Presale Report: ANZ Capital Notes 2 (ANZPE)

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1 11 February 2014 Presale Report: ANZ Capital Notes 2 (ANZPE) Recommendation: Subscribe at or above 3.40% Issue Summary Australia and New Zealand Banking Group Limited, or ANZ Bank, is looking to raise at least AUD 1,000 million in new capital via a bank capital note, ANZ Capital Notes 2. These perpetual securities are to be listed on the Australian Securities Exchange (proposed ASX Code: ANZPE) and are designed to provide tier-1 regulatory capital for the issuer, which complies with the Australian Prudential Regulation Authority s, or APRA s, newly implemented capital adequacy standards (Basel III requirements). ANZ Capital Notes 2 are fully paid, non-cumulative, convertible, transferable, redeemable, subordinated, perpetual, unsecured notes issued by ANZ Bank. Although this security is legally a perpetual instrument, it has embedded conversion mechanics, which (subject to satisfying the conversion conditions) requires conversion into ANZ Bank common stock at the mandatory conversion date (24 March 2024). However, as part of the structure, the issuer reserves the right to exchange (by means of conversion, redemption or resale) the security early, subject to APRA approval (the optional exchange date being 24 March 2022). This option is standard for an issuer as it provides it with additional flexibility in managing its capital. ANZPE pays fully franked discretionary distributions on a semi-annual basis in arrears. Payments are based on the 180-day bank bill swap, or BBSW, rate plus a margin. The indicative margin range is [3.25% to 3.40%]. Summary and Recommendation We recommend investors subscribe. This transaction has an almost identical risk profile to the ANZ Capital Notes issued in 2013 and hence they are likely to perform in a very similar manner. From a relative-value perspective, this instrument offers no term risk premium, but this is consistent with the broader market s listed tier-1 securities with similar maturity dates. The issuer risk profile continues to improve with a reasonably conservative capital management plan, but this is partially offset by a slightly riskier geographic asset composition. The introduction of the domestic systemically important bank capital buffer improves the stress capital buffer results, and we consider the probability of an economic event such as non-viability to be remote and likely to be related to securities fraud. As with the other tier-1 securities, structural considerations such as the capital and non-viability triggers change the dynamics of the security to make the risk profile asymmetric (unlimited downside but limited upside), which means that in difficult periods performance will have a higher correlation to equities than traditional fixed-income instruments such as treasury bonds. The performance of this security will be linked to the probability that the issuer will breach a minimum enterprise value (capital trigger) or approach insolvency in the eyes of the regulator (which is a focal point of the non-viability clause). These are complex issues to understand, and we explain these further in the body of this report. This security is suitable for investors looking for stable income with a stable to positive view on the credit profile of the issuer. This is not a defensive or growth asset, and should not be treated as such in the asset allocation process. It will not be subject to equity volatility except in the circumstance where there is a credible risk of default by the issuer. Reinvestment Offer ANZ CPS1 (ANZPB) As part of the offer, ANZ has announced a reinvestment offer for holders of ANZ Convertible Preference Shares (ASX Code ANZPB). Eligible holders will have the option to participate in the reinvestment offer. Eligible CPS1 Holders who elect to reinvest some or all or their CPS1 in ANZ Capital Notes 2 will receive a dividend on the scheduled CPS1 dividend payment date on 17 March 2014 plus a Pro Rata Dividend on the Reinvestment CPS1 on 31 March If holders elect Nicholas Yaxley Credit Analyst Contact Details Australia Helpdesk: helpdesk.au@morningstar.com New Zealand Helpdesk: helpdesk.nz@morningstar.com

2 11 February Figure 1: Historical Average Trading Margin of Basel III Compliant Tier 1 Securities Average major bank Tier % 3.50% 3.00% 2.50% 2.00% 30/03/12 30/06/12 30/09/12 31/12/12 31/03/13 30/06/13 30/09/13 31/12/13 Source: Morningstar, ASX Table 1: Morningstar s Key Qualitative Analyst Data Points Issuer Issuer Risk Business Risk Economic Moat Australia and New Zealand Banking Corporation Low Very Good Wide Commonwealth Bank of Australia Low Very Good Wide National Australia Bank Low Very Good Wide Westpac Banking Corporation Low Very Good Wide Bank of Queensland Medium Fair None Bendigo Bank Medium Fair None not to reinvest their capital proceeds they will receive their money back on 16 June It is important for investors to note that these are not like-for-like securities and hence we recommend investors look at the new issue on its own merit. Valuation ANZ Capital Notes 2 are classified as tier-1 regulated capital with multiple comparable securities, the closest being ANZ Capital Notes issued in July Although we agree that each prospectus has distinct terms that affect the performance of the security in different ways, we would also argue that there are enough comparable securities to create a credit spread curve. Investors should measure the perceived market value (or fair value) of a bond or capital security by measuring its trading margin (or credit spread) relative to its designated benchmark. This spread over the benchmark (typically a BBSW rate) measures the credit risk premium of the security which, together with the benchmark yield, gives the security yield. The credit spread curve is defined as a series of securities from comparable issuers with various maturity dates. As a general rule, the credit spread curve should be positively sloped, with the investor being compensated with an additional spread premium for each unit of additional risk. These risks increase with term to maturity as the cumulative probability of default (or conversion) increases with time. Term risk, combined with our fundamental and structural risk assessment, is the basic framework for identifying value. At present, the Tier 1 credit spread curve is relatively flat with investors in longer-dated securities not being appropriately compensated for the additional term risk. Historically, we have valued securities based on a relative and absolute basis, but in the interest of transparency, we will focus on how we arrive at these levels. First and foremost, we will always use the relative value approach for a given security except in the circumstance where relative measures look expensive when compared with long-term absolute fair value (or fair spread). New issues should offer at least the current trading margin of comparable issues to be considered a rational investment decision. The range offered for ANZ Capital Notes 2 is at fair value on a relative basis, however, the bottom of the range does not offer any term premium (i.e. compensation for greater uncertainty as a result of a longer term to maturity). Our market-based (relative value) fair margin is set at 3.40% which compensates the investor for additional term risk relative to comparable securities and is in line with ANZ Capital Notes (ASX Code ANZPD) in July The risk premium we allocate to structural features and liquidity is unchanged. This market-based fair margin is slightly above our absolute fair margin and hence we are comfortable with our recommendation. In the context of our ongoing recommendations, the subscribe recommendation provided in the presale report is equivalent to a hold or buy recommendation. Issuer Credit Perspective Morningstar s issuer credit perspective is our assessment of an issuer s ability to meet its legal obligations in a full and timely manner. Our analysis does not make any provision for government or agency support, and our assessment remains a standalone assessment of the issuer. Our process is based on four key pillars; business risk, capital stress test, bank solvency and probability of default. This assessment is specific to the financial health of the issuer and forms only part of the overall security assessment. Structural considerations change the risk profile of a security, so it is important to look at all elements of the analysis before making a decision on participation in the issue.

3 11 February Business Risks Morningstar s overall issuer analysis incorporates a number of measures but the only subjective measure is the assignment of a business risk score. Our assessment is made based on our understanding of the presence of any sustainable competitive advantages (economic moat); macroeconomic drivers of the industry (i.e. regulation, housing growth, unemployment); reliance on debt capital markets (domestic and foreign); and quality of management and sub-committees (risk and capital). Consistent with other domestic banks, we assign ANZ Bank a low business risk. ANZ Bank s position within our framework was solidified in September 2013 when it was upgraded from narrow to wide economic moat (see below). From a quantitative perspective, this has created a small buffer around any downside to its business risk score. Our concern about the bank's historical reliance on capital markets to fund asset growth is dwindling across the sector, but we are unlikely to see a scenario where assets are fully funded by deposits any time soon. It is therefore still very difficult to subjectively assign any one bank a different business risk rating under our bank analysis framework. Economic Moat In September 2013, we upgraded the Morningstar Economic Moat Ratings for Australia's four major banks from narrow to wide. This was primarily due to sustainable structural advantages of the Australian and New Zealand banking sectors. The wide moat rating recognises the structural competitive advantages Australia's four major banks possess. The four major banks dominate a regulated and rational oligopoly, bestowing structural advantages that are strong and durable. We believe the economic moats surrounding the major banks are sufficiently wide to ensure global sector-leading returns on equity for the foreseeable future. The wide-moat upgrade has far reaching implications, with Australia's four major banks now joining only one other bank awarded a wide moat across Morningstar's global bank coverage. 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. All four Australian major banks have wide moat ratings. The four major banks control more than 90% of the business and consumer lending markets, plus the vast majority of bank deposits. New Zealand is similar. Loan pricing is rational, but intense competition for customer deposits is crimping margins. The concentrated industry benefits from high barriers to entry across most segments, making it hard for new entrants to gain any sort of foothold, particularly in retail and business banking. Foreign banks have not made a serious dent in the domestic majors' market share. The smaller regional banks compete on service and local brand recognition, but face higher funding costs than the majors and have to accept lower profitability to compete on price. The major banks are price-makers, while regional banks tend to follow pricing decisions made by the major banks. Well-managed scale begets more scale. ANZ Bank leverages its large branch network to increase cross-sell rates, with higher growth areas of wealth management and insurance products proactively marketed to banking customers. An expansive and well-located distribution network generates substantial cost advantages over smaller banks and non-bank institutions. This enables ANZ Bank to price competitively, but still at levels sufficient to generate current attractive return on equity. Like the other majors, ANZ Bank has pricing power from brand strength, an intangible asset. Australians and New Zealanders have a cultural preference for large financial institutions with heritage brands, due to perceived greater financial security. This preference exists even when the customer is a borrower. Bank Solvency Capital, Funding, Liquidity & Asset Quality Morningstar assesses the financial health of an issuer using a purely objective assessment based on bank-specific accounting metrics. Our solvency score measures a bank's most recent performance in four key areas: capital adequacy, asset quality, earnings power and liquidity. These measures are scored against a fixed set of thresholds set by our global credit committee. Capital Capital adequacy can be a complex concept for Australian capital investors as there are a number of moving parts. APRA is now monitoring authorised depositary institutions, or ADIs, under the Basel III capital reforms (Level 1 & 2) but it yet to finalise what is known as conglomerate (or Level 3) rules. The group (Level1, 2 and 3) capital adequacy is measured using prudential capital ratios, but these are not formally disclosed to the public. While we acknowledge this is yet to be finalised, it does not have a major impact on our analysis as subsidiaries outside the banking group represent a small proportion of the group balance sheet liabilities.

4 11 February Table 2: ANZ Tier 1 Capital Components ANZ 30 September 2013 ANZ 31 December 2013 Pro-forma Adjustments Capital Notes 2 Issue Pro-forma Adjustments CPS1 Redemption Pro-forma ANZ Common Equity Capital Ratio 8.5% 7.9% 0.0% 0.0% 7.9% Tier 1 Capital Ratio 10.4% 9.6% +0.3% -0.3% 9.6% Tier 2 Capital 1.8% 1.6% 0.0% 0.0% 1.6% TOTAL CAPITAL RATIO 12.2% 11.2% +0.3% -0.3% 11.2% Source: ANZ Capital Notes 2 Prospectus Figure 2: Simplified Capital Structure Examples Higher ranking/ earlier priority Examples of existing ANZ obligations and securities 1,2 capital, we are comfortable with existing capital levels and believe that organic capital generation will be sufficient to meet this new buffer by its implementation date in Senior obligations Equal ranking obligations Liabilities preferred by law and secured debt Unsubordinated unsecured debt Term subordinated unsecured debt Perpetual subordinated unsecured debt Preference shares and other equally ranked instruments Liabilities in Australia in relation to protected accounts under the Banking Act (generally, savings accounts and term deposits) and other liabilities preferred by law including employee entitlements and secured creditors Bonds and notes, trade and general creditors. This includes covered bonds which are an unsecured claim on ANZ, though they are secured over assets that form part of the Group ANZ Subordinated Notes and other equal ranking dated subordinated unsecured debt obligations Perpetual Capital Floating Rate Notes issued in 1986 ANZ Capital Notes 2, ANZ Capital Notes, CPS3, CPS2, CPS1, and the preference shares comprised in the 2004 Trust Securities. In ANZ Bank's most recent capital adequacy disclosure statement (September 2013) it reported a common equity tier-1 ratio of 8.5%. This is not directly comparable to September 2012 because of the adjustments from reporting under the new regulatory framework. The common equity capital ratio has been adjusted down to 7.9% in December 2013 as a result of the dividend payments and a slight increase in RWA. A significant proportion of the change in risk-weighted assets over the years was not a function of real increasing capital leverage, but a reclassification of risk weights for particular assets (such as corporate) under Basel III. The bank will continually review its optimal capital mix and change its lending strategy to match this requirement. Lower ranking obligations Lower ranking/ later priority Ordinary shares Ordinary Shares 1 This is a very simplified capital structure of ANZ and does not include every type of security or other obligation issued by ANZ. ANZ has the right to issue further debt, deposits or other obligations or securities of any kind at any time. ANZ Capital Notes do not limit the amount of senior debt, deposits or other obligations or securities that may be incurred or issued by ANZ at any time. 2 If a Note is Written Off, all rights (including to Distributions) in respect of that Note will be terminated, and the Holder will not have their money repaid.if a Note is Converted, the Ordinary Shares a Holder receives on Conversion will rank equally with other Ordinary Shares in a winding up of ANZ. Source: Morningstar, ANZ Capital Notes 2 Prospectus However, during the last few months there has been a slight change in the prudential capital requirements, whereby the banking regulator has increased (by 1%) the capital conservation buffer to 3.5% for the four major Australian banks. This increase, known as the domestic systemically important banks, or D-SIBs, capital buffer, was not a surprise to the market as the banks and the regulator have been in discussions for some time. Morningstar s view is that, despite a number of media outlets suggesting the banks would need more ANZ Bank s primary objectives in capital management are: 33Compliance with regulatory minimum prudential capital ratios 33Holding sufficient economic capital to support the current ratings agency opinion of ANZ Bank. 33An appropriate balance between maximising shareholder returns and prudent capital management principles. ANZ Bank uses a strategic planning process across a three-year time horizon to achieve these objectives. This includes some subjective forecasts on economic and financial variables, which are used to assess capital ratios, targets, and composition of capital relative to the group's risk appetite. The final part is to ensure that, under a stressed economic environment, both the prudential capital ratios and economic capital requirements are sufficient. This is also part of Morningstar s analysis

5 11 February Figure 3: ANZ's Tier 1 Capital Components Additonal Tier 1 Common Equity Tier 1 ANZ Capital Notes 2 Capital Trigger % 2.00% 2.10% 1.90% % 8.80% 8.20% 8.50% % 7.90% potentially jeopardise future requirements is if there was a substantial deterioration in asset quality and, in turn, a large net increase in provisions was necessary. At this stage, we consider this an unlikely scenario. Asset Quality ANZ Bank s asset quality has slowly improved during the 12 months to September Write-offs as a proportion of the overall loan book were negligible and impaired assets (impaired and in loans in arrears) as a percentage of exposure at default reduced to 0.77% (from 0.95%). These levels are very low, even compared with our normalised loss estimates. 0 FY11 FY12 Mar-13 Sep-13 Dec-13 Proforma Source: Morningstar, ANZ Capital Notes 2 Prospectus Figure 4: Pre-tax, Pre-provision Earnings Growth p Pre-tax, Pre-provision Earnings Growth Rate % Source: Morningstar Although during the past year we have had concerns about release of provisions because of an expectation of deteriorating asset quality, we acknowledge this has not eventuated and, given the current trajectory, the provision coverage is sufficient for this point in the cycle. From an investor's perspective, we would prefer ANZ Bank increase the provision buffer, but this would be at the expense of shareholder return which would likely be discouraged by the board FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 Source: Morningstar Equities and is why we focus on a stress capital buffer. We discuss this in more detail in the Stress Test section of this document. The prospectus states that ANZ Bank will target an operating range for the common equity capital ratio in excess of 8%. It has also maintained guidance on the medium-term dividend payout ratio of 65% to 70%. This gives us confidence in the current capital plan and, if loan growth follows our expected path, this target is unlikely to get tested in the near future. We remain confident ANZ Bank is well placed to meet all future capital requirements under the given framework due to its conservative payout ratio and stable earnings profile. The only thing that could Our key concern about asset quality for ANZ Bank is the geographic loan composition relative to its peers. The Asian growth strategy is more advanced than that of its peers and, during the year to September 2013, ANZ Bank had a 32% increase in corporate loans outside Australian and New Zealand. While we acknowledge the bank reports provisions and impairments for these assets, it is also exposed to emerging markets which are, in our opinion, less transparent than domestic regulated markets. In saying this, we remain confident that ANZ Bank has sufficient expertise to operate a strong risk management system outside of its traditional markets. Earnings Power The pretax, pre-provision earnings, or PPE, are a bank's first line of defence against credit losses. As such, it receives the highest weighting in the bank solvency score. The higher a bank's core earnings power, the more losses it is capable of absorbing without affecting its allowance for loan losses or common equity tier-1 capital balance. ANZ Bank has always had very strong PPE return on assets and we expect this will continue into the future. We project PPE to grow at an average of 9.0% per annum during the next five years giving investors comfort that the first level of defence against deteriorating asset quality has a solid outlook.

6 11 February Figure 5: ANZ Funding Mix Short term wholesale funding Central bank deposits Long term wholesale funding Customer desposits and liabilities Shareholders equity and hyrbid debt 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: Morningstar, ANZ 8.0% 62.0% 17.0% 3.0% 12.0% 8.0% 61.0% 16.0% 3.0% 12.0% 8.0% 61.0% 15.0% 3.0% 11.0% 30/09/13 30/03/13 30/09/12 Figure 6: ANZ Bank Term Wholesale Funding & Maturity Profile (AUD Billions) Senior Unsecured Covered Bonds Government Guaranteed Tier 2 Issuance Maturities Funding and Liquidity The new Basel III liquidity and funding risk management framework took a step forward in the past few months as the liquidity reforms came into effect (1 January 2014). The liquidity reforms require banks to manage liquidity with two quantitative measures: 330-day liquidity coverage ratio, or LCR, to address an acute stress scenario 33Net stable funding ratio (NSFR) to encourage longer-term funding resilience; the NSFR has been deferred as a result of further review by the Basel Committee. As at the time of its last trading update ANZ Bank confirmed it had completed AUD 23.7 billion of term wholesale funding, meaning it easily met the annual funding target of AUD 20 to AUD 25 billion. Liquid assets have increased by 6% year-on-year to AUD billion. The composition of the liquidity portfolio is heavily skewed towards internal residential mortgage-backed securities. These securities have repo-eligibility with the Reserve Bank of Australia, or RBA. This relationship will continue into the future with the introduction of the RBA s committed liquidity facility, or CLF, in The balance between retail deposits and short-term wholesale funding seems to have plateaued as the cost of deposits exceeds short-term funding. In our opinion, the bank will continue to fund new asset growth with deposits, but possibly not at the expense of the overall funding cost. FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 Includes transactions with a call date or maturity date greater than 12 months at time of issue. Excludes Hybrids. Source: Morningstar, ANZ Bank FY18 FY19+ Counterparty risk is something that is not widely discussed, being another layer of complexity. However, in the event of a downgrade of ANZ Bank's rating by one notch, the bank would be required to put forward ~USD 460 million additional collateral with its counterparties. This would reduce ANZ's overall liquidity portfolio, but only marginally. Stress Test Loss Absorption Cushions Morningstar s bank stress test score evaluates a bank's capacity to absorb additional losses in its loan and securities portfolios. This ability depends on the bank's initial capital position, provisioning and its 12-month forward PPE as the first line of defence. The stress test score is based on a bank's expected capital position at the end of a two-year period of (hypothetical) elevated losses. Expected losses in various loan and security categories are applied to a bank's most recent asset composition (reported in APS 330). Losses are subtracted from the bank's last

7 11 February Figure 7: Capital Trigger (5.125%) Loss Absorption Cushion as at September 2013 Earnings Cushion Capital Cushion Provisions Cushion 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0% Source: Morningstar 1.3% 3.4% 3.2% 1.4% 1.5% 2.7% 3.9% ANZ CBA NAB WBC 3.3% 3.0% reported core equity tier-1 capital position. 1.3% 4.0% 3.9% As with other domestic major banks, ANZ Bank performed very strongly against Morningstar s stressed scenario. This stress test is arguably not as severe as APRA s own hypothetical stress tests, which are intended to test the boundaries of "severe but plausible" macroeconomic deterioration. Figure 7 shows the loss absorption cushion for ANZ Bank as a percentage of risk-weighted assets. This effectively shows the losses ANZ Bank can absorb during a 12-month period before breaching the capital trigger of 5.125%. Although Westpac s capital cushion is considerably higher than its peers, our thesis has for some time been that Westpac will pass through this additional capital in the form of a special dividend at some time in the near future. Distance to Default The final measure in Morningstar s credit opinion is distance to default. This is an adjusted form of Morningstar s structural model of default. This measure provides us with a guide to the probability of an issuer meeting its obligations (without covenants). This does not have a large impact on our overall assessment but is designed as a quantitative measure of default probability. Importantly, our fundamental assessment suggests that our default probability estimates are conservative relative to other market-based assessments (that is, implied default probability from credit default swaps). V. Structural Considerations Morningstar s credit opinion is a measure of strength of an issuer and the probability that it will meet all future obligations. It does not form a complete view on the risk of bank capital notes such as ANZ Capital Notes 2. The best way to think of the credit opinion in the context of ANZ Capital Notes 2 is a probability of non-conversion. It is important to note this is not probability of default, which has a lower probability. Excluding an early redemption event, conversion of ANZ Capital Notes 2 will happen only in three scenarios (excluding an early redemption event): 33Scheduled mandatory conversion, subject to conversion conditions, at 1% discount to volumeweighted average price, or VWAP, on mandatory conversion date 33Conversion as choice of exchange method on optional exchange date, subject to conditions 33Unscheduled conversion due to: 33capital trigger event. 33non-viability trigger. The mandatory conversion date is 24 March On this date, holders of ANZ Capital Notes 2 will be converted into ANZ Bank common equity at a 1% discount (AUD ) to the VWAP of ANZ common equity during the 20 business days preceding the mandatory conversion date. Mandatory conversion is subject to: 33First scheduled conversion condition VWAP of ANZ Bank shares on the twenty-fifth business day preceding the mandatory conversion date is greater than 56% of the issue date VWAP. 33Second scheduled conversion condition VWAP of ANZ Bank shares during the preceding 20 business days before the scheduled conversion date is greater than 50.51% of the issue date VWAP. 33No delisting of ordinary shares. These conditions are designed to protect the holder from short-term volatility in the underlying ANZ share price that might unnecessarily affect the scheduled conversion calculation. In our opinion, unscheduled conversion is an unlikely, but severe, scenario which, from a timing perspective, is before default or insolvency. The threshold is clear for the capital trigger (being 5.125% of common tier-1 capital) but non-viability has not been clearly defined. Both of these scenarios are key to the risk profile of the security. The risk profile is asymmetric with a low

8 11 February probability that the security will be converted, but loss-given-conversion can be high. These structural elements are described below and are designed to meet the loss absorption requirements set out by APRA. Note that conversion conditions do not apply during unscheduled conversion. Capital Trigger Event A capital trigger event is defined as when the issuer's common equity tier-1 capital ratio breaches the lower limit of 5.125%. This level was decided upon by the Basel Committee on Banking Supervision and implemented by APRA. Investors can monitor this trigger level on a quarterly basis as it is disclosed by the issuer in what is known as ANZ Bank s Pillar 3 report. Importantly, investors should understand that at 5.125% of core equity, capital still has significant enterprise value (this is different from market capitalisation) and hence investors will be converted when the company still has capital available to cover losses. To reach this capital level, we expect the macroeconomic environment would have to deteriorate substantially (or the bank be subject to some sort of securities fraud) with loan losses exceeding our worst-case scenario. In the event that this scenario did eventuate, ANZ Capital Notes 2 would be converted (conversion conditions to not apply at this point) into common equity to a point where the common equity tier-1 ratio is restored above the 5.125% level. Unscheduled conversion will occur using a predefined calculation with the number of shares received by investors a function of a calculation known as the conversion number. This conversion number has a maximum limit (known as the maximum conversion number) which will automatically write down the value of an investment depending on the common equity share price during the preceding five days (% days VWAP). This trigger event is not new and has been embedded in all tier-1 securities since ANZ CPS 3 (ASX Code: ANZPC). The timing of conversion for a capital trigger event is significant because, in our opinion, it should be before the point of non-viability and default/insolvency. If ANZ Capital Notes 2 is Figure 8: Theoretical Capital Risk Profile for Equity and Hybrid Instruments Bank Operating Environment Issuer Share Price ($) LHS Issuer Hybrid Price ($) RHS Share price Theoretical point of non-viability Common Equity Tier 1 Ratio Trigger (5.125%) Min Tier 1 ratio (plus Capital Conservation Buffer) Share price upside 30 limited as retained 120 capital very high Theoretical jump 5 to default 20 0 APRA Common Equity Tier 1 Ratio Source: Morningstar SPECULATIVE HIGH MEDIUM LOW ISSUER RISK RATING

9 11 February forced into unscheduled conversion, it is likely that the issuer will require a further equity capital injection and any recovery would be significantly diluted by new common equity capital. For this reason, Morningstar conservatively assumes 0% recovery on unscheduled conversion. Figure 8 shows a theoretical example of how the capital value of the ANZ Capital Notes 2 would work relative to its share price. We can see from the chart that the share price of an issuer will retreat significantly quicker as the level of capital reduces (this can be due to losses exceeding provisions) but the preference share price will only begin to reduce once it approaches the unscheduled conversion triggers. Ultimately, if the issuer defaults (a highly unlikely event in our view), the value of both securities would be zero. Hence, we conservatively assume nil recovery. Note, Figure 7 is designed to display the theoretical price, whereas in reality market prices are much more volatile. Non-viability Trigger Event The point of non-viability is the second line of defence before a public injection of funds if necessary to support the issuer. This point has not been clearly defined and it will remain subjective for APRA's purpose (which is ultimately to protect the public from having to support a failing banking institution). It is Morningstar s opinion that the point of non-viability is between default (or zero core equity capital) and the capital trigger (5.125% core tier-1 equity). It is reasonable to suggest that the only time a point of non-viability is reached is when a very large unexpected loss is attributed to the institution and there is a jump to non-viability. We expect it would be before insolvency because it is in the regulator's interest to maintain solvency in domestic banking institutions at all cost. A non-viability trigger event has been defined in the prospectus as: 33the issuance of a notice in writing by APRA to ANZ Bank that conversion or write-off of relevant securities is necessary because, without it, APRA considers that ANZ would become non-viable; or 33a determination by APRA, notified to ANZ Bank in writing, that without a public sector injection of capital, or equivalent support, ANZ Bank would become non-viable. This trigger ultimately gives APRA discretion to convert ANZ Capital Notes 2 into equity when it deems it appropriate. The use of this trigger event may not be limited to its concerns about ANZ Bank s capital levels and could extend to concerns about the bank s funding and liquidity. Importantly, the timing distinction between the capital trigger event and non-viability trigger event would in all likelihood be small. Each of these events are likely to be triggered as a result of a large unforeseen loss. In the event of a slow deterioration in capital, this would be captured by the capital trigger, but only a sharp deterioration where asset write-offs are very large would be captured by non-viability. As with the capital trigger event, conversion will occur using the same predefined calculation, with the number of shares received being a function of a calculation known as the conversion number. This conversion number has a maximum limit (known as the maximum conversion number) which will automatically write down the value of an investment depending on the common equity share price during the preceding five days (% days VWAP). As non-viability conversion is forced, Morningstar assumes 0% recovery. Distribution Restrictions As with all other tier-1 bank capital securities, distributions on ANZ Capital Notes 2 are discretionary. Historically distributions were only to be paid from distributable profits, but this test was removed by APRA in Distributions on ANZ Capital Notes 2 may be affected by the terms of other tier-1 securities issued by ANZ Bank. ANZ Capital Notes 2 also includes terminology that restricts payments of dividends on common equity (dividend and capital stopper) if distributions on ANZ Capital Notes 2 have not been paid. These restrictions are not as strong as dividend stopper conditions from older hybrid securities, but will be the standard for Basel III compliant securities. It is possible that ANZ Bank could keep paying distributions on ANZPA, ANZPB and ANZPC while not paying on ANZ Capital Notes 2. This situation is unlikely but possible, in our opinion. Inability Event If for some reason, ANZ Bank was unable to convert ANZ Capital Notes 2 following a trigger event (for example, a court order restriction on issuing shares) then ANZ Capital Notes 2 would be written off instead of converted.

10 11 February Early Redemption ANZ Bank has the option of early redemption of ANZ Capital Notes 2 on the optional exchange date (24 March 2022). Exchange can take the form of conversion, redemption or resale. For more information see the prospectus. Other early redemption events include tax and regulatory events. Change of Control Event In the event that ANZ Bank receives an unconditional takeover bid (or scheme of arrangement) an acquisition event will have occurred and ANZ Capital Notes 2 will automatically convert to common equity. Conversion will occur using the same calculations as conversion on the mandatory conversion date. Other Risks: Excluding the risks described above, ANZ Capital Notes 2 are subject to a number of other risks which investors should be aware of: Market Risk ANZ Capital Notes 2 have embedded equity risk (through the conversion process) which means it is exposed to market risk as a consequence of its trading activities and/or the management of its financial position. Therefore, it is reasonable to suggest it is exposed to adverse movements in levels and volatility of interest rates, foreign exchange rates, commodity prices, credit prices and equity prices. Interest Rate Risk ANZ Capital Notes 2 reset on a semi-annual basis. Technically, this is defined as short duration and therefore changes in benchmark interest rates will have a minimal impact on the capital performance of the security. Systemic Credit Risk Although idiosyncratic credit risk has been assessed in this document, systemic effects can have an impact on the performance of the security. This risk is difficult to quantify, but Morningstar mitigates this risk by incorporating a systemic risk premium in its fair value assessment. Event Risk Event risks arise as a result of unforeseen or unexpected events such as natural disasters, political reforms, mergers and acquisitions. K

11 11 February Table 3: Comparable Converting Major Bank Capital Securities ANZPE NABPB ANZPD WBCPD NABPA CBAPC Name ANZ Capital Notes 2 NAB CPS 2 ANZ Capital Notes Westpac Capital NAB CPS CBA PERLS VI Notes Type Mandatory Conversion Mandatory Conversion Mandatory Conversion Scheduled Conversion Mandatory Conversion Mandatory Converting Issuer ANZ NAB ANZ WBC NAB CBA Issue Size Min AUD 1000 million AUD billion AUD 120 AUD 1,380 million AUD billion AUD 2.0 billion Face Value AUD 100 AUD 100 AUD 100 AUD 100 AUD 100 AUD 100 Issue Date 31-Mar Dec Aug March Mar Oct-2012 Margin above Base Rate [ %] 3.20% 3.40% 3.20% 3.20% 3.80% p.a Base Rate 180-Day BBSW 90-Day BBSW 180-Day BBSW 90-Day BBSW 90-Day BBSW 90-Day BBSW First Optional Exchange Date Mandatory Exchange Date 24-Mar Dec Sep Mar Mar Dec Mar Dec Sep Mar Mar Dec-2020 Step-Up None None None None None None Distributions Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Capital Trigger Event 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% Yes, if common equity tier-1 ratio is equal to or below 5.125% Non-Viability Trigger Event Conversion into ordinary shares Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Ranking Above ANZ ordinary shares. Above NAB ordinary shares. Above ANZ ordinary shares. Above WBC ordinary shares. Above NAB ordinary shares. Above CBA ordinary shares.

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