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Materially strengthening
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delivering sound returns

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While we have achieved much in 2016, the year has been somewhat overshadowed by increasing public criticism of Australia’s banks

It has been another significant year for Westpac with the company making good progress on its strategy, materially strengthening its balance sheet and delivering sound returns.

Statutory net profit was lower over the year, principally because 2015 included some positive infrequent items including asset sales. Cash earnings (our preferred measure of performance) for the year ended 30 September 2016 were little changed compared to 2015, with disciplined growth across the business contributing to 3% revenue growth. This increase was largely offset by higher impairment charges mostly related to a small number of larger companies being downgraded to impaired early in the year.

While we have achieved much in 2016, the year has been somewhat overshadowed by increasing public criticism of Australia’s banks.

It is fair to say there have been recent examples of poor behaviour in the industry and in some instances the industry has fallen short of community expectations.

We work hard to win customers’ business and maintain returns for shareholders, and we must also continually work hard to maintain the trust of the community as a whole.

That is why Australia’s banks are implementing a comprehensive suite of measures to further protect customer interests and increase transparency and accountability. These include ensuring there are no conflicts in the way staff are incentivised, further protecting whistleblowers and enhancing the handling of complaints.

However, we also need to be proud of the important role banks play for Australians. The sector has not relied on capital from the government, nor has it weighed down economic activity – in fact the reverse is true. It is regrettable that the debate and coverage around banks has not acknowledged these benefits and, at times, has comprised broad and ill-informed accusations.

Before I share my observations on the year that has been, I would first like to offer some balance to this debate, so that shareholders are more fully informed and equipped to form their own views and contribute to the debate.

As Westpac’s Chairman, I see first-hand the overwhelming benefit Australian banks bring to the economy - at a macro level, supporting Australia’s investment requirements and needs for foreign capital, and at a micro level, supporting customers to meet their financial goals. It has been globally acknowledged that Australia and New Zealand have been well served by their major banks, both during and since the GFC. You need only look at other global markets such as the UK, parts of Europe and the US to appreciate the devastating impact poorly performing banks can have on customers and economies over extended periods.

Australia’s major banks have been well managed, have not relied on government support, and have overwhelmingly contributed positively to the nation. Here are some facts about the banking sector:

  • The Australian banking sector was not bailed out during the GFC. Unlike many other developed nations, no taxpayer funds were injected into the Australian banks. In fact, the sector paid $4.5 billion in fees for a guarantee that was never called upon, and continued to lend and support the economy through the crisis.
  • Australian banks pay the most income tax of any industry in Australia. With over $14 billion paid in taxes or levies in 2015, tax paid by banks accounted for nearly half of all income tax paid by companies in the ASX200. At Westpac, our effective tax rate this year was 29.9% – it is clear that we pay our fair share of tax.
  • Profitability of the Australian banks is consistent with a sector that needs to be seen as “unquestionably strong”. Australian banks need to be unquestionably strong to:
    • Continue to support households and businesses through economic cycles;
    • Support Australia’s current account deficit by raising funds offshore; and
    • Invest in innovation and create a better experience for customers.
    • Suggestions that banks should accept lower returns or pay additional levies are misguided. These measures would only weaken the system and its ability to support the economy in economic downturns, as well as reducing the banks’ competitiveness in a global market. Indeed, healthy profitability is one of the key measures that international rating agencies look at when assessing a company’s rating – which in turn impacts the cost and availability of overseas funding to support the economy.
  • Returns of Australian banks are in line with other leading banking systems and the market. The average return on equity (ROE) of the Australian major banks is currently around 12-15%, broadly similar to other high quality banking markets such as Canada or the Scandinavian countries. That return is above the return of the ASX200 of closer to 11% but below returns of other service industries. Australian major bank returns are above markets, such as the UK, parts of Europe and in the US. These markets are underperforming and in many respects are still recovering from the GFC, and as such are delivering performances to which we should not aspire. Separately, while Australian banks make large profits, they are in line with their size. Westpac has an asset base of around $840 billion and we make less than 1% return on those assets.
  • Customers are paying less for their banking. There is a perception that Australian banks are charging customers more for lending and paying less for deposits today than prior to the GFC. The net interest margin is the best aggregate measure of the value banks generate from their lending and borrowing activities and that margin has been declining. For Westpac, the facts are that in 2000 our net interest margin was 3.10%, in 2006 it was 2.29% and in 2016 it was 2.13%.

On 8 April 2017, Westpac will become the first company in Australia to celebrate 200 years. This is something that makes the Board, management and all our 40,000 employees incredibly proud. Westpac has supported Australia and New Zealand through the ups and downs of wars, depressions, crises and economic booms. Indeed our fortunes have mirrored those cycles.

Westpac’s success depends on the success of Australia and New Zealand.

We have never lost sight of this. We work with this in mind by supporting the needs of customers, employees and communities as well as working in the long-term interests of shareholders.

PERFORMANCE
METRICS
CASH EARNINGS BASIS
  1. Comparative information has been restated to incorporate bonus elements of the November 2015 capital raising in the weighted average number of ordinary shares
RETURNS OF AUSTRALIAN BANKS IN LINE WITH ASX SEGMENTS
(RETURN ON EQUITY)
TOTAL
SHAREHOLDER
RETURN

We approach our 200th anniversary in great shape

Building a service culture

The Board plays an important role in building a deeper service culture across the organisation. It starts with our own behaviours and of course extends to holding the Group to account in how it supports customers and responds to issues.

There is no doubt we have made significant progress in this respect. The 31% reduction in complaints across Australian operations over the year demonstrates our plans are working.

The Board has closely monitored recent industry issues and, together with management, has sought to ensure that your company remains strongly placed. As an example, following some industry issues in financial planning and life insurance, we have asked external reviewers to look closely at our own operations; assessing our policies and practices, and our actions and responses. Not surprisingly, with a business of our size we have had a small number of examples of poor behaviour but these are isolated and, where problems have been found, the company has committed to put things right.

2016 performance

Turning to performance, 2016 was a sound year in challenging circumstances. Westpac reported statutory net profit of $7,445 million, down 7% over the year. The decline in net profit was principally because 2015 included some positive infrequent items, including $665 million in gains (net of tax) associated with the partial sale of BT Investment Management. Because of the size and nature of these items, they were excluded from the calculation of cash earnings.

Westpac reported cash earnings of $7,822 million for the year ended 30 September 2016, which was little changed from the 2015 financial year. The Group uses cash earnings as a key metric for assessing performance, and is the basis on which executive performance is also determined.

The Group generated solid growth through the year, with lending rising 6% and customer deposits increasing 9%. These gains were however partially offset by a reduction in non-interest income, higher expenses, and a rise in impairment charges, or bad debts.

The 3% rise in expenses through the year was principally related to an increase in investment and higher regulatory and compliance spending. Business-as-usual expenses were largely offset by productivity gains.

Within expenses, I know there is much interest in our approach to executive remuneration. Similar to recent years, the Board has ensured that the starting salaries of new ‘key management personnel’ are below that of the prior incumbents. Two new executives became key management personnel this year although as their start date was 1 October 2016, their salaries will not appear in our remuneration tables until next year.

In addition, because of this year’s earnings performance, short-term incentives for the executive team are down, on average, 11% on the prior year. At the same time, long-term executive incentives did not vest this year as the hurdles set by the Board were not achieved. These long-term incentives make up around one third of each executive’s remuneration.

Higher impairment charges principally related to a small number of larger companies being classified as impaired in the first half of the year. We monitor asset quality trends closely and Westpac’s Board and management believe that the deterioration of these larger names is not indicative of a more widespread deterioration in asset quality. Where additional stress has emerged, it is principally related to those sectors and regions whose fortunes have been closely tied to the mining investment cycle. Additional stress has also emerged in New Zealand dairy, to which our exposure is modest.

Reflecting this trend, we have increased provisioning levels and our provisioning ratios remain strong. For example, the ratio of gross impaired asset provisions to gross impaired assets is 49% and leads the sector. This means our individual provisions cover almost half of our total impaired assets.

While on the topic of results, I must acknowledge the performance of the new management team and structure. Brian Hartzer has led Westpac as CEO for his first full year and our new operating structure and executive team have been in place for just over a year.

The Board has been pleased with the team’s performance. In particular there has undoubtedly been a further improvement in the Group’s service culture and the digital transformation of the company is gaining traction. Importantly, the team has maintained the disciplines and strengths that are hallmarks of Westpac. This includes the effective management of capital, leading the market on changing pricing for more capital, appropriately provisioning for new impaired assets as well as proactively responding to community calls for change.

Capital and dividends

The 2016 year saw the further strengthening of our balance sheet through both additional capital and an enhanced liquidity position.

After raising around $6 billion in capital in the 2015 calendar year, the Group’s common equity Tier 1 capital ratio of 9.48% is above our preferred range. On an internationally comparable basis this comfortably puts us in the top quartile of banks globally.

On liquidity, global regulators have been gradually introducing new measures to enhance banks’ ability to remain liquid in times of stress. The Australian regulator is seeking to be ahead of global trends, having already required compliance with the Liquidity Coverage Ratio in January 2015, and is looking for banks to meet the new Net Stable Funding Ratio from 1 January 2018. Today, based on current standards, Westpac is meeting both these requirements.

As I indicated in last year’s report, this strengthening of our balance sheet has come at a cost, increasing our shareholders’ equity, lifting shares on issue and incurring additional costs associated with our strengthened liquidity.

These changes have impacted earnings, and particularly Westpac’s return on equity (ROE) and earnings per share.

Reflecting the significant increase in shares on issue through the year, our cash earnings per share of 235.5 cents was down 5% over the year while the Group’s ROE was 14.0%, down from 15.8% in 2015.

The Group’s earnings, combined with our strong capital position (the common equity Tier 1 ratio of 9.48% is some 23 basis points above the top of the Group’s preferred range of 8.75 – 9.25%) has enabled the Board to determine a final ordinary dividend of 94 cents per share, fully franked. This dividend rate was unchanged from the 2016 interim ordinary dividend of 94 cents per share. Full year dividends totalled 188 cents per share up 1 cent or 0.5% relative to Full Year 2015.

The final ordinary dividend represents a payout ratio of 80.3% (Full Year 2016 80.3%). Allowing for shares to be issued under the DRP, the percentage of second half 2016 cash earnings paid out is estimated to be around 72%.

The 94 cent per share dividend represents a dividend yield of 6.4% based on the closing share price at 30 September 2016 of $29.51, or over 9% after adjusting for franking.

The final ordinary dividend will be paid on 21 December 2016 with the record date of 15 November 2016.

We recognise the importance of dividends for shareholders, and the franking credits attached to those dividends. Our approach is to continue to make dividend payments that are sustainable in the long-term; that is, ensuring we retain enough of our earnings to hold our capital levels while also retaining sufficient capital for growth. It is also about maximising the payment to distribute franking credits. We are prepared to wear some volatility in the payout ratio to give shareholders some consistency in dividend payments but we must continue to anchor our decision to a long-term sustainable position.

Board composition

The Board and management teams have been stable over the year. There were no changes to the Board, although subsequent to 30 September 2016, Elizabeth Bryan has decided that she will retire at the conclusion of our 2016 Annual General Meeting on 9 December 2016.

Elizabeth has been a great director making an outstanding contribution to the board over her 10 year tenure. She was a source of stability through the financial crisis, including serving on the important Board Risk Management Committee (now the Board Risk and Compliance Committee). Elizabeth has been an exceptional Chairman of this key committee since 2010. In addition to Elizabeth’s director experience, her deep understanding of the wealth management industry has also been a great asset to the Board.

Succession planning for new directors is continually discussed by the Board. We expect to be able to conclude discussions and announce the appointment of two non-executive directors in the first half of 2017, who will add further strength and diversity to your Board.

Outlook

Our outlook for the Australian and New Zealand economies remains positive and while growth remains a little uneven across States, the fundamentals remain sound. The relatively low level of the Australian dollar and low interest rates have supported good growth in the services sector (particularly health, education and tourism), a rise in residential and infrastructure investment, and improved net exports. These gains have offset the slowdown in mining investment.

These trends are expected to broadly continue in the year ahead with Australia’s GDP growth expected to grow a little ahead of 3% with unemployment likely to hold below 6%.

These settings, combined with persistent low inflation and low interest rates, will likely lead to similar system lending and deposit activity in 2017 as in 2016. How growth evolves for banks will also depend on regulatory requirements including for capital and liquidity.

Asset quality is expected to remain sound in the year ahead, although it is likely that additional stress will continue to emerge in sectors and regions undergoing some structural change.

With the banking sector in strong shape, competition is also expected to remain intense.

Summary

It has been a challenging year for the banking sector given the evolving operating environment. This has included changes to capital and liquidity requirements, strong competition and increased criticism of how customers have been treated.

Westpac has responded to these changes by materially strengthening our balance sheet for capital and liquidity purposes while working diligently to respond to community expectations and rebuild trust.

2017 will be an exciting year for Westpac. In addition to the significant changes taking place in banking, 2017 will mark our 200th anniversary – a milestone that is generating great excitement and pride across the Group.

We approach our 200th anniversary in great shape, a position of which our past Chairmen would be proud. Westpac is strong, our strategy is delivering, our operating divisions are well placed and our 40,000 employees are passionate about helping customers reach their financial goals. With this foundation, we expect to continue generating long-term value and sound returns for shareholders for many years to come.

LINDSAY MAXSTED
LINDSAY MAXSTED
Chairman
Westpac Group

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