier three TLAC instruments. Although direct drag on ROEs is going to be less material than direct capital raisings, additional qualifying capital is likely to replace less expensive short and long-term funding with corresponding cost to the P&L and ultimately profitability. Fig 13 Required TLAC issuance scenario Fig 131 Expected capital structure $bn (2-3) 3 (2-3) 2. (2-3) (9-1) - Current Expected target Implied shortfall to 16 Implied shortfall to 18 Core Tier 1 Tier 1 Tier 2 Qualifying Tier 3 TLAC Instruments Source: Company data, Macquarie Research, January 216 Source: RBA, Company data, Macquarie Research, January January

47 Leverage ratio The GHOS also discussed the final design and calibration of the leverage ratio. Members agreed that the leverage ratio should be based on a Tier 1 definition of capital and should comprise a minimum level of 3, and they discussed additional requirements for global systemically important banks. The GHOS will finalise the calibration in 216 to allow sufficient time for the leverage ratio to be implemented as a Pillar 1 measure by 1 January 218, with initial indications this could finalised at around 6. Fig 132 Major bank leverage ratios Leverage ratio (APRA basis) Leverage ratio (Int'l comp.) Source: Company data, Macquarie Research, January January

48 Bank by Bank and Financial Summaries Fig 133 Investment Fundamentals Victor German Brendan Carrig BEN BOQ Recommendation Outperform Neutral Outperform Neutral Neutral Neutral Price target (A$) Upside/downside to TP () Last Price (A$) Cash NPAT (A$mn) 21a f f f Fully dilluted EPS (cps) 21a f f f EPS grow th () 21a f f f Price/Earnings Ratio (x) 21a f f f PE rel to All Industrials ex banks (x) 21a f f f Price/Earnings rel to bank sector (x) 21a f f f DPS (A$) 21a f f f Current Yield () 21a f f f Price/Book ratio (x) 21a f f f ROE 21a f f f Price/NTA ratio (x) 21a f f f Source: Company data, Macquarie Research, January January

49 AUSTRALIA ANZ AU Price (at :11, 2 Jan 216 GMT) Outperform A$23. Valuation A$ DCF/PE month target A$ month TSR Volatility Index Low GICS sector Banks Market cap A$m 68,63 3-day avg turnover A$m 14.2 Number shares on issue m 2,918 Investment fundamentals Year end 3 Sep 21A 216E 217E 218E Net interest Inc m 14,616 1,628 16,46 17,249 Non interest Inc m,92,991 6,228 6,463 Underlying profit m 11,19 11,886 12,643 13,442 Reported profit m 7,493 7,473 7,83 8,2 Adjusted profit m 7,216 7,473 7,83 8,2 EPS adj EPS adj growth PER adj x PER rel x Total DPS Total div yield Franking ROA ROE Equity to assets P/BV x ANZ AU vs ASX 1, & rec history ANZ Bank Not for the faint hearted Event We upgraded our recommendation on ANZ to Outperform from Neutral. Impact While we acknowledge that ANZ faces more risks than peers due to its exposure to slowing Asian markets and overweight position in the resources sector, its valuation discount to peers looks increasingly difficult to ignore. We expect next 12 months to be a bumpy ride for ANZ as the new CEO is likely to take steps in reshaping its business. Over the medium term however, we believe ANZ has capacity to optimise its business mix and reduce exposure to low ROE assets. At ~1x PE multiple and 7. dividend yield, we believe the risk-reward profile is attractive. ANZ PE relative to the ASX ANZ PE Rel Long term average -1 Std Dev +1 Std Dev Source: Factset, Macquarie Research, January 216 Note: Recommendation timeline - if not a continuous line, then there was no Macquarie coverage at the time or there was an embargo period. Source: FactSet, Macquarie Research, January 216 (all figures in AUD unless noted) Analyst(s) Victor German victor.german@macquarie.com Brendan Carrig brendan.carrig@macquarie.com Earnings and target price revision Small EPS downgrades to FY16 and 3 downgrade to FY17. Our target price moves to $28. from $ Price catalyst 12-month price target: A$28. based on a DCF/PE methodology. Catalyst: 1Q16 trading update, 17 Feb 216 Action and recommendation We upgrade our recommendation on ANZ to Outperform. ANZ is now our second pick in the sector. 21 January 216 Macquarie Securities (Australia) Limited 21 January

50 Fig 1 ANZ Financial Summary ANZ Bank Year Ending 3 September 214 1H1 2H1 21 1H16 2H Outperform PER SHARE DATA Cash EPS (AUD) - Macquarie Basis Current Price Target Price Cash EPS Growth () $23. $28. DPS (AUD) Total Shareholder Return 26.6 BVPS (AUD) NTA PS (AUD) Bloomberg: ANZ AU Shares on issue (m) 2,77 2,766 2,93 2,93 2,922 2,94 2,94 2,992 3,38 Reuters: ANZ.AX VALUATION METRICS Macquarie Equities P/E (Cash) Analyst(s) Contact(s) P/B (Stated) Victor German P/NTA Brendan Carrig RoE () RoA () Dividend Yield () Dividend Payout () Volumes and margins Cost of Equity () H16 2H Net Interest Margin () GLAA growth () Efficiency and costs 1H16 2H Cost / Income Ratio () Cost growth () CET1 ratio and BDD/GLA 1H16 2H Core Tier 1 Ratio () - Basel III Impairment Charge / GLAA (bp) Source: Company data, Macquarie Research, January PROFIT & LOSS (AUDm) Net Interest Income 13,797 7,138 7,478 14,616 7,78 7,92 1,628 16,46 17,249 Non-Interest Income,781 3,47 2,8,92 2,967 3,24,991 6,228 6,463 Fees & Commissions 2,1 1,217 1,231 2,448 1,26 1,293 2,8 2,684 2,848 Financial Markets 1, , , ,32 Life and Funds 1, , ,811 1,98 2,2 Other Revenue Total Operating Income 19,78 1,18 1,333 2,18 1,67 1,944 21,619 22,688 23,712 Total Operating Costs 8,76 4,93 4,766 9,39 4,829 4,94 9,733 1,4 1,27 Employee Costs 4,836 2,67 2,66,263 2,673 2,7,373,479,3 Other Costs 3,924 1,986 2,11 4,96 2,1 2,24 4,39 4,66 4,74 Pre-Provision Operating Profit 1,818,92,67 11,19,846 6,4 11,886 12,643 13,442 Impairment Charge , ,62 1,827 2,4 Pre-Tax Profit 9,829,82 4,872 9,94,86,238 1,324 1,816 11,42 Tax Expense 2,7 1,398 1,326 2,724 1,399 1,44 2,839 2,974 3,136 Minority Shareholders Other Post Tax Items Macquarie Cash Profit 7,117 3,676 3,4 7,216 3,682 3,791 7,473 7,83 8,2 Extraordinary & Other Items Reported Net Profit 7,271 3,6 3,987 7,493 3,682 3,791 7,473 7,83 8,2 BALANCE SHEET & CAP AD (AUDm) Risk Weighted Assets* 361,29 386,863 41,937 41,937 49, ,38 439,38 481,62 33,29 Interest Earning Assets 661,1 73, , ,843 7,74 77,71 77,71 811, ,124 Gross Loans, Advances & Acceptances 2,34 61,97 6,676 6,676 82,684 97,282 97,282 63,61 669,134 Interest Bearing Liabilites 672,42 7,1 781, ,899 8,36 82,49 82,49 871,11 924,86 Total Assets 772,92 86,87 889,9 889,9 916, ,49 939,49 99,937 1,,779 Shareholders Equity 49,284 2,1 7,33 7,33 8,996 6,78 6,78 64,84 68,646 Tier 1 Capital* 38,61 41,88 4,484 4,484 47,127 48,489 48,489 2,31 6,377 Tier 1 Ratio ()* Core Tier 1 Ratio () - Basel III ASSET QUALITY Impairment Charge / GLAA (bp) Impairment Charge / NHL (bp) Provisions / NPLs () KEY RATIOS & GROWTH Net Interest Income growth () Non-Interest Income growth () Total Revenue growth () Cost growth () Pre-Provision Profit growth () RWA growth () GLAA growth () Deposit growth () Net Interest Margin () Cost / Income Ratio () January 216

51 Macquarie Quant View The quant model currently holds a neutral view on ANZ Bank. The strongest style exposure is Growth, indicating this stock has good historic and/or forecast growth. Growth metrics focus on both top and bottom line items. The weakest style exposure is Price Momentum, indicating this stock has had weak medium to long term returns which often persist into the future. 43/688 Global rank in Banks of BUY recommendations (8/16) Number of Price Target downgrades 4 Number of Price Target upgrades Fundamentals Attractive Quant Local market rank Global sector rank Displays where the company s ranked based on the fundamental consensus Price Target and Macquarie s Quantitative Alpha model. Two rankings: Local market (Australia & NZ) and Global sector (Banks) Macquarie Alpha Model ranking A list of comparable companies and their Macquarie Alpha model score (higher is better). Factors driving the Alpha Model For the comparable firms this chart shows the key underlying styles and their contribution to the current overall Alpha score. Westpac Banking Corporati Commonwealth Bank.7.6 Westpac Banking Corporati Commonwealth Bank ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation Valuations Growth Profitability Earnings Momentum Price Momentum Quality Macquarie Earnings Sentiment Indicator The Macquarie Sentiment Indicator is an enhanced earnings revisions signal that favours analysts who have more timely and higher conviction revisions. Current score shown below. Drivers of Stock Return Breakdown of 1 year total return (local currency) into returns from dividends, changes in forward earnings estimates and the resulting change in earnings multiple. Westpac Banking Corporati Commonwealth Bank ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation Westpac Banking Corporati Commonwealth Bank ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation Dividend Return Multiple Return Earnings Outlook 1Yr Total Return What drove this Company in the last years Which factor score has had the greatest correlation with the company s returns over the last years. Price to Earnings FY Price to Book FY Price to Sales LTM Price to Sales FY1 Change in PPE FY Sales Revisions 3 Month CPS Growth FY1 Profit Margin FY1-3 Negatives Positives How it looks on the Alpha model A more granular view of the underlying style scores that drive the alpha (higher is better) and the percentile rank relative to the sector and market. Alpha Model Score Valuation Growth Profitability Earnings Momentum Price Momentum Quality Capital & Funding Liquidity Risk Technicals & Trading Normalized Score Percentile relative to sector(/688) Percentile relative to market(/398) Source (all charts): FactSet, Thomson Reuters, and Macquarie Research. For more details on the Macquarie Alpha model or for more customised analysis and screens, please contact the Macquarie Global Quantitative/Custom Products Group (cpg@macquarie.com) 21 January 216 1

52 AUSTRALIA CBA AU Price (at :11, 2 Jan 216 GMT) Neutral A$77.61 Valuation A$ DCF/PE month target A$ month TSR Volatility Index Low GICS sector Banks Market cap A$m 132,23 3-day avg turnover A$m 179. Number shares on issue m 1,78 Investment fundamentals Year end 3 Jun 21A 216E 217E 218E Net interest Inc m 1,799 16,992 17,83 18,484 Non interest Inc m 7,779 7,868 8,344 8,74 Underlying profit m 13,8 14,39 1,8 16,39 Reported profit m 9,63 9,6 1,219 1,6 Adjusted profit m 9,137 9,6 1,219 1,6 EPS adj EPS adj growth PER adj x PER rel x Total DPS Total div yield Franking ROA ROE Equity to assets P/BV x CBA AU vs ASX 1, & rec history Commonwealth Bank Relative upside now limited Event We downgrade our recommendation on CBA to Neutral from Outperform. Impact While CBA s high ROE business justifies a premium valuation, we believe its 1 outperformance relative to peers since September 21 (2 to ANZ/NAB) limits further relative upside. Our analysis on margin trends suggests that the benefit for the sector from mortgage repricing has been overstated by the market. Furthermore, CBA s relatively high exposure to the resources sector is likely to translate into additional provisioning in its upcoming 1H16 result. With near-term risk to earnings relative to expectations coupled with a premium multiple, we downgrade CBA to Neutral. CBA PE relative to the ASX CBA PE Rel Long term average -1 Std Dev +1 Std Dev Source: Factset, Macquarie Research, January 216 Note: Recommendation timeline - if not a continuous line, then there was no Macquarie coverage at the time or there was an embargo period. Source: FactSet, Macquarie Research, January 216 (all figures in AUD unless noted) Analyst(s) Victor German victor.german@macquarie.com Brendan Carrig brendan.carrig@macquarie.com Earnings and target price revision EPS downgrades of 4 in FY16E and 7 in FY17E. Our target price moves to $82. from $ Price catalyst 12-month price target: A$82. based on a DCF/PE methodology. Catalyst: 1H16 Result Presentation, 1 Feb 216 Action and recommendation We downgrade our recommendation on CBA to Neutral. CBA is now our third pick in the sector. 21 January 216 Macquarie Securities (Australia) Limited 21 January 216 2

53 Fig 1 CBA Financial Summary Commonwealth Bank of Australia Year Ending 3 June 214 1H1 2H1 21 1H16 2H Neutral PER SHARE DATA Cash EPS (AUD) - Macquarie Basis Current Price Target Price Cash EPS Growth () A$77.61 $82. DPS (AUD) Total Shareholder Return 11.1 BVPS (AUD) NTA PS (AUD) Bloomberg: CBA AU Shares on issue (m) 1,621 1,621 1,628 1,628 1,7 1,711 1,711 1,724 1,733 Reuters: CBA.AX VALUATION METRICS Macquarie Equities P/E (Cash) Analyst(s) Contact(s) P/B (Stated) Victor German P/NTA Brendan Carrig RoE () - Cash RoA () Dividend Yield () Volumes and margins Dividend Payout () Cost of Equity () H16 2H Net Interest Margin () GLAA growth () Efficiency and Costs PROFIT & LOSS (AUDm) Net Interest Income 1,91 7,891 7,98 1,799 8,378 8,61 16,992 17,83 18,484 Non-Interest Income 7,31 3,836 3,943 7,779 3,917 3,91 7,868 8,344 8,74 Fees & Commissions 3,213 1,6 1,621 3,276 1,67 1,69 3,32 3,9 3,714 Financial Markets , ,43 Life and Funds 2,72 1,386 1,344 2,73 1,441 1,417 2,89 3,36 3,23 Other Revenue Total Operating Income 22,41 11,727 11,81 23,78 12,29 12,66 24,861 26,146 27,229 Total Operating Costs 9,499 4,914,79 9,993,144,179 1,322 1,66 1,87 Employee Costs,42 2,96 2,91,816 2,992 3,6,998 6,111 6,27 Other Costs 3,97 2,8 2,169 4,177 2,12 2,173 4,32 4,4 4,613 Pre-Provision Operating Profit 12,92 6,813 6,772 13,8 7,11 7,387 14,39 1,8 16,39 Impairment Charge ,24 1,2 1,741 Pre-Tax Profit 11,949 6,373 6,224 12,97 6,6 6,729 13,294 14,78 14,619 Tax Expense 3,2 1,74 1,699 3,439 1,8 1,817 3,622 3,836 3,947 Minority Shareholders Other Post Tax Items Macquarie Cash Profit 8,68 4,623 4,14 9,137 4,748 4,91 9,6 1,219 1,6 Extraordinary & Other Items Reported Profit 8,631 4,3 4,28 9,63 4,748 4,91 9,6 1,219 1, H16 2H Cost / Income Ratio () Cost growth () CET1 ratio and BDD/GLA H16 2H Core Tier 1 Ratio () - Basel III Impairment Charge / GLAA (bp) BALANCE SHEET & CAP AD (AUDm) Risk Weighted Assets 337,71 33,48 368, , , ,81 429,81 472,49 19,624 Interest Earning Assets 72, , , , ,37 812, ,166 83,282 93, Gross Loans, Advances & Acceptances 68, , , , , , , ,241 76,672 Total Interest bearing Liabilities 681,43 723,36 748, , ,6 786,74 786,74 826,84 876,923 Total Assets 791,41 8, , , ,96 917,3 917,3 962,76 1,2,62 Shareholders Equity 49,348,888 2,888 2,888 9,66 61,682 61,682 6,617 69,314 Tier 1 Capital 37,68 4,998 41,147 41,147 47,924 49,941 49,941 2,676,78 Tier 1 Ratio () Core Tier 1 Ratio () - Basel III ASSET QUALITY Impairment Charge / GLAA (bp) Impairment Charge / NHL (bp) Provisions / NPLs () KEY RATIOS & GROWTH Net Interest Income growth () Non-Interest Income growth () Total Revenue growth () Cost growth () Pre-Provision Profit growth () RWA growth () GLAA growth () Deposit growth () Net Interest Margin () Cost / Income Ratio () Source: Company data, Macquarie Research, January January 216 3

54 Macquarie Quant View The quant model currently holds a reasonably positive view on Commonwealth Bank. The strongest style exposure is Earnings Momentum, indicating this stock has received earnings upgrades and is well liked by sell side analysts. The weakest style exposure is Profitability, indicating this stock is not efficiently converting its investments to earnings as proxied by ratios such as ROE, ROA etc. 26/688 Global rank in Banks of BUY recommendations 43 (6/14) Number of Price Target downgrades Number of Price Target upgrades 2 Fundamentals Attractive Quant Local market rank Global sector rank Displays where the company s ranked based on the fundamental consensus Price Target and Macquarie s Quantitative Alpha model. Two rankings: Local market (Australia & NZ) and Global sector (Banks) Macquarie Alpha Model ranking A list of comparable companies and their Macquarie Alpha model score (higher is better). Factors driving the Alpha Model For the comparable firms this chart shows the key underlying styles and their contribution to the current overall Alpha score. Commonwealth Bank.6 Commonwealth Bank Suncorp -.2 Suncorp Valuations Growth Profitability Earnings Momentum Price Momentum Quality Macquarie Earnings Sentiment Indicator The Macquarie Sentiment Indicator is an enhanced earnings revisions signal that favours analysts who have more timely and higher conviction revisions. Current score shown below. Drivers of Stock Return Breakdown of 1 year total return (local currency) into returns from dividends, changes in forward earnings estimates and the resulting change in earnings multiple. Commonwealth Bank.3 Commonwealth Bank Suncorp -.1 Suncorp Dividend Return Multiple Return Earnings Outlook 1Yr Total Return What drove this Company in the last years Which factor score has had the greatest correlation with the company s returns over the last years. Price to Earnings FY Price to Book FY1 Dividend Yield FY Price to Book FY DPS Growth yr Historic Return on Equity NTM EPS Growth FY1 Return on Equity FY1 Negatives Positives How it looks on the Alpha model A more granular view of the underlying style scores that drive the alpha (higher is better) and the percentile rank relative to the sector and market. Alpha Model Score Valuation Growth Profitability Earnings Momentum Price Momentum Quality Capital & Funding Liquidity Risk Technicals & Trading Normalized Score Percentile relative to sector(/688) Percentile relative to market(/398) Source (all charts): FactSet, Thomson Reuters, and Macquarie Research. For more details on the Macquarie Alpha model or for more customised analysis and screens, please contact the Macquarie Global Quantitative/Custom Products Group (cpg@macquarie.com) 21 January 216 4

55 AUSTRALIA NAB AU Price (at :11, 2 Jan 216 GMT) Outperform A$26.74 Valuation A$ - DCF (WACC 9.6, beta 1., ERP., RFR.8) month target A$ month TSR Volatility Index Low GICS sector Banks Market cap A$m 7,37 3-day avg turnover A$m Number shares on issue m 2,638 Investment fundamentals Year end 3 Sep 21A 216E 217E 218E Net interest Inc m 14,193 14,799 1,448 16,41 Non interest Inc m,32,194,27, Underlying profit m 9, 1,79 11,429 12,7 Reported profit m 6,4 6,438 7,6 7,223 Adjusted profit m,887 6,746 6,924 7,91 EPS adj EPS adj growth PER adj x PER rel x Total DPS Total div yield Franking ROA ROE Equity to assets P/BV x NAB AU vs ASX 1, & rec history National Australia Bank Value at the core Event We maintain our Outperform recommendation on NAB, with the stock now our preferred exposure the sector. Impact We expect the market s focus to increasingly turn to NAB s underlying franchise. Although its recent business margin trends and cost performance suggest there is further scope for disappointment in FY16, we note that NAB s core domestic franchise is arguably less prone for material credit related disappointments. NAB s underweight position in the resources space and loss of market share in business lending suggests that its credit performance should be on par or better than peers. Following NAB s 12 underperformance relative to CBA and WBC since September 21 we see increasing value in NAB. We maintain our Outperform recommendation and NAB is now our most preferred exposure to the sector. While we recognise that our view on NAB s dividend cut is contrary to both consensus expectations and management s guidance, we believe that the market is well aware of this issue and arguably a dividend cut is largely reflected in NAB s share price. Based on our forecasts, NAB s current reduced dividend yield of 6. appears attractive. NAB PE relative to the ASX Note: Recommendation timeline - if not a continuous line, then there was no Macquarie coverage at the time or there was an embargo period. Source: FactSet, Macquarie Research, January 216 (all figures in AUD unless noted).7.6 NAB PE Rel Long term average -1 Std Dev +1 Std Dev Source: Factset, Macquarie Research, January 216 Analyst(s) Victor German victor.german@macquarie.com Brendan Carrig brendan.carrig@macquarie.com 21 January 216 Macquarie Securities (Australia) Limited Earnings and target price revision EPS downgrades of 12 in FY16E and 17 in FY17E. Our target price moves to $31. from $ Price catalyst 12-month price target: A$31. based on a DCF/PE methodology. Catalyst: 1Q16 trading update, 16 Feb 216 Action and recommendation We maintain our Outperform recommendation on NAB, with the stock now our most preferred exposure the sector. 21 January 216

56 Fig 1 NAB Financial Summary National Australia Bank Year Ending 3 September 214 1H1 2H1 21 1H16 2H Outperform PER SHARE DATA Cash EPS (AUD) - Macquarie Basis Current Price Target Price Cash EPS Growth () A$26.74 $31. DPS (AUD) Total Shareholder Return 24.2 BVPS (AUD) NTA PS (AUD) Bloomberg: NAB AU Shares on issue (m) 2,366 2,421 2,626 2,626 2,64 2,69 2,69 2,693 2,727 Reuters: NAB.AX VALUATION METRICS Macquarie Equities P/E (Cash) Analyst(s) Contact(s) P/B (Stated) Victor German P/NTA Brendan Carrig RoE () RoA () Dividend Yield () Volumes and margins Dividend Payout () Cost of Equity () H16 2H Net Interest Margin () GLAA growth () Efficiency and Costs PROFIT & LOSS (AUDm) Net Interest Income 13,77 6,94 7,72 14,17 7,323 7,47 14,799 1,448 16,41 Non-Interest Income,138 2,624 2,67,281 2, 2,64,194,27, Fees & Commissions 2, 1,18 1,268 2,43 1,297 1,329 2,62 2,762 2,926 Financial Markets Life and Funds 1, , ,612 1,43 1,493 Other Revenue Total Operating Income 18,913 9,69 9,729 19,298 9,878 1,11 19,993 2,6 21,46 Total Operating Costs 1,18 4,31,48 9,899 4,72 4,631 9,23 9,226 9,489 Employee Costs 4,32 2,3 2,423 4,778 2,42 2,462 4,914 4,94,68 Other Costs,648 1,996 3,12,121 2,12 2,169 4,288 4,272 4,421 Pre-Provision Operating Profit 8,733,218 4,181 9,399,36,484 1,79 11,429 12,7 Impairment Charge ,18 1,1 1,899 Pre-Tax Profit 7,86 4,77 3,81 8,76 4,749 4,86 9,66 9,914 1,17 Tax Expense 2,492 1,394 1,168 2,62 1,349 1,379 2,728 2,88 2,93 Distributions Other Post Tax Items Macquarie Cash Profit,184 3,272 2,67,839 3,33 3,411 6,746 6,924 7,91 Extraordinary & Other Items Reported Profit,29 3,44 2,898 6,338 3,41 3,477 6,878 7,6 7, H16 2H Cost / Income Ratio () Cost growth () CET1 ratio and BDD/GLA H16 2H Core Tier 1 Ratio () - Basel III Impairment Charge / GLAA (bp) BALANCE SHEET & CAP AD (AUDm) Risk Weighted Assets * 367,62 393, ,78 399,78 49,9 448, ,328 3,729 1,97 Interest Earning Assets 716,18 73, , , , , , , ,31 Gross Loans, Advances & Acceptances 4,361 73,49 84,147 84,147 98,71 61,216 61, ,18 689,74 Total Interest bearing Liabilities 763,692 83, ,29 823,29 843,39 866, , ,31 97,2 Total Assets 883,31 98,87 9,2 9,2 978,74 1,,48 1,,48 1,61,19 1,12,283 Shareholders Equity 47,98 49,82,32,32 7,131 8,72 8,72 61,944 6,213 Tier 1 Capital 39,78 43,72 49,743 49,743 1,342 2,63 2,63,644 8,423 Tier 1 Ratio () * Core Tier 1 Ratio () - Basel III ASSET QUALITY Impairment Charge / GLAA (bp) Impairment Charge / NHL (bp) Provisions / NPLs () KEY RATIOS & GROWTH Net Interest Income growth () Non-Interest Income growth () Total Revenue growth () Cost growth () Pre-Provision Profit growth () RWA growth () GLAA growth () Deposit growth () Net Interest Margin () Cost / Income Ratio () Source: Company data, Macquarie Research, January January 216 6

57 Macquarie Quant View The quant model currently holds a neutral view on National Australia Bank. The strongest style exposure is Growth, indicating this stock has good historic and/or forecast growth. Growth metrics focus on both top and bottom line items. The weakest style exposure is Profitability, indicating this stock is not efficiently converting its investments to earnings as proxied by ratios such as ROE, ROA et 466/688 Global rank in Banks of BUY recommendations 7 (8/14) Number of Price Target downgrades 3 Number of Price Target upgrades Fundamentals Attractive Quant Local market rank Global sector rank Displays where the company s ranked based on the fundamental consensus Price Target and Macquarie s Quantitative Alpha model. Two rankings: Local market (Australia & NZ) and Global sector (Banks) Macquarie Alpha Model ranking A list of comparable companies and their Macquarie Alpha model score (higher is better). Factors driving the Alpha Model For the comparable firms this chart shows the key underlying styles and their contribution to the current overall Alpha score. Westpac Banking Corporati Commonwealth Bank.7.6 Westpac Banking Corporati Commonwealth Bank ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation Valuations Growth Profitability Earnings Momentum Price Momentum Quality Macquarie Earnings Sentiment Indicator The Macquarie Sentiment Indicator is an enhanced earnings revisions signal that favours analysts who have more timely and higher conviction revisions. Current score shown below. Drivers of Stock Return Breakdown of 1 year total return (local currency) into returns from dividends, changes in forward earnings estimates and the resulting change in earnings multiple. Westpac Banking Corporati Commonwealth Bank ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation Westpac Banking Corporati Commonwealth Bank ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation Dividend Return Multiple Return Earnings Outlook 1Yr Total Return What drove this Company in the last years Which factor score has had the greatest correlation with the company s returns over the last years. Price to Sales FY Dividend Yield FY EV/EBITDA FY Price to Book LTM Return on Assets NTM Profit Margin NTM Profit Margin FY1 EBITDA Revisions 3 Month Negatives Positives How it looks on the Alpha model A more granular view of the underlying style scores that drive the alpha (higher is better) and the percentile rank relative to the sector and market. Alpha Model Score Valuation Growth Profitability Earnings Momentum Price Momentum Quality Capital & Funding Liquidity Risk Technicals & Trading Normalized Score Percentile relative to sector(/688) Percentile relative to market(/398) Source (all charts): FactSet, Thomson Reuters, and Macquarie Research. For more details on the Macquarie Alpha model or for more customised analysis and screens, please contact the Macquarie Global Quantitative/Custom Products Group (cpg@macquarie.com) 21 January 216 7

58 AUSTRALIA WBC AU Price (at :11, 2 Jan 216 GMT) Neutral A$3.6 Valuation A$ DCF/PE month target A$ month TSR Volatility Index Low GICS sector Banks Market cap A$m 11,44 3-day avg turnover A$m 138. Number shares on issue m 3,37 Investment fundamentals Year end 3 Sep 21A 216E 217E 218E Net interest Inc m 14,239 1,329 1,989 16,642 Non interest Inc m 6,31 6,383 6,728 7,16 Underlying profit m 11,9 12,888 13,671 14,482 Reported profit m 8,12 8,49 8,784 9,198 Adjusted profit m 7,82 8,49 8,784 9,198 EPS adj EPS adj growth PER adj x PER rel x Total DPS Total div yield Franking ROA ROE Equity to assets P/BV x WBC AU vs ASX 1, & rec history Westpac Margin beat tough to repeat Event We downgrade our recommendation on WBC to Neutral from Outperform. Impact WBC delivered sector leading performance in FY16 underpinned by its superior margin trends. Furthermore, following its mortgage repricing initiatives in FY1, the outlook for WBC s margins appears supportive. However, as our analysis highlights, we expect WBC to compete more aggressively for deposits and when we incorporate other likely margin offsets we estimate only modest improvement to WBC s margins in FY16. In our view this highlights a potential risk to the market s expectations. Following WBC s outperformance over the last three months, we see limited further upside and downgrade WBC to Neutral. WBC PE relative to the ASX WBC PE Rel Long term average -1 Std Dev +1 Std Dev Note: Recommendation timeline - if not a continuous line, then there was no Macquarie coverage at the time or there was an embargo period. Source: FactSet, Macquarie Research, January 216 (all figures in AUD unless noted) Analyst(s) Victor German victor.german@macquarie.com Brendan Carrig brendan.carrig@macquarie.com Source: Factset, Macquarie Research, January 216 Earnings and target price revision EPS downgrades of 4 in FY16 and in FY17. Our target price moves to $32. from $ Price catalyst 12-month price target: A$32. based on a DCF/PE methodology. Catalyst: 1Q16 Pillar 3 Update, Feb 216 Action and recommendation We downgrade our recommendation on WBC to Neutral. WBC is our least preferred exposure to the sector. 21 January 216 Macquarie Securities (Australia) Limited 21 January 216 8

59 Fig 1 WBC Financial Summary Westpac Bank Year Ending 3 September 214 1H1 2H1 21 1H16 2H Neutral PER SHARE DATA Cash EPS (AUD) - Macquarie Basis (diluted) Current Price Target Price Cash EPS Growth () A$3.6 $32. DPS (AUD) Total Shareholder Return 12.3 BVPS (AUD) NTA PS (AUD) Bloomberg: WBC AU Shares on issue (m) 3,19 3,12 3,184 3,184 3,339 3,38 3,38 3,39 3,422 Reuters: WBC.AX VALUATION METRICS Macquarie Equities P/E (Cash) Analyst(s) Contact(s) P/B (Stated) Victor German P/NTA Brendan Carrig RoE () RoA () Dividend Yield () Volumes and margins Dividend Payout () Cost of Equity () H16 2H Net Interest Margin () GLAA growth () Efficiency and Costs PROFIT & LOSS (AUDm) Net Interest Income 13,496 6,934 7,3 14,239 7,89 7,74 1,329 1,989 16,642 Non-Interest Income 6,324 3,86 3,21 6,31 3,19 3,274 6,383 6,728 7,16 Fees & Commissions 2,926 1,478 1,464 2,942 1,1 1,38 3,39 3,196 3,387 Financial Markets 1, ,72 1,133 1,28 Life and Funds 2,26 1,134 1,9 2,224 1,4 1,117 2,121 2,21 2,424 Other Revenue Total Operating Income 19,82 1,2 1,2 2,4 1,698 11,14 21,711 22,717 23,82 Total Operating Costs 8,246 4,24 4,381 8,63 4,373 4,4 8,823 9,46 9,319 Employee Costs 4,638 2,32 2,311 4,631 2,336 2,349 4,684 4,689 4,741 Other Costs 3,68 1,934 2,7 4,4 2,38 2,11 4,139 4,36 4,78 Pre-Provision Operating Profit 11,74,766 6,139 11,9 6,324 6,64 12,888 13,671 14,482 Impairment Charge ,232 1,49 Pre-Tax Profit 1,924,42,727 11,12,871 6,4 11,912 12,439 13,23 Tax Expense 3,23 1,613 1,661 3,274 1,73 1,72 3,44 3,67 3,777 Minority Shareholders Macquarie Cash Profit 7,628 3,778 4,42 7,82 4,14 4,26 8,49 8,784 9,198 Extraordinary & Other Items Reported Profit 7,6 3,69 4,43 8,12 4,14 4,26 8,49 8,784 9, H16 2H Cost / Income Ratio () Cost growth () CET1 ratio and BDD/GLA BALANCE SHEET & CAP AD (AUDm) Risk Weighted Assets* 331, ,823 38,8 38,8 369,211 42,22 42,22 47,873 17,772 Interest Earning Assets 69,67 678,68 689,31 689,31 74, , , ,17 89,724 Gross Loans, Advances & Acceptances 83,16 68, , , ,78 661,48 661,48 698, ,8 Total Interest bearing Liabilities 479,48 482, ,9 494,9 7,646 21,66 21,66,689 84,226 Total Assets 77,842 79, ,16 812,16 832,18 8,139 8,139 92,266 96,61 Shareholders Equity 49,337,317 3,91 3,91 9,1 6,737 6,737 64,36 67,942 Core Tier 1 Capital 29,724 3,388 34,69 34,69 39,14 4,89 4,89 44,14 48,9 Core Tier 1 Ratio () Tier 1 Capital 34,997 3,742 4,798 4,798 4,883 47,619 47,619 1,243 4,824 Tier 1 Ratio () -Basel ASSET QUALITY Impairment Charge / GLAA (bp) Impairment Charge / NHL (bp) Provisions / NPLs () H16 2H Core Tier 1 Ratio () Impairment Charge / GLAA (bp) KEY RATIOS & GROWTH Net Interest Income growth () Non-Interest Income growth () Total Revenue growth () Cost growth () Pre-Provision Profit growth () RWA growth () GLAA growth () Deposit growth () Net Interest Margin () Cost / Income Ratio () Source: Company data, Macquarie Research, January January 216 9

60 Macquarie Quant View The quant model currently holds a reasonably positive view on Westpac Banking Corporation. The strongest style exposure is Earnings Momentum, indicating this stock has received earnings upgrades and is well liked by sell side analysts. The weakest style exposure is Quality, indicating this stock is likely to have a weaker and less stable underlying earnings stream. 166/688 Global rank in Banks of BUY recommendations 7 (12/16) Number of Price Target downgrades Number of Price Target upgrades 1 Fundamentals Attractive Quant Local market rank Global sector rank Displays where the company s ranked based on the fundamental consensus Price Target and Macquarie s Quantitative Alpha model. Two rankings: Local market (Australia & NZ) and Global sector (Banks) Macquarie Alpha Model ranking A list of comparable companies and their Macquarie Alpha model score (higher is better). Factors driving the Alpha Model For the comparable firms this chart shows the key underlying styles and their contribution to the current overall Alpha score. Westpac Banking Corporati Commonwealth Bank.7.6 Westpac Banking Corporati Commonwealth Bank ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation Valuations Growth Profitability Earnings Momentum Price Momentum Quality Macquarie Earnings Sentiment Indicator The Macquarie Sentiment Indicator is an enhanced earnings revisions signal that favours analysts who have more timely and higher conviction revisions. Current score shown below. Drivers of Stock Return Breakdown of 1 year total return (local currency) into returns from dividends, changes in forward earnings estimates and the resulting change in earnings multiple. Westpac Banking Corporati Commonwealth Bank ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation Westpac Banking Corporati Commonwealth Bank ANZ Bank National Australia Bank Scentre Group Suncorp Westfield Corporation Dividend Return Multiple Return Earnings Outlook 1Yr Total Return What drove this Company in the last years Which factor score has had the greatest correlation with the company s returns over the last years. Price to Cash FY Dividend Yield FY Dividend Yield NTM Dividend Yield FY1 Relative Turnover Operating Margin NTM Return on Equity NTM Return on Equity FY1-33 Negatives Positives How it looks on the Alpha model A more granular view of the underlying style scores that drive the alpha (higher is better) and the percentile rank relative to the sector and market. Alpha Model Score Valuation Growth Profitability Earnings Momentum Price Momentum Quality Capital & Funding Liquidity Risk Technicals & Trading Normalized Score Percentile relative to sector(/688) Percentile relative to market(/398) Source (all charts): FactSet, Thomson Reuters, and Macquarie Research. For more details on the Macquarie Alpha model or for more customised analysis and screens, please contact the Macquarie Global Quantitative/Custom Products Group (cpg@macquarie.com) 21 January 216 6