Presale Report: CBA PERLS VII (CBAPD)

Transcription

1 22 August 2014 Presale Report: CBA PERLS VII (CBAPD) Commonwealth Bank remains a preferred issuer, just not at this price Recommendation: Do not subscribe Overview Commonwealth Bank of Australia will raise AUD 2 billion via a new hybrid issue, to be listed on the Australian Securities Exchange, CommBank PERLS VII Capital Notes (ASX Code: CBAPD). These securities will provide tier-1 regulatory capital for Commonwealth Bank, in compliance with the Australian Prudential Regulation Authority's, or APRA's, capital adequacy standards (Basel III requirements). CBAPD is a perpetual, convertible, unguaranteed and unsecured note with a scheduled exchange date of 15 December This is subject to exchange conditions, unless they are exchanged earlier as a result of a trigger event or Commonwealth Bank exercising an option to call the security two years early on 15 December Distributions are discretionary, non-cumulative, franked They will be paid quarterly in arrears, based on the 90-day bank-bill swap, or BBSW, rate plus a margin in the indicative range of 2.80% to 3.00%. With the current 90-day BBSW rate at 2.62%, this equates to a total estimated gross yield range of 5.42% to 5.62%. Face value of the notes is AUD 100. This issue will fund the redemption of PERLS V (ASX Code: CBAPA), which are approaching their mandatory conversion date of 31 October Summary and Recommendation We recommend investors do not subscribe at these levels. While CBAPD is supported by a wide-moat and Exemplary stewardship rated issuer, we believe the indicative pricing range is not attractive for the commensurate risks, so we suggest waiting for an entry point closer to our fair margin of 3.30% over the 90-day BBSW rate, for an estimated gross yield of 5.92%. We anticipate the final margin to be at the lower end of the indicative range, driven by the expected high participation levels in the CBAPA reinvestment offer. Other hybrids comparable to CBAPD, as listed in Exhibit 1, are currently priced at an indicative margin range of 2.80% to 3.00%. We discuss this in more detail in our valuation commentary. CBAPA is being replaced with a security that has greater risk for the investor, a lower margin and a longer term to conversion. We acknowledge credit markets have tightened significantly since the issuance of CBAPA. We're also well aware that it's in the best interest of equityholders for Commonwealth Bank to issue new capital at the best price available. However, we believe the market is increasingly mispricing risk when it comes to Basel III compliant hybrids. We are seeing margins tighten sharply on recent securities despite having inferior terms to the "old-style" issues in the form of non-viability and capital triggers. Although we don't anticipate such triggers being activated, we believe investors should be incrementally compensated for taking on that risk. We reiterate our approach of taking a longer term-view when assigning our fair margin, as we try to look through the credit cycle. As with any investment, investors should consider comparable alternatives to gain an understanding of the risk/reward merits of the investment on a relative basis, such as bank deposits, bank equity or other hybrids. Online savings accounts have the benefit of a guarantee under the Australian Government Financial Claims Scheme (subject to limits), but yield approximately 140 to 160 basis points less than CBAPD based on the indicative trading margin range. Our Commonwealth Bank equity analyst believes the company's ordinary are reasonably valued, and as outlined in Exhibit 2, forecasts a gross dividend yield of about 7.5% during fiscal year 2015, approximately 190 to 210 basis points higher than that of CBAPD. Equity allows investors to participate in capital upside, but presents higher price volatility and risk than hybrids. However, investors often underestimate the tendency of hybrids to become volatile in times of distress, similar to and unlike traditional senior bonds. While some argue John Likos, CFA Credit Analyst Ravi Reddy Associate Analyst Contact Details Australia Helpdesk: helpdesk.au@morningstar.com New Zealand Helpdesk: helpdesk.nz@morningstar.com

2 22 August Exhibit 1: Comparable Major Bank Hybrids Name Commonwealth Bank PERLS V CBAPA CBAPD ANZPD ANZPE NABPB WBCPE Commonwealth Bank PERLS VII ANZ Capital Notes ANZ Capital Notes 2 NAB Convertible Preference Shares II Westpac Capital Notes 2 Security Type Mandatory Conversion Mandatory Conversion Mandatory Conversion Mandatory Conversion Mandatory Conversion Mandatory Conversion Issuer CBA CBA ANZ ANZ NAB WBC Issue Size AUD 2,000 million AUD 2,000 million AUD 1,120 million AUD 1,610 million AUD 1,717 million AUD 1,310m Face Value AUD 200 AUD 100 AUD 100 AUD 100 AUD 100 AUD 100 Issue Date 14-Oct-09 1-Oct-14 7-Aug Mar Dec Jun-14 Margin above Base Rate 3.40% 2.80% % 3.40% 3.25% 3.25% 3.05% Base Rate 90-Day BBSW 90-Day BBSW 180-Day BBSW 180-Day BBSW 90-Day BBSW 90-Day BBSW First Call Date 31-Oct Dec-22 1-Sep Mar Dec Sep-22 Mandatory Exchange Date 31-Oct Dec-24 1-Sep Mar Dec Sep-24 Distributions Capital Trigger Event No Yes, if Common Equity Tier 1 ratio is equal to or below 5.125% Yes, if Common Equity Tier 1 ratio is equal to or below 5.125% Yes, if Common Equity Tier 1 ratio is equal to or below 5.125% Yes, if Common Equity Tier 1 ratio is equal to or below 5.125% Yes, if Common Equity Tier 1 ratio is equal to or below 5.125% Non-Viability Trigger Event No Yes Yes Yes Yes Yes Conversion into ordinary Yes Yes Yes Yes Yes Yes Ranking in windup Above CBA ordinary Above CBA ordinary Above ANZ ordinary Above ANZ ordinary Above NAB ordinary Above WBC ordinary Gross Running Yield * 6.19% 5.42% % 5.98% 5.93% 5.95% 5.76% Gross Yield to Reset * N/A 5.43% % 5.57% 5.73% 5.66% 5.59% Trading Margin * N/A 2.80% % 2.80% 2.97% 2.89% 2.81% Recommendation HOLD N/A HOLD HOLD HOLD HOLD * As at 20 August 2014 Source: Morningstar, ANZ, CBA, NAB, WBC Exhibit 2: Morningstar Commonwealth Bank Forecasts CBA FY13A FY14A FY15F FY16F FY17F Net Profit after Tax ($M) 7,779 8,635 9,180 9,782 10,554 EPS Growth 8.1% 10.3% 5.0% 5.2% 6.6% DPS Growth 9.0% 10.2% 5.2% 5.2% 6.8% Dividend Yield (incl. franking) * 8.4% 7.6% 7.5% 7.9% 8.4% Net Interest Margin 2.13% 2.14% 2.14% 2.16% 2.18% Return on Equity 18.2% 18.5% 18.7% 19.3% 19.9% Return on Assets 1.1% 1.1% 1.1% 1.2% 1.2% Cost to Income Ratio 44.7% 42.4% 41.2% 40.6% 39.6% Assets/Equity x Dividend Payout Ratio 74.9% 74.8% 75.0% 74.9% 75.1% Loan growth 5.7% 7.2% 4.7% 6.6% 6.7% Net Loans and Leases / Deposits 114.7% 114.2% 110.7% 110.9% 111.7% Tier 1 Ratio 10.2% 11.1% 11.0% 10.9% 10.7% Bad Debt Expense to Average Loans (bps) Pre-Tax Pre-Provision Earnings Growth 8.6% 8.5% 9.6% 6.3% 8.4% * Historical yields are base on average share prices. Forecast yields are base on the share price as at 20-Aug-14 Sorce: CBA and Morningstar hybrids fulfil the need for fixed-income diversification in an investor's portfolio, we're in the camp that views them as a complex form of equity with only mild improvements in risk and limited diversification in an adverse economy or market. CBAPD ranks equally with PERLS VI (ASX Code: CBAPC) and any preference or other subordinated unsecured debts excluding junior ranking securities. In other words, it only ranks higher than Commonwealth Bank ordinary, putting them on par with the most equity-like Basel III compliant hybrid securities issued by the big four banks. Unlike the CBAPA security that they are replacing, the CBAPD now includes a non-viability and capital trigger. Exhibit 3 provides a summary of Commonwealth Bank s capital structure ranking, highlighting the relatively low position of CBAPD.

3 22 August Exhibit 3: Ranking of CBAPD (PERLS VII) in a winding up of Commonwealth Bank Existing CBA obligations/securities 1 Higher ranking Secured debt 3 Covered bonds Liabilities preferred by law Senior Ranking Obligations 3 Liabilities in Australia in relation to protected accounts 3 Other liabilities preferred by law including employee entitlements 3 Deposits (other than protected accounts) 3 Senior debt 3 CommBank Retail Bonds 3 General unsubordinated unsecured creditors 3 Tier 2 Capital Equal Ranking Securities 3 PERLS VII 2 3 PERLS VI 2 3 Any preference or other subordinated unsecured debts 3 Lower ranking Junior Ranking Securities 3 Ordinary Shares 1. This is a simplified capital structure of CBA and does not include every type of security issued or that could be issued in the future by CBA. CBA could raise more debt or guarantee additional amounts at any time 2. Ranking prior to Exchange 3. Excluding Junior Ranking Securities Source: CBAPD prospectus Valuation Our valuation is based on a combination of relative and absolute value analysis. New issues should offer at least the current trading margin of comparable securities to be considered a rational investment. For the purposes of relative valuation, we compare CBAPD to ANZPD, ANZPE, NABPB and WBCPE, which are trading in the indicative 2.80% to 3.00% margin range. More specifically, the respective trading margins of ANZPD, ANZPE, NABPB and WBCPE were 2.80%, 2.97%, 2.89% and 2.81% as at 20 August On these numbers, CBAPD is priced within the range of comparable securities. CBAPD looks fairly valued on a relative basis at the top end of the indicative pricing range, otherwise, we prefer holding the higher-yielding ANZPE or shorter-term NABPB. On an absolute valuation basis, we believe CBAPD should offer a margin closer to our fair margin of 3.30%. Our fair margin reflects the return we believe the investor requires for the commensurate risks, which includes credit risk, liquidity risk, non-viability risk and extension risk. On this basis we believe CBAPD is not attractive at the indicative pricing range. We recommend investors do not subscribe and wait for a better entry point. The Offer The offer comprises: 33A reinvestment offer for holders of CBAPA; 33A broker firm offer for clients of eligible brokers; and 33A securityholder offer for holders of eligible securities, being Commonwealth Bank ordinary, PERLS III (PCAPA), PERLS V (CBAPA) and PERLS VI (CBAPC), Commonwealth Bank Retail Bonds (CBAHA) and Colonial Group Subordinated Notes (CNGHA). There is no general offer to subscribe. What Are the Options Available to CBAPA Securityholders? 1. Participate in the reinvestment offer. Via this offer CBAPA holders can sell all or part of their holdings through the on-market buyback facility for face value (AUD 200) and automatically reinvest in CBAPD. This offer is only available to CBAPA holders who are registered holders on the record date of 22 August 2014 with a registered address in Australia. Applications received under this offer will be given priority allocation. 2. Sell on-market. CBAPA holders can sell on-market for cash by the last trading date which is expected to be 21 October Take no action/hold on for resale. This is effectively redemption for cash at face value (AUD 200) with all remaining CBAPA securities being automatically acquired by the resale broker on 31 October 2014 Final Distribution for CBAPA Securityholders 1. For CBAPA holders participating in the reinvestment offer, the final distribution will be paid on 8 October 2014, for the period from 31 July 2014 up to, and including, 30 September CBAPA holders that don't participate in the reinvestment offer and don't sell on-market after the ex-distribution date will receive a distribution on 8 October 2014, for the period from 31 July 2014 up to, and including, 30 September If they continue to hold CBAPA until 31 October 2014, holders will receive a final distribution on 31 October 2014, for the period of 1 October 2014 to 30 October 2014.

4 22 August Exhibit 4: Commonwealth Bank Regulatory Capital Common Equity Tier 1 Internationally Harmonised Basis 14% 12% 10% 8% 6% 4% 2% 0% 6.9% 4.5% Source: CBAPD Presentation 9.8% 7.5% 11.0% 12.1% 8.2% 9.3% Sep-07 Jun-12 Jun-13 Jun-14 Security Risks 33Capital trigger risk. CBAPD has a capital trigger event clause which requires immediate exchange of some or all securities into ordinary equity if the bank's core capital ratio falls below 5.125%. Commonwealth Bank's common equity tier-1 ratio on a Basel III basis was 9.3% as at 30 June 2014 (Exhibit 4), representing a healthy buffer of about AUD 14 billion over the 5.125% minimum. This ratio is not likely to trickle down to 5.125%, as action would be taken beforehand. Any fall to, or below 5.125%, would probably be sudden, possibly through a major operational failure or a significant increase in bad debts. Put in context, such an event would have to erase about AUD 14 billion of capital, or almost 18 months' profit based on Morningstar forecasts not impossible, but highly unlikely. If this ratio did fall below 5.125%, CBAPD holders would likely suffer a capital loss as a result of the maximum exchange number of condition, where holders could potentially receive ordinary worth less than the AUD 100 face value of CBAPD securities. For example, if we assume an issue date volume-weighted average price, or VWAP, of AUD for Commonwealth Bank, the price would have to fall to about AUD for CBAPD holders to receive Commonwealth Bank ordinary worth less than AUD 100. We think this scenario is highly unlikely, reiterated by our AUD bear-case fair value estimate for Commonwealth Bank ordinary. 33Non-viability risk. CBAPD has a non-viability trigger, which is required by the prudential regulator, APRA, as part of the Basel III reforms. The non-viability trigger gives APRA the discretion to require some or all of CBAPD to be exchanged into Commonwealth Bank ordinary, making CBAPD more equity-like than the security it is replacing. Similar to exchange following a capital trigger event, holders could potentially receive ordinary worth less than AUD 100. A non-viability trigger event occurs if APRA believes that Commonwealth Bank would become non-viable without an exchange of some or all of CBAPD or a public-sector injection of capital or equivalent support. The use of this trigger event by APRA is at its discretion so may not be limited to its concerns about Commonwealth Bank's capital levels and could extend to funding and liquidity concerns. Exhibits 5 to 7 suggest that this is an unlikely scenario given Commonwealth Bank s strong funding and liquidity position. These terms are imposed by APRA and effectively make CBAPD subordinate and riskier than the hybrid securities issued under the previous less-stringent regulatory regime, such as CBAPA. 33Mandatory exchange risk. A fall in Commonwealth Bank's share price to below the minimum exchange price near the mandatory exchange date (15 December 2024) would result in CBAPD not being exchanged on that date and remaining on issue until the next distribution payment date when the exchange conditions are met. For example, if we assume a VWAP of AUD for Commonwealth Bank for the 20 business days immediately preceding the issue date for CBAPD, the Commonwealth Bank share price has to be above AUD on the 25th business day before a possible mandatory exchange date to satisfy the first mandatory exchange condition. We think this scenario is unlikely, supported by our AUD bear-case fair value estimate for Commonwealth Bank ordinary. 33Credit/default risk. The risk of loss arising from Commonwealth Bank defaulting on its payments, whether in the form of distribution payments or principal repayment. Distributions are noncumulative, meaning distributions that are not paid do not accrue, and do not have to be paid subsequently. This is largely offset by Commonwealth Bank s strong credit profile. 33Subordination risk. CBAPD is an unsecured, subordinated investment, so in a wind-up scenario, investors could potentially lose all of their

5 22 August Exhibit 5: Commonwealth Bank Term Funding Profile at 30 June Source: CBAPD Presentation Exhibit 6: Commonwealth Bank Liquid Assets at 30 June 2014 Cash, Govt, Semi-Govt Bank, NCD, Bill, RMBS, Supra Internal RMBS Billions (AUD) Source: CBAPD Presentation 69 Regulatory Minimum Customer Deposits 64% ST Wholesale 16% LT Wholesale <1 year 4% LT Wholesale >1 year 10% Covered Bonds 3% RMBS 2% Hybrids 1% Jun-14 investment. Furthermore, in the event of Commonwealth Bank issuing further equal- or higher-ranking securities on the capital structure, CBAPD may become further subordinated. 33Market price risk. The market price of CBAPD could decrease below that of face value, depending on various market-related factors such as credit spreads, interest rates or Commonwealth Bank's underlying share price performance. 33Liquidity risk. There is a risk that liquidity of the security will be low, which will impact the bid/ask spread. This is somewhat offset by the significant size of the issue. 33Regulatory risk. Hybrid securities continue to be scrutinised heavily by the regulators, so investors need to be aware of the possibility of a change in laws and regulations that could materially impact the value of their investment. 33Extension risk. If CBAPD is not called at the first call date it may trade like a perpetual security. 33Event risk. Event risk arises as a result of unforeseen or unexpected events such as natural disasters, or mergers and acquisitions. Key Dates for CBAPD 33Bookbuild: 25 August Announcement of margin: 26 August Offer opens: 26 August Closing date for offer: 19 September Issue date: 1 October Commencement of trading: 2 October First distribution payment date: 15 December Call date: 15 December Mandatory exchange date: 15 December Key Dates for CBAPA 33Record date for reinvestment offer: 22 August Reinvestment offer opens: 26 August Closing date for reinvestment offer: 17 September On-market buy-back date: 26 September Record date for final distribution on CBAPA which participated in the reinvestment offer: 30 September Payment date for final distribution on CBAPA which participated in the reinvestment offer: 8 October Last date of trading for CBAPA which did not participate in the reinvestment offer: 21 October Resale Date for CBAPA which did not participate in the reinvestment offer: 31 October Key Terms 33Face value: AUD 100 per security. 33Minimum subscription amount: AUD 5,000 (50 units). This is not applicable to the reinvestment offer for eligible CBAPA holders. Additional amounts can be bought in increments of AUD 1,000 (10 units). 33Amount to be raised: Commonwealth Bank plans to raise AUD 2 billion via the issue of 20 million securities but has the ability to raise more or less. 33Cash distribution rate: (90-day BBSW rate + margin) x (1-corporate tax rate). 33Margin: The indicative margin range is 2.80% to 3.00%. The margin will be set via a bookbuild process. 33Frequency of distributions: Quarterly on 15 March, 15 June, 15 September and 15 December. 33Franking: Fully franked. If a distribution is not franked or partially franked, the cash distribution

6 22 August Exhibit 7: Commonwealth Bank Term Debt Maturity Profile at 30 June 2014 Long-term Wholesale Debt Govt Guaranteed Covered Bonds Billions (AUD) Source: CBAPD Presentation FY15 FY16 FY17 FY18 FY19 >FY19 amount will be increased to compensate for any franking shortfall. 33Distributions: Distribution payments are discretionary and subject to payment conditions being satisfied, the most material being that payment does not cause Commonwealth Bank to breach its regulatory capital requirements or become insolvent and APRA not objecting. Distributions are not cumulative, so Commonwealth Bank does not have to make up unpaid distribution payments. From 1 January 2016 there will be restrictions on the proportion of profits that can be paid through ordinary dividends, additional tier-1 distributions (such as CBAPD) and discretionary staff bonuses if a bank's common equity tier-1 ratio falls below 8%. 33Dividend stopper: If a CBAPD distribution is not paid in full within five business days then Commonwealth Bank cannot pay dividends on its ordinary, undertake a buyback or reduce capital on any ordinary until a distribution is paid in full on a subsequent distribution payment period. 33Term: Perpetual, with a mandatory exchange date of 15 December 2024, or any subsequent distribution payment date, subject to exchange conditions or if they are exchanged earlier as a result of a trigger event or Commonwealth Bank exercising an option to call the security two years early on 15 December Capital classification: Tier-1 capital. 33Mandatory exchange date: If CBAPD has not been exchanged or redeemed earlier, on 15 December 2024, CBAPD will convert into a variable number of Commonwealth Bank ordinary worth approximately AUD at a 1% discount to the business day VWAP of Commonwealth Bank ordinary. This is subject to exchange conditions. If these conditions are not satisfied, exchange will be deferred until the next distribution payment date after 15 December 2024 that the conditions are met. 33The mandatory exchange conditions are: 33First condition: The VWAP of Commonwealth Bank ordinary on the 25th business day before (but not including) the mandatory exchange conditions Date (15 December 2024) is equal to or greater than 56% of the issue date VWAP of Commonwealth Bank ordinary ; 33Second condition: The VWAP of Commonwealth Bank ordinary during the 20 business days before (but not including) a possible mandatory conversion date is equal to or greater than 50.51% of the issue date VWAP of Commonwealth Bank ordinary ; and 33Commonwealth Bank ordinary are listed and admitted to trade on the Australian Securities Exchange. 33Capital trigger event: If Commonwealth Bank determines, or APRA believes, that Commonwealth Bank's common equity tier-1 ratio is equal to or less than 5.125%, Commonwealth Bank must exchange a sufficient amount of CBAPD into Commonwealth Bank ordinary to return this ratio above 5.125%. The number of on exchange will be based on the VWAP five business days before the exchange date. Exchange following a capital trigger event is not subject to mandatory exchange conditions being satisfied. This means CBAPD holders could potentially receive Commonwealth Bank ordinary worth less than AUD 100. This is because the maximum exchange number of will apply based on 20% of the issue date VWAP. For example, if the issue date VWAP of Commonwealth Bank ordinary was AUD 80.00, the maximum exchange number of will equal 6.25 Commonwealth Bank ordinary for each CBAPD (AUD 100/(AUD 80.00x20%)). Therefore, if the Commonwealth Bank share price on exchange was AUD 10.00, then CBAPD holders would receive Commonwealth Bank worth approximately AUD (6.25xAUD 10.00) for each security. 33A non-viability trigger event occurs if APRA notifies Commonwealth Bank that it believes that exchange of some or all CBAPD (or some action in

7 22 August relation to other Commonwealth Bank capital instruments) is required because without it Commonwealth Bank would become non-viable; or a public sector injection of capital is required because without it Commonwealth Bank would become non-viable. Following such an event Commonwealth Bank must immediately exchange such number of CBAPD securities that is specified by APRA or necessary to satisfy APRA that Commonwealth Bank will no longer be non-viable. Exchange following this event is not subject to mandatory exchange conditions being satisfied. The consequence is similar to exchange following a capital trigger event where CBAPD holders could potentially receive Commonwealth Bank ordinary worth less than AUD 100. A non-viability event occurs at the discretion of APRA. The circumstances where APRA may exercise its discretion may not be limited to its concerns about the group's solvency or capital levels, but could extend to concerns about funding and liquidity. 33Early redemption: Commonwealth Bank has the option to redeem some or all the notes early for cash equal to face value on the 15 December 2022 call date or subsequent distribution payment date. The notes can also be redeemed early following a tax or regulatory event. Redemption is subject to certain conditions including APRA approval. 33Early resale: On the 15 December 2022 call date, Commonwealth Bank can choose to resell the notes to a third party for cash equal to face value. From a noteholder's perspective the effect is the same as having the notes redeemed for cash. 33CBAPD holders have no right to request early exchange or redemption. 33Ranking in wind-up: CBAPD ranks ahead of ordinary, equally with equal-ranking capital securities (such as PERLS VI (CBAPC)), behind senior creditors, liabilities preferred by law (such as bank deposits) and secured debt (covered bonds). We have only presented a summary of the material terms. Investors should examine the prospectus in detail. Issuer Details Profile Commonwealth Bank of Australia is Australia's second-oldest and largest bank with a market capitalisation of AUD 130 billion. Operations span Australia, New Zealand and Asia. Its core business is the provision of retail, business and institutional banking services. It is also a major fund manager and the second-largest life insurer in Australia. Commonwealth Bank operates the largest financial services distribution network in the country. The strategy, which has been stable and successful, emphasises a well-managed, diversified business model, strong balance sheet, stable financial platform and conservative underwriting. The bank reported total assets of AUD 791 billion as at 30 June 2014, including AUD 607 billion in gross loans, bills and receivables. Cash net profit after tax for fiscal 2014 was AUD 8.7 billion, representing a return on equity of 18.7%. Investment Thesis Commonwealth Bank of Australia is one of Australia's four highly profitable, wide-moat rated major banks. It offers a full suite of banking services in Australia and New Zealand, also operates in certain Pacific and Asian countries, and sells wealth management, life and general insurance in Australia. The financial crisis exposed some poor commercial lending decisions but in the long run the bank has consistently grown shareholder wealth in favourable economic times. The loan book's large weighting to home loans and the high proportion of customer deposits in funding reduce risk. Commonwealth Bank weathered the global financial crisis as one of the highest-rated banks in the world. In our opinion, a wide moat rating is justified. Securitising non-bank financials and foreign banks previously provided fairly strong competition for Commonwealth Bank in home and business loans and business deposits but the bank's return on equity has not fallen below the cost of equity for the past 10 years. Foreign banks are a lesser force now but even in their heyday they never mounted a serious assault on the retail franchises, market or branch networks of the major banks. The sunk costs and infrastructure were too great to replicate. Local regional banks tend to follow the majors on pricing and are not currently in a position to threaten Commonwealth Bank's economic returns. Bouts of apparently intense price competition between the four major banks have not threatened superior shareholder returns. Many investors are concerned about a potential sharp downturn or crash in the Australian housing

8 22 August Exhibit 8: Bad Debt Expense to Average Loans Basis Points Source: CBAPD presentation FY09 FY10 FY11 FY12 FY13 FY14 market. While Australian housing is expensive and debt-to-household income ratios are high, we remain comfortable for several reasons. Tight underwriting standards, lenders' mortgage insurance, low average loan-to-valuation ratios, a high incidence of loan prepayment, full-recourse lending, a high proportion of variable-rate home loans and the scope for interest-rate cuts by the Reserve Bank of Australia, or RBA, combine to mitigate potential losses from mortgage lending. We cannot rule out falling home prices, but investors who readily compare the Australian residential real-estate market to that of the U.S. and other markets are ignoring fundamental differences. The main current influence on earnings growth is soft credit growth, a product of household risk aversion and deleveraging, and delays to business plans for capital expenditure. Despite reduced pressure on funding costs, intense competition is constraining interest margins. Bad and doubtful debts expense peaked in first-half fiscal 2009 and continues to decline, but is unlikely to fall much further from current levels. Writebacks of the economic overlay, a general provision for higher bad debts in case the economy deteriorates sharply, are on hold despite improving economic conditions. Wealth management earnings are trending higher as equity markets recover and confidence improves. Australia's superannuation system guarantees strong long-term growth in assets for Australia's wealth management industry. In addition, tight cost control will underpin earnings growth, particularly in periods of soft revenue growth. 16 Financial Health On 30 June 2014, Commonwealth Bank of Australia had a Basel III common equity tier-1 capital ratio of 9.3%, one of the strongest of the four major banks based on the Australian regulator's tough interpretation of Basel III rules. Commonwealth Bank is one of the world's highest rated banks and continues to generate capital organically as a result of its high return on equity (18.7% in fiscal 2014), and modest lending growth. We forecast return on equity to rise to approximately 20% by fiscal Recent announcements by global regulators helped to clarify future capital and liquidity requirements for the Australian banking industry. The Basel III requirements regarding capital are very manageable for Commonwealth Bank within the timeframes. Commonwealth Bank's common equity tier-1 ratio of 12.1%, based on a globally harmonised basis, compares favourably with global peers. Customer deposits contributed 64% of total funding as at June 2014, up from 62% in The bank's superior credit rating and strong reputation in funding markets enable it to find the remainder from securitisation, hybrids and wholesale funding, of which 38% was sourced within Australia at 30 June The home-loan book is high quality. On 30 June 2014, the average loan-to-valuation ratio, or LVR, was 48% based on current market values. Nearly 80% of customers were ahead with their payments an average of seven monthly payments. An allowance for interest-rate rises of 150 basis points is built into serviceability tests. Mortgagee-in-possession loans were just 0.04% of the portfolio. In fiscal 2014 loan impairment expense was just 16 basis points of gross loans, down every half from the 85 basis points peak in first-half fiscal 2009, at the height of the credit crisis. We forecast a rise to a mid-cycle average of about 20 basis points during the next five years. These outcomes reflect a long-term organisational policy to have a low-risk balance sheet. There is no intention to change the policy. Capital Structure Leverage (assets/equity) peaked at 20.1 times on 30 June 2009 but declined to 16.2 times on 30 June This ratio is high, but sustainable, given the

9 22 August quality of the assets. The bank's preference for a lower-risk approach to growing the balance sheet leads us to forecast no change in leverage. Trading securities and other fair-value assets were just 12% of the balance sheet on 30 June 2014, which compares with averages of 24% and 26% respectively for U.K. and U.S. banks. Commonwealth Bank's balance sheet is less volatile because of this low proportion of fair-value assets. The fiscal 2014 payout ratio was 75% and we forecast a steady payout ratio of 75%, with dividends growing in line with earnings per share. There is no imminent need to cut the dividend to support the balance sheet. Fundamental tier-1 capital (ordinary equity, reserves and retained earnings) after deductions contributed 77% of total regulatory capital on 30 June Residual tier-1 capital contributed another 15%. This is a strong capital structure. Economic Moat We assign a wide moat rating to Commonwealth Bank of Australia, mainly because of sustainable structural characteristics of the Australian and New Zealand banking industries generating high returns on equity. The other three major banks also have wide moat ratings. In our opinion, efficient scale and cost advantage are the main sources of the wide economic moats for Australia's four major banks. Intangible assets and switching costs provide important, but less prominent, moat sources. Management & Stewardship Commonwealth Bank of Australia has a successful long-term track record of maximising shareholder returns and safeguarding capital. We therefore allocate an Exemplary stewardship rating to Australia's largest bank by market capitalisation. Since the worst of the global financial crisis, the bank has steadily increased return on equity and it is currently above 18%. Conservative management and a domestically focused growth strategy is a long-term feature. Strong risk management is an overarching feature of the bank's internal processes and procedures. Commonwealth Bank has committed to maintaining capital well above regulatory minimums, and we expect surplus capital to be reinvested in the business and/or returned to shareholders via higher dividends and not wasted on expensive and dilutive acquisitions or risky expansion plans. K

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