Westpac Subordinated Notes (WBCHA)

18 July 2012 Westpac Subordinated Notes (WBCHA) Special Report Recommendation: Subscribe Overview Westpac (WBC) will raise $500m via an ASX-listed security issue, Westpac Subordinated Notes (WBCHA). WBCHA are subordinated, unsecured securities with a 10-year maturity. WBC has an option to redeem the notes early at the five-year mark, on any subsequent interest payment date, or following a taxation or regulatory event, subject to APRA approval. The notes pay quarterly interest based on the 90-day BBSW rate plus a margin, expected to be in an indicative range of 2.75% to 2.95% p.a. The notes rank ahead of WBC ordinary and preference shares (including WBCPA, WBCPB, WBCPC and WCTPA) and subordinated perpetual debt. The distributions are interest payments, so are not franked. The offer is open to registered holders of WBC ordinary shares, holders of WBCPA, WBCPB, WBCPC and WCTPA, and clients of participating brokers and certain institutional clients. There is no general public offer. Table 1: Selected Major Bank Hybrid Yields as at 16 July 2012 ASX Code Issuer Contract Style Source: Morningstar Trading Margin % Summary and recommendation We recommend eligible investors Subscribe. This issue is very similar to the recent subordinated note issues (ANZHA and NABHB) by Australian and New Zealand Banking Group (ANZ) and National Australia Bank (NAB). We liked those offers and also think WBCHA is an attractive offer that will likely attract strong investor interest. WBCHA is a pure debt security with a relatively simple structure, has non-deferrable interest payments subject to a solvency test. Investors need to understand WBCHA is still an unsecured and subordinated investment, so in a wind-up scenario, investors could potentially lose all their investment. Put simply, it is riskier than a bank deposit. We don t rate a wind-up as anything but a risk to note we don t rate that risk highly! Potential investors should be aware WBCHA is a floating rate note that reprices quarterly, so interestrate changes will affect interest payments. In a declining interest-rate environment, interest payments are likely to fall. The opposite is the case in a rising interest-rate environment. Potential investors may weigh up alternative investment options, depending on their individual preferences: you can also invest in bank deposits or bank equity. Yields on major bank equities still look attractive, albeit they carry more risk and prices are more volatile than hybrids. Gross Running Yield % Gross YTR % BBSW Risk ANZPA ANZ Mandatory Conversion 3.22 6.83 6.90 90-day Low ANZPB ANZ Mandatory Conversion 2.82 6.20 6.51 90-day Low ANZPC ANZ Mandatory Conversion 3.60 6.84 7.25 180-day Low ANZHA ANZ Note 2.68 6.39 6.33 180-day Low CBAPA CBA Mandatory Conversion 2.78 7.00 6.39 90-day Low PCAPA CBA Step-up 3.91 5.13 7.68 90-day Low WBCPA WBC Mandatory Conversion 2.85 6.08 6.54 90-day Low WBCPB WBC Mandatory Conversion 2.99 7.40 6.64 90-day Low WBCPC WBC Mandatory Conversion 3.72 6.99 7.36 180-day Low WCTPA WBC Step-up 3.98 5.13 7.75 90-day Low NABHA NAB Perpetual Note 3.63 7.12 90-day Low NABHB NAB Note 2.63 6.38 6.27 90-day Low Ravi Reddy Credit Analyst Contact Details Australia Helpdesk: +61 2 9276 4446 Email: helpdesk.au@morningstar.com New Zealand Helpdesk: +64 9 915 6770 Email: helpdesk.nz@morningstar.com 2012 Morningstar, Inc. All rights reserved. Neither Morningstar, nor its affiliates nor their content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Limited, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. You should consider the advice in light of these matters and, if applicable, the relevant Product Disclosure Statement (in respect of Australian products) or Investment Statement (in respect of New Zealand products) before making any decision to invest. Neither Morningstar, nor Morningstar s subsidiaries, nor Morningstar s employees can provide you with personalised financial advice. To obtain advice tailored to your particular circumstances, please contact a professional financial adviser. DISCLOSURE: Morningstar employees may have an interest in the securities discussed in this report. Please refer to Morningstar s Financial Services Guide (FSG) for more information www.morningstar.com.au/s/fsg. pdf. Note: Some material is copyright and published under licence from ASX Operations Pty Limited ACN 004 523 782 ("ASXO").

18 July 2012 2 Table 2: Major bank dividend yields as at 16 July 2012 ASX Code Morningstar Gross FY12 Forecast Yield % Morningstar Gross FY13 Forecast Yield % ANZ 9.3 9.8 CBA 8.6 8.9 NAB 10.9 11.8 WBC 10.6 11.1 Source: Morningstar For example, Morningstar has a forecast FY12 maximum gross yield of around 10.6% for WBC based on a share price of $22.16. Given the pricing of recent issues, we expect the final margin to come in at 2.75% p.a., the bottom end of the indicative range. The indicative pricing range of WBCHA is similar to ANZHA and NABHB, which pay interest at a 2.75% p.a. margin above the 90-Day BBSW. ANZHA and NABHB were trading at respective margins of 2.68% and 2.63% as at 16 July 2012. We assign WBCHA a 2.15% fair margin, calculated using a credit spread of 1.80% based on our assessment of this security having low investment risk, an illiquidity cost of 0.10% and an additional 0.25% for features such no noteholder call rights and no step-up margin. This is the same as our fair margins for ANZHA and NABHB. Our preferred hybrid exposures are issues by major banks and high-quality industrials. While the earnings outlook for Australian banks looks challenging, we believe they are well-positioned. We have narrow moat ratings on each of the top four banks. They are well-provisioned and are better capitalised, hold more liquid assets and have a lower wholesale funding requirement than they did going into the GFC. But in an exceptionally dire scenario, we would expect hybrid holders to wear some of the pain, as would ordinary equity holders. We remain comfortable with an investment in WBC. The latest updates by the major banks reaffirm this view. WBC delivered a solid 1H12 result, with cash NPAT up a modest 1% on 1H11. Underlying earnings were up 4.6%, but the 31% increase (albeit off a very low 1H11) in the bad debt expense hit on the bottom line. The 8% increase in the interim dividend surprised on the upside. Net interest income was up 4.3%, with average interest-earning assets growth of 6% offsetting the 4-basis-point decline in the net interest margin. Non-interest income grew 5.0%, driven by increased trading income. Cost growth was below revenue, which saw the cost-to-income ratio improve from 41.8% to 41.1%. Credit quality is under minor pressure, particularly in small-medium enterprises and residential, but is nothing too alarming. Mortgage arrears improved from 0.59% in 1H11 to 0.55%. Bad debts of $608m for the half were up, but remain in line with Morningstar s full-year forecast of $1,190m. Overall, the business is well-provisioned and the capital, funding and liquidity position is strong. The main risks we see for Australian banks in the current environment are: deteriorating credit quality, difficulty accessing European wholesale debt markets, and funding cost pressures. A major slowdown in the Australian economy would impact on credit quality, with a rise in corporate and business bad debts. Employment is the key driver of housing credit quality. A sharp rise in unemployment would see a flow-on impact on housing bad debts. We expect fiscal and monetary levers would be used to try to soften the impact of a major economic slowdown. The RBA would cut interest rates further, though rates are already very low and the government might increase spending to stimulate the economy unless it thought the resource investment boom was already sufficient stimulation. Regardless, we would not get through unscathed. While European debt markets are difficult to access, US and Asian debt markets are open. If all markets closed, the government would probably reintroduce the wholesale funding guarantee. The banks can afford to stay out of wholesale funding markets for several months, but a prolonged closure would limit their ability to lend. Key dates 33Bookbuild: 20 July 2012. 33Margin announced: 23 July 2012. 33Offer opens: 23 July 2012. 33Closing date for security holder offer: 16 August 2012. 33Closing date for broker firm offer: 22 August 2012. 33Issue date: 23 August 2012. 33Commencement of trading: 24 August 2012. 33First interest payment date: 23 November 2012. 33First optional redemption date: 23 August 2017. 33Maturity date: 23 August 2022. Key terms 33ASX code is expected to be WBCHA. 33Face value: $100 per security. 33Minimum subscription amount: $5000 (50 units). 33Amount to be raised: $500m, with the ability to increase or decrease the offer size. 33Interest rate: 90-day BBSW + margin. 33Indicative margin range: 2.75% to 2.95% p.a. to be set via a bookbuild process. 33Interest payments are cumulative, unfranked and payable quarterly in arrears, on the 23rd of February, May, August and November. 33Interest payment test: Interest payments are not

18 July 2012 3 deferrable. WBC must make interest payments, unless it is not solvent immediately before payment is due or will not be solvent after making a payment. 33Term: 10 years. 33Early redemption: WBC has an option to redeem the notes early on 23 November 2017, on any subsequent interest payment date or following a taxation or regulatory event, subject to APRA approval. 33Capital classification: WBCHA will be treated as Tier 2 regulatory capital. WBC expects WBCHA to be eligible for transitional treatment under the new prudential guidelines, known as Basel III. 33Ranking in wind-up: 33Behind any senior creditors (including depositors and holders of WBC senior unsubordinated notes and bonds), 33Equally with other WBC unsecured subordinated debt with a fixed maturity date, 33Ahead of WBC unsecured subordinated debt with no fixed maturity date, 33Ahead of WBC hybrids (including WBCPA, WBCPB, WBCPC and WCTPA), and 33Ahead of WBC ordinary shares and any others shares of WBC. 33Redemption amount: $100 face value plus accrued and any unpaid interest, subject to solvency conditions. 33There is no conversion into WBC ordinary shares. 33Step-up margin: none. 33Holder call rights: Holders cannot request the notes be redeemed early. 33Voting rights: Holders have no right to vote at any meeting of WBC shareholders. We have only presented a summary of material terms. Investors should examine the prospectus in detail. Risks specific to WBCHA WBCHA are unsecured, subordinated debt, so in a wind-up scenario noteholders could potentially lose all of their investment. WBC could default on the payment of face value or interest. WBC could issue more equal or higher-ranking securities, which may reduce the ability of WBCHA holders to recover their investment in a wind-up scenario. Table 3: Comparison to recent note issues by financial services companies WBCHA NABHB ANZHA CNGHA Name Westpac Subordinated Notes NAB Subordinated Notes ANZ Subordinated Notes Colonial Subordinated Notes Type Unsecured Subordinated Note Unsecured Subordinated Note Unsecured Subordinated Note Unsecured Subordinated Note Issuer Westpac (WBC) National Australia Bank (NAB) ANZ Bank (ANZ) Colonial Holding Company Issue Size $500m with the ability to raise more or less. $1.173bn $1.509bn $1.0bn Margin above Base Rate Indicative range 2.75% to 2.95% p.a. 2.75% p.a. 2.75% p.a. 3.25% p.a. Base Rate 90-Day BBSW 90-Day BBSW 90-Day BBSW 90-Day BBSW First Call Date 23-Aug-2017 18-Jun-2017 14-Jun-2017 31-Mar-2017 Maturity Date 23-Aug-2022 18-Jun-2022 14-Jun-2022 31-Mar-2037 Step-Up None None None None Interest/Dividend Payments Interest/ Dividend Deferral Unfranked, floating rate quarterly cash payments in arrears. No, unless WBC is not solvent or will not be solvent after making payment. Unfranked, floating rate quarterly cash payments in arrears. No, unless NAB is not solvent or will not be solvent after making payment. Unfranked, floating rate quarterly cash payments in arrears. No, unless ANZ is not solvent or will not be solvent after making payment. Conversion into shares No No No No Ranking Ahead of WBC ordinary equity and preference shares (incl. WBCPA, WBCPB, WBCPC & WCTPA) and WBC subordinated perpetual debt. Ahead of NAB ordinary equity, preference shares and income securities (NABHA). Ahead of ANZ ordinary equity and preference shares (incl. ANZPA, ANZPB & ANZPC). Risk Low Low Low Medium Unfranked, floating rate quarterly cash payments in arrears. Up to 5 years, but missed payments must be made up. Above Colonial ordinary equity. Other These securities are liabilities of Colonial and are not guaranteed by Colonial's parent CBA. Source: Morningstar

18 July 2012 4 The price of the security once listed may be impacted by changes in credit spreads, interest rates and the financial performance of WBC. These are floating rates notes that will reprice quarterly, so interest-rate changes will affect interest payments. There is a risk that liquidity of the notes will be low, which will impact the bid/ask spread. About the issuer Issuer Thesis WBC is one of the four major banks operating in Australia and is approaching its bicentenary in 2017. It offers a full suite of banking and financial services to the consumer, business and corporate sectors. It also operates throughout New Zealand and the South Pacific. The WBC franchise is robust, and its position within the Australian and New Zealand banking oligopoly justifies a narrow moat rating emanating from scale advantages and high customer switching costs. The four major banks control over 90% of the business and consumer lending markets, plus the vast majority of bank deposits. CBA and WBC control close to 60% of the housing loan market and retail deposits sectors. Despite the dominant market position, competition is intense between the four major banks. WBC keeps tight control on credit and operating costs, consistently delivering net returns well in excess of our cost-of-equity estimate. Importantly, we expect this to continue. There has been substantial investment made in Residential Lending, Wealth Management and Business Banking. The acquisition of St George Bank boosted WBC s position in the Australian banking industry. The enlarged bank has a 26% share of home lending, is the largest wealth platform provider and has the second-largest market capitalisation after CBA. The 'merger' created a stronger organisation with an enhanced growth profile. The extensive distribution network enables the expanded product range to be marketed to a significantly larger customer base. WBC's CEO was the CEO of St George and this assisted the successful integration of the two operations. WBC remains focused on the domestic markets in Australia and New Zealand, offering a wide range of banking and financial services. It seeks to leverage Australasian growth opportunities including retail banking, superannuation and other high-growth segments in Australia and New Zealand. Table 4: WBC Selected Asset Quality Metrics Asset Quality Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Impairment charges to average gross loans (annualised) 37bps 24bps 19bps 22bps 24bps Write-offs to average loans (annualised) 18bps 36bps 28bps 49bps 29bps Impaired assets to gross loans 0.90% 0.95% 0.98% 0.92% 0.88% Impaired asset provisions to total impaired assets 43.1% 40.7% 42.2% 36.0% 37.8% Total provisons to gross loans 110bps 105bps 102bps 88bps 86bps Chart 1: WBC Stressed Exposures as a % of Total Committed Exposures 4.0 3.0 2.0 1.0 % Impaired 90+ days past due well secured Watchlist and substandard 2007 2008 1H09 2H09 1H10 2H10 1H11 2H11 1H12 WBC is well-positioned in the current volatile environment with a lower-risk strategy, a focus on establishing comparative advantage in core markets, a conservative balance sheet, strict risk disciplines across the business, conservative management of capital, sound capital ratios, a diversified funding base and a prudent liquidity profile. Inherent leverage is the main investment risk for banks. Earnings risks include exposure to credit, operational and market volatility. Risk is mitigated due to diversification spanning the consumer, business, corporate and institutional customer segments. The bank is exposed to changes in economic activity, adverse movements in interest rates, inflation, unemployment, FX rates and consumer sentiment, as they impact economic conditions. Deteriorating economic conditions could increase loan losses. Regulatory changes could affect group risk profile. Consistency across all businesses is a feature of WBC's recent performance. Momentum continues to build with the multi-brand growth strategy and lower bad debts driving earnings growth during FY10 and FY11, although global financial uncertainty continues to test risk parameters across the sector. Issuer risk WBC is a leveraged financial group with banking operations spanning the consumer, business and large corporate and institutional segments of the economy.

18 July 2012 5 Chart 2: WBC Tier 1 Regulatory Capital Ratios 15.0 12.5 10.0 7.5 5.0 2.5 % Common Equity Ratio Residual Tier 1 7.8 8.1 1.8 1.5 6.0 6.6 9.1 9.7 9.8 1.6 1.6 1.8 7.5 8.1 8.0 Sep-08 Sep-09 Sep-10 Sep-11 Mar-12 (Basel 2.5) Chart 3: WBC Customer Deposits to Loans 70 60 50 40 30 20 10 120 100 80 60 40 20 $bn 52.6 % Sep-08 Sep-09 Sep-10 Sep-11 Mar-12 Chart 4: WBC Funding Mix SFR 64% SFR 77% SFR 79% 16% 9% 9% 45 20% 10% 5% 44% 4% 12% 11% 4% 7% 2% 7% 1% 74 34 14% 12% 52% 54% Sep-08 Sep-11 Mar-12 Chart 5: WBC Liquid assets 57.7 Cash, Gov't and Semi-Gov't Bonds Private Securities and Gov't Guaranteed Paper Self Securitisation 58.7 Customer Deposits Equity Securitisation Wholesale Offshore > 1yr Wholesale Onshore > 1yr Wholesale Offshore <1 yr Wholesale Onshore <1 yr 82 35 103 101 33 35 31 30 38 29 29 39 36 7 11 18 Sep-08 Sep-09 Sep-10 Sep-11 Mar-12 62.5 63.2 5% 2% The bank is exposed to changes in economic conditions, adverse movements in interest rates, inflation, unemployment and exchange rates. Banks are bankers to the economy and changes in GDP growth affect business activity and earnings growth. Regulatory changes could increase the risk profile. Weak credit growth, a loss of market share and a contraction in net interest margins would negatively impact net interest income, which represents 70% of total operating income. While well-provisioned, a sharp increase in impairment losses would reduce earnings. Higher capital requirements could dampen earnings growth. Latest results update WBC delivered a solid 1H12 result, with cash NPAT was up a modest 1% on 1H11. Underlying earnings were up 4.6%, but the 31% increase (albeit off a very low 1H11) in the bad debt expense hit on the bottom line. The 8% increase in the interim dividend surprised on the upside. Looking at the key drivers, net interest income was up 4.3%, with average interest-earning assets growth of 6% offsetting the 4-basis-point decline in the net interest margin. Funding pressure continues to weigh on the banks. Non-interest income grew 5.0%, driven by increased trading income. Cost growth was below revenue, which saw the cost-toincome ratio improve from 41.8% to 41.1%. Asset quality As at 31 March 2012, housing loans represented around 66% of WBC s total on-balance sheet lending. Business lending represented 28% and consumer loans 3%. Of the Australian housing portfolio, 6% comprised low-documentation (lo-doc) loans. In terms of total assets, housing loans represented around 52%. Impairment charges to average loans have ticked up to 24 basis points in 1H12 versus 22 basis points in the prior half. However, loan write-offs have come down from 49 basis points in 2H11 to 29 basis points in 1H12. Credit quality is under minor pressure, particularly in small-medium enterprises (SME) and residential, but is nothing too alarming. Mortgage arrears improved from 0.59% in 1H11 to 0.55%. Bad debts of $608m in 1H12 were up, but remain in line with Morningstar s full-year forecast of $1,190m. Capital, funding and liquidity The regulatory capital, funding and liquidity position is strong. Customer funding represented 54% of total funding and 63.2% of net loans as at 31 March 2012. Overall, the stable funding ratio (SFR) has increased from 64% in FY08 to 79% in 1H12. The bank's short-term wholesale funding has declined 2% over the half to 21% of total funding, while long-term

18 July 2012 6 wholesale funding is steady at 16%. With deposits growing faster than lending, there is less pressure on wholesale debt. The ability to issue covered bonds also helps diversify the funding base. Covered bonds are new source of funding for Australian banks and allow banks to borrow money using a pool of assets, such as a mortgage, as security. WBC had a $101bn portfolio of liquid assets, including $35bn in selforiginated RMBS, which can be repurchased by the RBA and RBNZ. Tier 1 capital was strong at 9.81% as at 31 March 2012. WBC is using new Basel 2.5 standards, which has had a negative 37-basis-point impact upon the total capital ratio. Basel 2.5 has changed risk-weighted assets applied to market risk and securitisation. WBC's common equity ratio stood at 7.96%. Under the draft Basel III, its common equity ratio stood at 7.78%, above the 7.0% required and including a 2.5% capital conservation buffer expected to come into effect on 1 January 2016. K