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At a glance ...............................................5

Executive summary ..................................6

Net Interest Income ............................... 10

Asset Quality .......................................... 13

Non-interest income ............................... 15

Capital .................................................... 17

Costs ...................................................... 19

Return on Equity .................................... 21

Major Australian Banks: Half Year 2018 Results Analysis

© 2018 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name and logo and are registered trademarks or trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.

Half Year 2018 Results Snapshot

5 Major Australian Banks: Half Year 2018 Results Analysis


At a glance ANZ CBA1 NAB WBC

1H18 PCP2 1H18 PCP2 1H18 PCP2 1H18s PCP2

Ranking

By profit before tax 3 3 1 1 4 4 2 2

By total assets 2 2 1 1 4 4 3 3

By total equity 3 3 1 1 4 4 2 2

By market capitalisation 3 3 1 1 4 4 2 2

By CET 1 capital ratio 1 1 3 3 4 4 2 2

Financial Performance – P/L

Profit before tax ($ million) – statutory basis 5,356 4,389 6,975 6,770 4,058 3,984 6,035 5,643

Profit after tax ($ million) – statutory basis 3,323 2,911 4,906 4,895 2,583 2,545 4,198 3,907

Cash profit after tax ($ million) 3,493 3,355 4,735 4,828 2,759 3,294 4,251 4,017

Performance Measures – P/L

Net interest margin – cash basis (basis points)

193 200 216 210 187 182 217 207

Cost to income ratio – cash basis (%) 45.0 45.0 43.9 42.7 52.2 42.7 41.7 41.8

Basic earnings per share3 – statutory basis (cents)

114.2 119.9 282.2 292.0 93.9 100.8 123.7 121.2

Basic earnings per share3 – cash basis (cents) 119.4 117.9 272.2 279.9 102.2 125.4 125.0 119.9

Return on average equity3 (%) – cash basis 11.9 11.7 14.5 15.6 11.4 13.9 14.0 13.6

Credit Quality Measures

Impairment charge ($ million) (statutory basis)

408 719 596 599 382 399 393 493

Impaired loans to loans and advances to customers (%) – B/S

0.34 0.41 0.45 0.43 0.71 0.70 0.22 0.22

Collective provision to credit RWA (%) – B/S 0.75 0.79 0.76 0.73 0.89 0.86 0.75 0.76

Financial Position – B/S

Total assets ($ million) 935,116 897,326 961,930 976,318 796,068 788,325 871,855 851,875

Total equity ($ million) 59,500 59,075 66,091 63,660 52,401 51,317 62,665 61,342

Capital Measures – B/S

Capital Adequacy Ratios (%)

- Total 14.9% 14.8% 14.8% 14.2% 14.4% 14.6% 14.8% 14.8%

- Tier 1 12.9% 12.6% 12.4% 12.1% 12.4% 12.4% 12.8% 12.7%

- Common Equity Tier 1 11.0% 10.6% 10.4% 10.1% 10.2% 10.1% 10.5% 10.6%

Market capitalisation4 ($ billion) 77.9 86.9 140.6 142.9 62.0 84.3 97.4 117.7

1 CBA as reported as at 31 December 2017. 2 Prior comparable period (PCP) data comprises of 1H17 for profit and loss (P/L) metrics and 2H17 for balance sheet (B/S) metrics, unless otherwise stated. 3 Comparative amount reported as of 2H17 4 Market capitalisation sourced from statutory accounts or ASX.



Executive summary The first half year 2018 (1H18) results of the Australian major banks (the majors) shows that growth continues to be challenging in a new era of industry transformation. Whilst reporting continued improvements in loan impairments and margins, the results indicate a difficult regulatory and operating environment facing the majors, with slowing revenue growth, rising capital levels and increasing legal and remediation costs, as the industry works to restore trust.

The majors reported a combined cash profit of $15.2 billion for the half year, down 2% compared to the previous corresponding period (1H17 or PCP). This decrease is primarily driven by lower non-interest income and higher restructuring and regulatory costs.

Aggregated net interest income (cash basis) increased by 4.8% to $31.7 billion for the half year, while aggregated non-interest income (cash basis) decreased by 5.8% to $11.5 billion mainly due to one-off asset disposals, the removal of ATM fees and regulatory changes (e.g. interchange rates).

Diagram 1. Cash profit after tax by segment (1H18)

“The half year results begin to reflect the

transformation of the industry that is

underway, as the majors re-shape their

business models for the future to reflect the

societal, regulatory and technology agenda.”



Diagram 2. Average net interest margin

Aggregated average net interest margin of 203 basis points (cash basis) increased by 3 basis points compared to 1H17 primarily due to mortgage and deposit re-pricing offsetting lower earnings on capital market’s income and the impact of the Major Bank Levy.

Loan impairment charges continue to fall across the majors. The implementation of AASB 9 Financial Instruments (AASB 9) is expected to increase the collective loan impairment provisions across the banks as it introduces a forward looking methodology for provisioning.

The average cost-to-income ratio increased by 265 basis points across the majors to 45.7%, attributed to meeting rising regulatory compliance, legal and remediation requirements, as well as restructuring costs and increased investment in technology.



Diagram 3. Profit before tax and provisions vs operating profit before tax (statutory basis)

The majors’ capital position continued to rise, with their average Common Equity Tier 1 (CET1) capital ratio rising by 20 basis points over the half year to an average of 10.5% of risk-weighted assets (RWAs), reflecting the impact of increased regulatory capital requirements (as the industry works towards APRA’s “unquestionably strong” benchmark).

As a consequence of these requirements, the increase in banks’ capital levels has continued to compress industry returns. The majors’ returns on equity (ROE) decreased by 78 basis points to an average ROE of 12.9% for the half year.

Diagram 4. Total capital vs return on equity



Outlook

Looking ahead, economic conditions in Australia are expected to remain relatively mixed, with a cooling property market and subdued wage growth continuing to be offset by relatively strong employment growth and rising business investment. The medium term outlook - which has many economists predicting a rise in interest rates some time in 2019, coupled with persistently high household debt levels - will require constant vigilance from the majors to ensure they maintain disciplined lending practices.

Furthermore, the uncertainty of the future operating and regulatory environment will present substantial challenges for the majors’ Boards and management teams, as they execute on a range of measures to restore public trust, respond to the Royal Commission and manage the introduction of policy changes, such as mandatory Comprehensive Credit Reporting (this year) and Open Banking (in the middle of 2019). These changes, both individually and collectively, will play a critical role in the transformation of the banking industry in the future.

While the majors pursue different strategic initiatives and investments, they are each seeking to simplify, digitise and re-orientate their business models – balancing the needs of all stakeholders – in order to deliver enhanced customer outcomes and at the same time decent returns to shareholders.

Despite slowing demand for credit

and increasing regulatory and

capital costs, the majors are

accelerating their efforts to transform

their business portfolios, invest in digitial capabilities

and simplify their operating models.



Net Interest Income Net interest income increased 5.0% to $31.6 billion on aggregate compared to 1H17. This is driven by mortgage and deposit repricing, an increase across interest earning assets and a decrease in wholesale funding costs, partially offset by the Major Bank Levy and weaker markets and treasury performance. Accordingly, net interest margin has increased by 3 basis points to an average of 2.03% compared to 1H17.

Cash basis HY17

Movement %

NET INTEREST INCOME 1H18 1H17

ANZ 7,350 7,419 (0.9%)

CBA 9,253 8,710 6.2%

WBC 8,278 7,613 8.7%

NAB 6,750 6,393 5.6%

Aggregate 31,631 30,135 5.0%

NET INTEREST MARGIN 1H18 1H17

ANZ 193 200 (7 bps)

CBA 216 210 6 bps

WBC 217 207 10 bps

NAB 187 182 5 bps

Average 203 200 3 bps

Net interest margin

Although the low interest rate environment put downward pressure on the net interest margin, the majors have reported an increase in net interest margin compared to 1H17 due mainly to the favourable movements in house lending and re-pricing of interest only and investment loans in response to more stringent regulatory requirements. However, the interest rate environment continued to affect markets interest income in particular, with all four majors posting a decrease in markets and treasury earnings. Other factors such as the Major Bank Levy and lower earning rates on capital also constrained increases in the average net interest margin.



Diagram 5. Interest margins

Lending asset growth

Housing credit recorded growth in the half year of 1.8% compared to non-housing credit which only grew 0.9%. Housing credit has been impacted by the slowing Australian housing market and the introduction of APRA’s prudential cap on interest-only lending.

Regulators have been scrutinising property lending and borrower serviceability as an area of heightened risk, particularly given high levels of household debt where movements in interest rates have the potential to impact the serviceability of loans. Despite APRA capping the new interest-only lending at 30% of the total new residential mortgages and limiting the generation of such loans at loan-to-value ratio above 80%, the majors recorded an increase in average interest earning assets across their portfolios of 1% to 777,195 whilst also decreasing gross impaired assets, demonstrating balance sheet resilience. We note that APRA has now removed the interest only cap as it considers it has had the desired impact.

However, the increase in average interest earning assets for the past six months of 1%, compared to the 2% increase in second half 2017 (2H17), shows that interest earning assets growth continues albeit at a slower pace. This is in line with the cooling off of the Australian housing market, as well as low economic growth, interest rates and increasing competition.



Diagram 6. Loans to households and market share of household loans

Funding mix

The major banks continue to change their funding mix towards longer term wholesale funding to build and stabilise a comfortable buffer above the new Net Stable Funding Ratio (NSFR) minimum requirement of 100%.

The Basel III NSFR requirement became effective from 1 January 2018, with the majors all reporting their compliance at an average of 113%. This has been achieved with a decrease in deposits and wholesale funding costs.

Diagram 7. Customer deposits proportionate to total gross loans



Asset Quality A benign economic environment and APRA’s regulatory focus on lending standards has seen this half continue the trend of decreasing impairment charges with the majors recording a decrease of 19.5% to $1.8 billion. These prudential measures have strengthened lending standards resulting in lower levels of impaired assets observed in the past year which continued into the current half, demonstrating an improvement in the risk profile of the majors’ lending portfolios.

Key asset quality metrics indicate that prudential measures put in place in the past, in particular around limits on investor loans and interest-only lending, have flowed onto the majors, with gross impaired assets across the majors decreasing from $8,837 million to $8,545 million. Despite the recent slowdown of housing loan growth and eventual rise of interest rates creating possible future headwinds, the current credit impairment charge compared to gross loans and advances has fallen by 4 basis points, indicating that these vulnerabilities have not yet impacted the financial results of the majors.

Diagram 8. Loan impairment charge



In line with the lower level of impaired assets, the provision for credit impairment has fallen across the majors with the exception of NAB which recorded an increase of 9% compared to 1H17. NAB’s results included a higher collective provision for additional forward looking adjustments for targeted sectors experiencing elevated levels of risk.

With the exception of NAB which has already adopted AASB 9, the implementation of AASB 9 is expected to increase the collective provision as it introduces a forward-looking methodology for provisioning as opposed to using historical incurred losses. CBA announced the implementation of AASB 9 in FY2019 will increase its collective provisions by $850 million with a 25 basis point impact on capital. ANZ noted the new standard is expected to increase its collective provisions in the range of $240-to-$540 million, with a 3 to 6 basis point impact on capital.

Looking ahead, the Australian banking industry will face challenges in sustaining asset quality, as the current record low levels of interest rates eventually increase, placing stress on households with high debt levels. Whilst recent measures have increased the resilience of the majors’ balance sheets, both regulators and banks will need to actively monitor the macroeconomic environment for emerging signs of stress in their lending books.



Non-interest income The majors reported a combined non-interest income of $11.5 billion, down 5.8% from 1H17, as they continue to face competitive pressure and regulatory scrutiny on fees and commission structures. The decrease also reflects challenging trading conditions, partially offset by one-off asset sales as the majors continue to divest non-core businesses and focus on meeting capital requirements.

CBA’s non-interest income of $3,869 million decreased by 6% compared to 1H17. Excluding prior period’s one-off revenue from the sale of Visa Inc., non-interest income movement was flat, reflecting an increase in commission income, offset by lower trading income.

NAB’s trading income of $610 million decreased by 15% compared to 1H17. This primarily reflects $241million favourable movements in economic hedges in the prior period, compared to $41 million in the current half.

ANZ’s non-interest income of $2,458 million decreased by 4% compared to 1H17. This primarily reflects lower markets revenues including the lower impact of derivative valuation adjustments compared with 1H17.

WBC's non-interest income decreased by $218 million (7%) from 1H17 primarily due to a large decrease in trading income of $206 million from lower risk income and customer activity. They also recorded a lower credit card fee income due to the full impact of the regulatory changes to Australian interchange rates from 1 July 2017.

Diagram 9. Breakdown of non-interest income (statutory basis)



Asset sales

As the majors continue to restructure their wealth management businesses, the following divestments were announced during the period:

• On 21 September 2017, CBA announced the $3.8 billion sale of its life insurance business including CommInsure Life and Sovereign to AIA, which is expected to be completed in 2018. A partnership with AIA will be in place to continue distributing life insurance products to CBA customers in Australia and New Zealand.

• NAB announced in their 1H18 results that they intend to target an end of calendar year 2019 to exit their Advice, Platform and Superannuation and Asset Management businesses which are currently under their MLC and other brands.

• ANZ announced the sale of OnePath pensions and investments and aligned dealer groups to IOOF on 17 October 2017 and the sale of its life insurance business to Zurich Financial Services Australia on 12 December 2017. Both sales are expected to close in 1H19.

Wealth management and insurance

Profits in the wealth and insurance businesses increased by 8.3% to $2.6 billion as the majors benefited from more focused wealth management offerings, and an increase in funds under management compared to 2H17.

Diagram 10. Net funds management and insurance income



Capital Australian regulatory conditions remain challenging in the midst of rising APRA capital requirements and the implementation of new accounting standards for annual financial reporting periods commencing on or after 1 January 2018. Despite this, the Australian major banks continued to perform favourably in key capital metrics on the back of prior steps taken to enhance balance sheet strength.

At the end of 1H18, organic growth from cash earnings continued to drive a modest increase in the Basel III Common Equity Tier 1 (CET1) ratio to an average of 10.5% across the major banks. This will continue to be an area of focus for the majors going forward to meet APRA’s “unquestionably strong” target of 10.5% by 1 January 2020. The adoption of AASB 9 and the resulting expected increase in loan impairment provisions will place further downwards pressure on the CET1 ratio, ensuring that the majors will need to continue to strengthen their balance sheet.

Dividends, which are a key variable in sustainable capital metrics, are largely flat compared to 1H17. Dividend payout ratios have increased to an average of 77.6% across the majors. ANZ reported a flat dividend of 80 cents and a decrease in the payout ratio from 1H17 to 66%, moving them towards their stated target payout ratio of 60 to 65%. ANZ’s higher capital position from announced and completed asset sales provides flexible capital management options going forward, including dividends.

Capital adequacy metrics ANZ CBA NAB WBC

1H18 2H17 1H18 2H17 1H18 2H17 1H18 2H17

Common Equity tier 1 ratio 11.0 10.6 10.4 10.1 10.2 10.1 10.5 10.6

Tier 1 capital (total) 12.9 12.6 12.4 12.1 12.4 12.4 12.8 12.7

Tier 2 2.0 2.2 2.4 2.1 2.0 2.2 2.0 2.2

Total regulatory capital ratio 14.9 14.8 14.8 14.2 14.4 14.6 14.8 14.8

Tier 1 capital ($ million) 51,125 49,324 54,465 52,684 48,048 47,417 53,246 42,670

Total capital ($ million) 59,165 57,993 65,087 62,076 55,899 55,707 61,653 59,910

Risk weighted assets ($ million) 395,777 391,113 440,836 437,063 387,415 382,114 415,744 404,235

Credit risk weighted assets ($ million) 342,822 336,834 366,985 377,259 329,882 325,969 361,391 349,258



The majors reported continued compliance with minimum capital adequacy requirements throughout the period, including the new Net Stable Funding Ratio requirements that came into effect on 1 January 2018. In addition:

• The Liquidity Coverage Ratio (the amount of high quality liquid assets held that can be used to meet the bank’s liquidity needs for a 30 day calendar liquidity stress scenario) is at an average of 131.5% versus the stipulated 100% minimum; and

• The Leverage Ratio (the amount of Tier 1 capital held divided by average total consolidated assets of the bank) for the majors is running at an average of 5.5% which is also in excess of the currently agreed minimum Basel requirement of 3%.



Costs The majors continue to intensify their efforts to improve their business efficiency. However, combined operating expenses has increased mainly attributable to restructuring costs, increasing regulatory and legal expenditure (e.g. Royal Commission) and CBA’s AUSTRAC provision. The majors continue to invest in technology and have reported productivity efficiencies which have led to reduced personnel costs. Cost management continues to be a strategic imperative and will rely on further efforts to simplify product offerings, streamline processes and investment in technology to realise a step-change in their cost bases in the future.

Operating expenses have increased in aggregate by 7.3% to $19,573 million across the majors. The half’s results include NAB restructuring costs of $755 million with CBA’s provision for the AUSTRAC proceedings of $375 million and additional regulatory, compliance and remediation programs of $200 million.

The average cost to income ratio has also increased by 265 basis points to 45.7%, mainly due to the above costs and the Major Banks Levy.

Diagram 11. Average cost to income ratio

Technology

Technology spend continues to increase, rising by 5.3% to $2.0 billion across the majors. The rise in technology investment provides the majors with an opportunity to strengthen and streamline their product offerings and operating environments, allowing them to provide an enhanced customer experience and at the same time addressing growing areas of concern, such as cyber and information security.

CBA has increased their investment in technology by 6% to $503 million when excluding the lower amortisation due to the one-off acceleration of specific software assets in 1H17.



Diagram 12. Capitalised software

Personnel

Overall personnel numbers across the majors continue to decline as the majors are reporting benefits from productivity initiatives. Full Time Equivalents (FTE) reduced by 6,326 to 152,702. Most notably, ANZ reported a reduction of 3,316 FTE to 41,580 during the half, attributed to the divestment of their Asia Retail and Wealth businesses.

Looking ahead, the majors will continue to focus on operational improvements through the implementation of emerging technologies such as robotic process automation and artificial intelligence. As a result, the demand for jobs that require unique skillsets and technical capabilities will continue to increase, as evidenced by NAB’s announcement to hire 2,000 people with ‘digital’ skills and competencies.

Diagram 13. Average personnel costs per FTE



Return on Equity The majors will face increased pressure to manage shareholder expectations as industry Returns on Equity continue to trend downwards owing to slowing revenue and rising capital, regulatory and operating expenses.

The prospect of increasing and sustaining ROE has proved challenging for the majors as they report a decline in cash profits and return on equity. This is evident during the period, where ROE has decreased in aggregate across the majors by 78 basis points to an average ROE of 12.9%, primarily due to both internal and external costs such as the Major Bank Levy, in a slowing revenue environment.

In particular, this result was driven by NAB and CBA who recognised decreases of 250 basis points to 11.4% and 110 basis points to 14.5% respectively, owing to a large increase in operating expenses from costs associated with NAB’s restructuring program and CBA’s recognition of a provision for the ongoing AUSTRAC proceedings. Meanwhile, ANZ’s ROE increased by 20 basis points to 11.9% on the back of their $1.5 billion share buyback plan currently underway and dividends paid.

Diagram 14. Profit before tax against return on equity



Dividends

Despite combined cash profit being down across the majors, dividends remained largely flat with only CBA recording an increase on PCP of 1% share. The dividend payout ratio increased across the majors on average by 3%. Individually, the payout ratio varied across the majors. Both NAB and ANZ held their dividend flat, with NAB’s ratio increasing from 79.9% in 1H17 to 96.9% with lower cash profit during the half, whilst ANZ’s ratio decreasing from 70% to 66.2% with higher cash earnings.

Looking ahead, in particular over the short-to-medium term, sustaining the historical high levels of payout ratios will become an increasingly challenging task with rising regulatory pressures and capital costs, in a low growth environment.

Diagram 15. Dividend yield vs payout ratio


ACKNOWLEDGEMENTS

The following KPMG staff have made a significant contribution to the development of this publication.

Ashley Trang Michele Cappai Daphne Lam

Dejia Li Jessica Tse Daniel Valeri

www.kpmg.com.au

The information contained in this document is of a general nature and is not intended to address the objectives, financial situation or needs of any particular individual or entity. It is provided for information purposes only and does not constitute, nor should it be regarded in any manner whatsoever, as advice and is not intended to influence a person in making a decision, including, if applicable, in relation to any financial product or an interest in a financial product. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

To the extent permissible by law, KPMG and its associated entities shall not be liable for any errors, omissions, defects or misrepresentations in the information or for any loss or damage suffered by persons who use or rely on such information (including for reasons of negligence, negligent misstatement or otherwise).

© 2018 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

The KPMG name and logo and are registered trademarks or trademarks of KPMG International.

Liability limited by a scheme approved under Professional Standards Legislation. ACS098113

January 2016

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Adrian Fisk National Industry Leader, Financial Services +61 2 9335 7923 [email protected]

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Documents

At a glance...Common Equity Tier 1 (CET1) capital ratio rising by 20 basis points over the half year to an average of 10.5% of risk-weighted assets (RWAs), reflecting the impact …