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Edited Transcript of BOQ.AX earnings conference call or presentation 17-Oct-19 12:30am GMT

Full Year 2019 Bank of Queensland Ltd Earnings Presentation

Brisbane, Queensland Oct 21, 2019 (Thomson StreetEvents) -- Edited Transcript of Bank of Queensland Ltd earnings conference call or presentation Thursday, October 17, 2019 at 12:30:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Daniel Ryan

Bank of Queensland Limited - Head of IR

* George Frazis

Bank of Queensland Limited - MD, CEO & Director

* Matthew Baxby

Bank of Queensland Limited - CFO

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Conference Call Participants

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* Andrei Stadnik

Morgan Stanley, Research Division - VP

* Andrew Lyons

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Andrew Triggs

JP Morgan Chase & Co, Research Division - Research Analyst

* Azib Khan

Morgans Financial Limited, Research Division - Senior Banks Analyst

* Brendan Sproules

Citigroup Inc, Research Division - VP

* Brett Le Mesurier

Shaw and Partners Limited, Research Division - Senior Analyst of Banking and Insurance

* Brian D. Johnson

Jefferies LLC, Research Division - Equity Analyst

* Edmund Anthony Biddulph Henning

CLSA Limited, Research Division - Research Analyst

* James Ellis

BofA Merrill Lynch, Research Division - Director

* Joshua Freiman

Macquarie Research - Analyst

* Richard E. Wiles

Morgan Stanley, Research Division - MD

* T.S. Lim

Bell Potter Securities Limited, Research Division - Head of Research and Banks & Insurance Analyst

* Victor German

Macquarie Research - Analyst

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Presentation

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Daniel Ryan, Bank of Queensland Limited - Head of IR [1]

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Well, good morning, everyone, and welcome to BOQ's Full Year Financial Results for 2019. My name is Daniel Ran, I'm Head of Investor Relations at BOQ.

I'd like to begin by acknowledging the traditional custodians on the land on which we're meeting today, the Gadigal people of the Eora Nation, and pay my respects to elders, past, present and emerging. In terms of the agenda for today's presentation. Shortly, I'll hand over to our Managing Director and CEO, George Frazis. And thereafter, Matt will come in to talk through the financials in detail. George will come back at the end to summarize and provide some commentary on the outlook. This will be followed by the opportunity for our analysts and investors to ask questions.

With that, I'll hand it over to George.

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [2]

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Thank you, Dan, and good morning, everyone. I'm delighted to be here with you today as Managing Director and CEO of the Bank of Queensland. I'm joined by Matt, as mentioned, our CFO, to present BOQ's FY '19 results. I'd like to firstly take this opportunity to thank Matt, greatly, for his contribution over the last 7 years and wish him all the best for the future.

At the end of the month, Racheal Kellaway, who's here with us today, our Deputy CFO, will be interim CFO until Ewen Stafford joins BOQ, who we announced last week, as our new CFO and COO. I'd also like to acknowledge Anthony Rose, who is here today, and thank him for his contribution over the last 7 years and also for helping us out during the transition. Thank you, Anthony.

I'm joined by my executive team: Deb, who runs People and Culture; Adam, our Chief Risk Officer; Lyn, who runs our Retail Bank; Peter, who runs our Business Bank; and Donna, our Chief Digital and Information Officer. I should actually -- I should have started by acknowledging Patrick Allaway, who's here today. Patrick takes over as Chair tomorrow. Patrick, Congratulations. I really look forward to working closely with you. I also want to acknowledge and thank Roger Davis, our outgoing Chairman.

I want to start by saying, I was attracted to BOQ because fundamentally, it is a good business. One with a mix of businesses, which provides the opportunity to differentiate and grow during a time of change and evolution in the banking industry. Importantly, our bankers who care for our customers and care deeply for the bank will be crucial to realizing those opportunities.

I'm happy to say that today that while only 6 weeks into the CEO role, I'm excited by the potential across the company confirming my earlier observations. The growth we have achieved in recent years, for example, in Virgin Money Australia and niche business segments demonstrates that we can differentiate and compete well when the customer proposition is right.

Today, we're here to present the financial results. And clearly, they are disappointing. It underscores the need to bring about a change in our culture, the way we do business, and how we prioritize our investments that will change our future. We are very aware we need to move quickly to return the company to sustainable and profitable growth. In this regard, I'll be working very closely with the Board and the senior executive leadership team to develop an overarching strategy to deliver those key objectives.

As I said at the outset, BOQ is fundamentally a good business. But while there are a number of foundational investments already underway as we work towards building an organization that is innovative, nimble and makes banking easy for our customers, this will take time. I have deep experience in retail and business banking. And as you would expect, I'm conducting a detailed review across all elements of our business. We will present the go-forward strategy to the market in late February.

Turning now to the results themselves. Statutory net profit after tax decreased 11% from FY '18 to $298 million and cash earnings after tax decreased 14% to $320 million. Cash return on equity reduced to 8.3%, with common equity Tier 1 also lower at 9.04%. I would note that we remain well-positioned for unquestionably strong in 2020, and await clarification from the regulator on the revised risk-weighting framework, which is due to be implemented in 2022.

Balance sheet strength is a key priority for me, and I'll be paying significant attention to it. Cash earnings per share decreased 16% to $79.6 per share. The Board has taken the prudent approach to maintain the dividend payout ratio with a second half dividend of $0.31, resulting in a full year dividend per share at $0.65, a reduction of 14%.

As Matt will walk you through, the performance in the second half represents a deterioration across all of these metrics relative to the first half. This together with the decision to reduce the dividend reflects the challenging environment, particularly in the past 6 months. In terms of the drivers of the results on Slide 5. Total lending grew by $937 million or 2% during the year, with the first half slightly stronger. This was primarily driven by the business bank with mortgages underperforming.

Net interest margin reduced by 5 basis points from FY '18, with most of the reduction evident in the first half. As total income reduced by 2% and operating expenses increased by 4%, the cost to income ratio increased to 50.5% for the year and was higher in the second half. Loan impairment expense increased by $33 million to $74 million or 16 basis points of gross loans. This included a number of one-off impacts, which Matt will explain further.

Underlying asset quality remains sound with arrears at low levels. These results are disappointing and the management team recognizes this. As CEO, I have a clear objective and mandate to take decisive action and improve our performance for both customers and shareholders.

To summarize my early observations on the business, I would start by reiterating that BOQ is fundamentally a good business. It has a solid platform for differentiation through the niche business segments and Virgin Money Australia. Underlying asset quality is sound, and our balance sheet is solid. Our bankers importantly care for our customers and the bank. But there are some clear areas requiring attention: turning around the retail bank's performance; fixing our onerous lending processes; addressing our rising costs, given the revenue challenges in the current environment; close the digital gap between BOQ and our peers, this extends to also improving our data platforms; and building on our people, skills and capability, particularly when it comes to execution.

Based on these early assessments and together with the Board, I have therefore identified 5 high level priorities: The first is to return to profitable and sustainable growth. The second is to embed our purpose-led, customer culture, building on our people's skills and capabilities. Our next priority is to simplify our business, improve productivity and address costs. Fourthly, closing the digital and data gap that has emerged between us and our

Peers, by delivering a refreshed BOQ digital offering and our investment in a Virgin

Money Australia digital bank, which will broadly form BOQ's future digital platform. Finally, we need to continue to strengthen the bank.

I will come back later to provide some more thoughts on the outlook and my focus, but for now, I will hand over to Matt to take you through the 2019 financials in more detail.

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Matthew Baxby, Bank of Queensland Limited - CFO [3]

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Thanks, George. I'll start by taking you through some of the key themes that are evident through the results. There's no doubt we are operating in a challenging environment with slow credit growth and historically low interest rates, together with rising regulatory and customer expectations. BOQ has felt these impacts in FY '19. We've continued to see good growth momentum in our niche segments and Virgin Money Australia, which demonstrates what can be achieved with a highly targeted customer offering. This was offset by further contraction in the BOQ branded housing loan book. We've also made good progress on our foundational investments, which will set us up for the future.

On Slide 10, we've highlighted how a challenging operating environment has impacted our income and increased expenses. Low credit growth and lower interest rates have hampered net interest income growth. Regulatory changes have impacted insurance income through St Andrew's. In addition, changing customer preferences are driving lower fee income.

Our operating expenses have increased, in line with the guidance we provided at the first half result. The uplift in regulatory and compliance costs that we previously called out came through in the second half, and we expect this to continue in FY '20. I will provide more detail on this later. Although our underlying asset quality metrics remain sound, loan impairment expense increased significantly during the year, albeit from a low base. Of the $74 million in total loan impairment expense, $22 million was attributable to the collective provision. Within this, $10 million related to model adjustments made in the second half, to provide greater resilience given an uncertain economic outlook. There were also specific provisions of $9 million, which relate to 2 large exposures, which became impaired in the second half, as a result of specific issues that pertain to them.

Despite these challenges, Slide 11 demonstrates the continuing strong momentum in our niche segments. BOQ Finance achieved consistently strong growth across both halves, with the portfolio growing by 15% over the years to $5.3 billion. This was achieved primarily through a focused proposition in our intermediated equipment finance business, which has resonated very well with both customers and brokers. BOQ Specialist has delivered strong housing and commercial loan growth again through its core medical segment, taking its overall lending portfolio to $8.7 billion.

Virgin Money Australia also continued its strong level of customer acquisition, with close to $1 billion of growth through FY '19 taking its total home loan portfolio to over $2.5 billion. These businesses demonstrate what can be achieved with a clear target market and a focused customer offering. A key imperative remains rebuilding the foundation for growth in BOQ's retail bank, which saw further contraction in its residential housing loan book.

We called out in the first half that a fundamental step in BOQ's path to restoring returns is delivering a number of must-do foundational investments. During the second half, significant progress was made to deliver a large number of projects, which will better set BOQ up for the future. These foundational investments include modernization of our infrastructure, meeting regulatory requirements as well as a number of digital and simplification initiatives.

Our infrastructure modernization continues through the migration to a hybrid cloud model, leveraging API micro-services and exploring further opportunities to automate and utilize robotics capability. A new mobile app and improved internet banking functionality has been rolled out for BOQ Specialist customers, including Apple Pay. This will support the ongoing growth we've experienced in this segment. For customers of the retail bank, the new mobile app and digital banking platform is under development with a phased rollout planned and a pilot commencing in the first half of 2020. A number of lending process improvements are also being deployed periodically with further improvement in lending volumes expected as a result of these changes in FY '20.

It's also worth noting that the new revenue share arrangement flagged at our half year result is being rolled out to our Owner Managers in the first half of FY '20.

The Group's financial performance for FY '19 compared to FY '18 is outlined on Slide 14. Total income reduced $21 million or 2% from FY '18. Within this, net interest income was largely flat, with loan growth of 2% offset by a 5 basis point decline in the net interest margin. Non-interest income reduced $17 million or 12% impacted by a decline in insurance income and lower banking fees. Operating expenses increased by 4%, which meant underlying profit decreased by 8%. I've already touched on loan impairment expense, which increased by $33 million during the year to $74 million. This reflects the application of a new collective provisioning model under AASB 9, which incorporates more forward-looking elements and results in more volatility in model outcomes. Underlying portfolio trends remain sound.

Cash earnings reduced by 14%, with statutory profit down 11% given there was a lower amount of non-cash items in FY '19 compared to FY '18.

We've provided a half-on-half comparison on Slide 15. Income grew in the second half, assisted by increased day-count, but this was more than offset by higher operating expenses, emanating from the regulatory and compliance uplift that we flagged in the first half. Loan impairment expense was also higher due to collective provision model adjustments and higher specific provisions related to a small number of large exposures. This meant second half cash earnings were 8% lower than the first half result. We've broken the second half result down by business segment on Slide 16. You can see that cash earnings improved in the retail bank, with flat income offset by higher expenses, but with an improved loan impairment result.

BOQ Business had a larger impact from the provision increases in its commercial portfolio and BOQ Finance portfolios. Some of this relates to one-off model adjustments, which I'll talk through later.

BOQ Business was also impacted by rising compliance and employee costs associated with managing its growing portfolio.

Moving to the group loan portfolio on Slide 17. Total loan growth of $937 million was achieved over the year. This was driven primarily by growth of 15% in BOQ Finance, with housing loan balances flat and commercial loans growing by 1%. Strong levels of growth were achieved in our niche segments, with BOQ Specialist contributing solid growth in both its housing and commercial loan portfolios.

I'll touch on BOQ retail housing growth next. Growth has been split out by business segment on Slide 18. This shows the continued strong growth in Virgin Money Australia, which was offset by a further contraction in the BOQ housing loan book. A key driver of this has been our fulfillment processes. We've implemented a number of changes to simplify our lending processes in the second half. These changes should result in a faster time to unconditional approval for our customers and improved productivity of our lenders.

Moving to BOQ Business. Both BOQ Finance and BOQ Specialist delivered strong growth, as I've already mentioned. We saw $237 million of growth through our commercial niche segments over the year. This was offset by some large paydowns in our commercial portfolio, including some clients taking opportunities to sell assets and, therefore, reduce their lending requirements.

We are well-positioned on funding, which is outlined on Slide 19. During the year we've lengthened the tenor of our wholesale funding, increased our deposit to loan ratio and improved our mix of deposit funding. The launch of our Fast Track Saver and Fast Track Starter accounts resulted in improved growth in savings and transaction accounts, which has reduced our reliance on term deposits. These products have also improved our customer growth in younger demographics. The launch of our new digital offering in 2020 will further support growth.

The actions we've taken to enhance our long term wholesale funding during the year have built further resilience in our funding profile. BOQ's ability to use a range of debt programs to access long term wholesale funding markets provides diversification benefits whilst also allowing for manageable refinancing towers over the medium term.

Net interest margin reduced by 5 basis points over the year, and 2 basis points in the second half. These movements are summarized on Slide 20. Asset pricing actions in January and July contributed a 6 basis point positive benefit to NIM during the half. This benefit was partially offset by continued price competition for new housing loans, which was responsible for a 4 basis point reduction in NIM. Funding costs reduced NIM by 5 basis points. Retail and middle market funding costs increased in the second half as industry pricing lagged a reduction in short term rates, which was a risk we called out in our outlook commentary in the first half. Wholesale funding costs also rose in line with a lengthening of portfolio duration to strengthen the bank's net stable funding ratio. The impacts of hedging costs improved NIM by 3 basis points in the half driven by reductions in basis and other hedging costs. Half of the improvement was due to the basis portfolio spreads reducing from an average of 46 basis points to 39 basis points. The remainder was from favorable positioning of other hedging over the period. The return on BOQ's $4.4 billion replicating portfolio declined in the half as the lower interest rate environment impacted the portfolio reinvestment rates. This drove a 2 point -- basis point reduction in NIM.

Turning to the outlook, we expect the front to back book dynamic to continue providing a headwind of around 4 basis points per half. Based on pricing changes we've announced and full year benefit of changes made in July, we expect a benefit to NIM of 5 to 6 basis points in the first half of 2020 to help offset this. Given where the cash to bill spread is today, we'd expect a 3 basis point benefit to NIM through hedging costs. As long term interest rates have continued to decrease, this represents a headwind of 3 to 4 basis points in the first half, through lower returns on capital and low cost deposits. The impact of funding costs is uncertain and can move quickly, but given where rates are today, our current estimate would be that this remains a headwind to NIM in the first half of 2020, albeit not to the same extent as the second half of FY '19. There will continue to be a strong focus on margin management going forward.

Noninterest income is on Slide 21, and I've already touched on some of the key drivers here. Outside of insurance income, we saw a slight uptick in non-interest income in the second half. Banking income was impacted by a step down related to the migration of our merchant service arrangements to a new provider. This impact is now fully embedded. There were also impacts from the continuing trend towards lower or no-fee products and from the implementation of AASB 15 Revenue from Contracts with Customers.

There was a good second half contribution from trading income, but this is a line with some volatility. Insurance income, being the contribution from the St Andrew's business, saw a reduction in the second half of FY '19 due to the ongoing impact of regulatory reform. There was also some claims volatility in the second half relative to the first half. The decision has been made to cease consumer credit insurance sales in response to the change in industry dynamics and future outlook. Existing customers will continue to be served and the interests of policyholders will remain a priority. We expect the FY20 non-interest income contribution from insurance to remain consistent with the second half of 2019. Options to maximize value and capital will be considered on an ongoing basis.

Moving to operating expenses on Slide 22, and the second half increase was in line with the guidance we provided at the first half result. The regulatory uplift of $7 million was felt on top of an underlying increase of a little over 2.5%. IT costs increased due to data collection activities addressing compliance requirements and new software services resulting from the bank's transformation programs.

General and other expenses increased, largely due to regulatory and compliance requirements. The transition between data center locations as part of the bank's infrastructure modernization program also carried some additional costs. The assets under construction balance increased due to the foundational investments that are underway. A number of other investments were completed during the year, driving the increase to the software intangible asset balance.

Looking forward to 2020. We expect the regulatory uplift to continue, with the $7 million we incurred in the second half likely to be closer to $10 million in each half of 2020. In addition, we expect amortization to increase by $10 million to $15 million in FY '20 as a result of the increased capital investment evident through 2019 and

Continuing in FY '20. George will outline the investment profile for the build out of the VMA digital bank, but some of the launch costs may be incurred in the second half of FY '20 depending on the final launch timing. An operating model is review -- an operating model review is underway to identify efficiency opportunities. It is likely, however, that the benefits from this review will be more evident in FY '21 than FY '20.

Slide 23 provides a summary of the non-cash earnings items for the year. Overall, noncash items represent a smaller proportion relative to the prior year.

Turning to asset quality now on Slide 24 and the underlying metrics in our lending portfolio remain sound. As I mentioned earlier, the key drivers of the increase in loan impairment expense were higher collective provisions. In the second half, this was amplified by model adjustments designed to build additional resilience, which I will touch on next. Excluding these model adjustments, second half loan impairment expense would have been 15 basis points of gross loans compared to the 19 basis points we have reported. The increase in provision balances are evident on Slide 25. There is some noise in the provisioning coverage ratio due to our largest impaired exposure, which is well secured and, therefore, has a low specific provision against it.

Collective provisions increased by $33 million or 29% year on year. This included the transitional adjustment, which resulted in the model overlay being increased by $10 million to account for model and methodology developments. In addition to this, in the second half, we took 2 one-off model adjustments totaling $10 million. One to better reflect observed loss given default metrics in our vendor finance portfolio. The other to provide additional coverage across our agribusiness portfolio. The second half was also impacted by specific provisioning activity related to 2 large exposures for a total of $9 million. Overall we remain comfortable with our provision coverage and believe we have built in a prudent level of resilience given an uncertain economic outlook.

The arrears trends on Slide 26 demonstrate the sound underlying performance of our 3 main portfolios. Overall, arrears remain at low levels, with only small increases evident in 90-day housing and BOQ Finance arrears over recent quarters. This reflects the low interest rate environment, a resilient domestic labor market and company balance sheets being in relatively good shape.

Moving to capital now on Slide 27. CET1 was 9.04%, a reduction of 22 basis points during the half. Underlying capital generation was impacted by growth in profitable, but higher risk-weighted business segments, lower DRP participation and lower earnings. This was fully offset by a $1 billion capital efficient securitization transaction that we completed in the half, which provided 7 basis points of capital benefit. There were a couple of items that created some volatility. Movements in fair value of other comprehensive income reserves created a drag larger than usual, as credit spreads widened late in the half, together with some one-time portfolio movements. We wouldn't expect an ongoing drag of this magnitude. There was a 12 basis point impact from the increased capitalized software spend, which we flagged at the 2018 full year results and, again, at the 2019 first half results. This supported the critical foundational investments that I ran through earlier.

Putting the Virgin Money investment to one side, the net capital impact of BAU software investment in FY '20 will be significantly lower than what we experienced in FY '19. Like the rest of the industry, the implementation of the new leasing standard, AASB16, has a transitional impact on capital. In BOQ's case, this will be no more than 8 basis points. BOQ remains well-positioned for unquestionably strong in 2020. The revised risk-weighting framework due to be implemented in 2022 is reliant on clarity from the regulator.

As George has indicated, the strength of our balance sheet is a key priority and our focus is on returning to profitable and sustainable growth. This includes by taking advantage of favorable securitization markets and the optimization of risk-weighted assets, to support improved organic capital generation. We've today announced a final dividend of $0.31 per share, which brings the full year dividend to $0.65 per share. This is a reduction of 14% from 2018 and is reflective of the challenging operating environment and outlook.

The Board has taken a prudent approach, which keeps the payout ratio consistent with the level of the first half.

With that, I'll hand back to George.

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [4]

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Thank you, Matt. When thinking about the outlook for 2020, it's important to consider the macroeconomic environment. In this regard, conditions remain challenging and economic growth is likely to be subdued. Although the labor market is strong and house prices appear to be stabilizing, wage growth and confidence remain low, with the global economic slowdown and trade wars adding to the uncertainty.

While lower interest rates are helping those with debt to repay quicker, savers are feeling the pinch as their spending capacity has reduced, which hurts overall confidence across the economy. Business conditions, particularly for SMEs, are perceived as being weaker and also impacted by a tightening of lending standards. While business credit growth has been stronger, this has been mostly driven by the larger firms. There remains the potential for an extended drought period, hence we are working very closely with our agri customers during these challenging times. Our agri book is around $0.5 billion and represents 4% of our commercial loan book.

Company balance sheets generally remain in good shape and employment is holding up, and we see this in our portfolio with underlying asset quality trends remaining sound. We are likely to see a gradual increase in the growth of credit for mortgages and business lending. Despite this uncertain backdrop, I still believe there are good opportunities for BOQ to return to profitable growth, with a differentiated and focused strategy.

I touched on my high level priorities earlier but wanted to give you a bit more detail on what I'm focused on. We will return to profitable and sustainable growth, but there will be a transition period required to achieve this. We need to optimize revenue and margin and also fix our lending processes. This will lift our distribution performance and assist to profitably grow our customer base. Our ability to build our purpose-led customer culture will take strong leadership at all levels. There is a lot of evidence, and indeed my own experience points to achieving such a culture would lead to better customer outcomes and better business outcomes.

To support this top priority, I've focused on quality appointments to key executive positions that were vacant after a period of significant change. We need to build on our peoples' skills and capabilities. In order to simplify our business, improve productivity and address costs, we are conducting a structural productivity and operating model review. This will include simplifying and reducing the number of products we have on offer, simplifying our IT platforms as part of our infrastructure migration to a cloud environment. A simpler business will also make it somewhat easier for us to navigate the rising investment and regulatory costs we face.

We have put in place initiatives to control and address cost growth. Closing the digital and data gap that has emerged with our peers is absolutely critical to our success. We must deliver our new BOQ branded mobile banking offering to lift the experience for our customers. We will also ensure that our Virgin Money Australia digital bank milestones are met. I will talk more about the investment we are making shortly.

While doing all of this, we are committed to continue strengthening the bank through robust risk and compliance standards and maintaining a strong balance sheet. A segment by segment analysis will provide meaningful insights to optimize risk-weighted assets and improve risk-adjusted returns. We plan to come back to the market in late February 2020 with a detailed strategy update, outlining our objectives for the future. We will be transparent about our transformation and provide clear milestones that can be used to monitor our progress. An exciting development is the decision we have made to continue building on the strong momentum in Virgin Money Australia. Following the successful completion of stage 1 digital bank proof of concept, we are now planning the full build and implementation. There will be a phased delivery, with transaction and savings accounts, in approximately 12 months, followed by migration of VMA's home loan portfolio and other products in subsequent phases. This is an investment in long term value creation, as we move towards a common cloud-based platform.

Completion of the phase 1 build will require approximately $30 million of capital expenditure throughout FY '20, ahead of the targeted launch in late 2020. It will also require higher operating expenses on launch with additional resources and marketing to support the customer offering and growth. This could be up to $10 million in the back end of FY '20, depending on the timing of launch. Over time though, this investment in VMA is expected to deliver compelling value to the group. It will also broadly form the group's digital platform. I'll provide further detail on the VMA digital bank at our strategy update.

In conclusion, the FY '19 results are clearly disappointing. We are already taking decisive action to improve financial performance on both revenue and costs. That being said, FY '20 will also be a difficult year. We expect lower year-on-year cash earnings in FY20, with revenue and impairment outcomes in line with FY19, subject to market conditions. We also expect higher post-Hayne regulatory and compliance costs and increased operating expenses related to our investment in technology.

In summary, BOQ fundamentally is a good business with a sound platform for differentiation. Investments are underway as both Matt and I have covered. I am undertaking a detailed review of all of our businesses and will present back to the market in February. I wanted to finish by saying how excited I am to be here leading BOQ.

Thank you for listening and we will now move to Q&A. Dan.

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Questions and Answers

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Daniel Ryan, Bank of Queensland Limited - Head of IR [1]

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Thank you, George. We will start with questions from analysts and investors in the room, then take some questions on the phone. (Operator Instructions)

For those who are in the room, please raise your hand. If you'd like to ask a question, wait for the microphone, name your -- state your name and organization. And let's begin with [John] in the middle here.

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Unidentified Analyst, [2]

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Thanks, Dan. Just trying to place a few things in account in there, George. It's obviously a challenging time to start. But you said it's going to take time, fundamental investment is required. You're trying to build a new digital bank for Virgin Money. It's coming through. The underlying earnings outlook is challenging. And I think on Slide 39, you've got a list of potential headwinds that come through, which is in title and a page long. The DRP participation was lower, and you want to maintain a strong balance sheet as you go through this whole transition program. So with all that in mind, I can understand where you want to get to, and you're going to provide more information coming out in February about what you want to get to, but should we be thinking next year is going to be even more challenging than this year? Should we expect, if you want a strong balance sheet, you're going to have to cut the dividend again next year to maintain the capital to get through this transition phase?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [3]

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Thanks, [John]. And I'll let Matt kind of add to that. I mean the starting point is that our objective is to return to sustainable and profitable growth. And the objective of that is for us to be organically generating capital in the medium to long term. So that's the strategy we want to embark on, and that's what we will be presenting back to the market in February. There is absolutely no doubt one of my key focuses is to make sure we maintain a strong balance sheet, and that's going to be taking a lot of my attention leading up to February. At this stage, we remain on track and are comfortable with our unquestionably strong for FY 2020. But as I said, this is going to be an area of focus. I'll hand over to Matt to kind of add to that.

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Matthew Baxby, Bank of Queensland Limited - CFO [4]

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Yes. I think probably, the points I'd add are obviously, February is critical in terms of laying out the business strategy and the needs of the business. But I think also, this half, which we called out, was impacted by a number of more volatile items, which resulted in more of a calm down than we'd ordinarily expect. There's obviously levers available in terms of managing capital carefully. They include, and George mentioned a couple of them, continuing to optimize risk-weighted assets; obviously, looking closely at the operating model, the mix of growth that we drive. I think they are all factors that contribute to that. But as I've said, I think the February strategy session is critical for the shape of the business.

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Daniel Ryan, Bank of Queensland Limited - Head of IR [5]

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Yes. Pass across to Andrew.

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Andrew Triggs, JP Morgan Chase & Co, Research Division - Research Analyst [6]

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Andrew Triggs from JPMorgan. Just a question on the BOQ retail part of the bank. We've had a lot of focus in recent years on the niche segments. But the -- of the $31 billion mortgage book, the vast majority of that remains in BOQ retail. So George, maybe some initial thoughts from you on what you think needs to be done to turnaround momentum in that part of the business? And I note that I think there's another 5 -- another 5 reduction in the number of branches during the half, so that's been a long term decline, partly intentional, but obviously, a lot of that unintentional. So what needs to be done outside of Virgin Money to improve the retail offering?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [7]

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Thanks, Andrew. And the standpoint is, I'm 6 weeks into this role. So obviously, I am looking at all parts of our business in detail but, it's fair to say, when it comes to retail banking and business banking, this is something I've got a lot of experience in. So my initial observations on the retail bank are that there are a number of opportunities for us that we can actually improve our performance. My sense is that probably the critical thing is our onerous mortgage lending processes, so we've gone to the extreme in terms of conservatism, in terms of how we conduct those. So there is opportunity for us to streamline those. There are some improvements that we've already made, but we've got a long way to go on that. So that's going to be one of my key focuses going forward.

The other thing is, we haven't quite got the trade-off between our volume and price rates are being much more commercial and really being careful about the decisions we make on a daily, weekly basis. And again, this is something that I've got a lot of experience in. And Andrew, you did mention the other critical point is, for us to grow in our retail bank, we need to make sure distribution is optimized and performing. So a reduction of that capacity is not the right way to approach it, not until we actually get productivity up, and also our digital offering, which is another avenue that our customers have when it comes to distribution.

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Matthew Baxby, Bank of Queensland Limited - CFO [8]

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Probably the one thing I'd add to that was, one of the things we called out in the first half was the removal of the regulatory overhang as we move through the Royal Commission, and then the need to simplify the commission model. And as we called out that's something the team have worked hard on over the last 6 months with a view to rolling that out in the first half of FY '20. So that's simpler, ensures there's alignment of interest. I think that's a key factor, key ingredient as well.

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [9]

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Yes, actually -- maybe I should add to that. It's a good point, Matt. In the sense that if you look at our owner-manager branch network and, again, it's early days for me, but my initial observations and a good example of that, if you look at Frank, who runs our Bourke Street, the owner-manager there.

Now he's well-established in that community, really has good contacts with the business and the commercial community, provides great service to his customers. So we have got a point of differentiation that could be really -- that's going to be valuable for us. And how we incentivize him, how do we make sure that the alignment between the customer outcomes, what BOQ requires and also the owner-manager is going to be something that we can tap into.

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James Ellis, BofA Merrill Lynch, Research Division - Director [10]

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It's James Ellis from Bank of America. Just to unpack a bit more the guidance statements for fiscal '20 of an expectation broadly in line for revenues and bad debts. On the revenue side, we've probably got at least one more cash rate cut coming through. Noninterest income continues to struggle to find the floor and there's -- as we've discussed in the room, not a lot of momentum in the mortgage book. So just wondering how do we square that off? Why would revenues be broadly in line as opposed to lower? And then similarly with the bad debt charge, if the bad debt charge for fiscal '19 had upward pressure from accounting changes and risk model changes, which are presumably not going to be recurrent in the next year, why would bad debt charges not be lower as opposed to broadly in line?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [11]

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James, thanks for that. I'll -- maybe I'll touch on the revenue and you can add to both of them if you want, Matt. Following the outcome, I mean, the key driver in terms of our revenue performance was, one, what was our asset growth. And you'll have to say, given the improvements that we are going to put in place in terms of particularly our mortgage processes and our lending process in general, our sense is that we've got some leeway to actually increase our growth. That's not going to come at the expense of margin. It really is all about service improvement and improving that time to the right decision for our customers. So that's the starting point. There will be some degradation in margin. There's some tailwinds and headwinds. We've broken that up, and Matt can sort of touch on that more broadly. So in line, revenue is taking those 2 and looking at the balanced outcome for FY '20. But Matt, do you want to...

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Matthew Baxby, Bank of Queensland Limited - CFO [12]

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Yes. Well, there's probably not a great deal to add beyond the moving parts that we called out in the presentation. There's obviously -- there's a continuing front-to-back book. We've got some pricing benefits that are sort of locked in and flowing through FY '20.

I think hedging costs, I think, probably where we're maybe a little bit different to some others in the industry is the rolling hedging program that we have there. So I called out a couple of the data points in terms of the step down from first half to the second half in basis. That's an enduring benefit that flows through the first half of '20, which gives us some margin support.

And then the unknown, as ever, is funding costs. I think in the second half of '19, we did see elevated costs associated with a bit of a repositioning of the balance sheet. So built some momentum in, obviously, deposits lengthened the portfolio tenor in wholesale. And we think as I said, I think it will continue to be a headwind, maybe a bit less.

I think in terms of your question on provisioning, part of the reason we called out the moving parts on provisioning is to try and give the market clarity as to what led to the loan impairment result in the second half. I think that was an important part. And they were the bright prudent steps to ensure that we built resilience. The second part of that is obviously a couple of those specific provisions. They were onetime large exposures. They happen from time to time. Again, that was the driver of the loan impairment expense in the second half.

In terms of the outlook being in line, I think the way we look at that is, obviously, there is an uncertain economic outlook. We're confident in the quality of the underlying portfolio. The AASB 9 has shown there's volatility in model outcomes. And so I think that's -- there's a degree of conservatism in that. But I think it's probably the right shape of what FY '20 is likely to look like.

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Andrei Stadnik, Morgan Stanley, Research Division - VP [13]

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Andrei Stadnik from Morgan Stanley. Look, I just wanted to ask around the growth in mortgages in this half -- second half '19. It seems as though there was quite a substantial pickup in the growth of interest-only has gone from about 16% to 24% of new flows. It's a -- kind of 2 parts to that. Do you think -- firstly, do you think you can increase that further because that is a higher-margin business? And then secondly, in this half, it seems that the increase in interest-only was actually on owner-occupiers because overall mix shift went towards owner-occupiers. So like, are you comfortable with lending to owner-occupiers on interest-only?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [14]

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Okay. So maybe I'll take that. Again, just starting off in terms of mortgages, I think there's opportunity for us to actually improve our performance in terms of mortgage volume growth. And again, not at the expense of margin but improving our processes. In terms of interest-only, if you look at the book that we've got in interest-only, we're really comfortable with where that's at, and I think there's opportunity for us to grow in that. You're right in the sense that if we think about our go-forward focus on where we see opportunity for that to grow, it is more on the investor space rather than the owner-occupier. And there's going to be really good reasons why we're saying yes to interest-only for owner-occupiers and there are situations where that makes sense. So the go-forward position for us will be there is opportunities in interest-only. It will be primarily in investors.

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Daniel Ryan, Bank of Queensland Limited - Head of IR [15]

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I think, Andrei, there was a note, too, that we did reclassify some construction lines into interest-only, which -- and so the increase wasn't quite as big as you flagged it.

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Brendan Sproules, Citigroup Inc, Research Division - VP [16]

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It's Brendan Sproules from Citigroup. I just got a couple of questions on a couple of business lines that are growing at the moment. So firstly, on BOQ Finance, it does say that business has been growing but it does seem to be chewing up quite a bit of risk-weighted asset growth. And as we saw this year, quite a bit of collective provision. There doesn't seem to be much coming through on the revenue line as we see in the disclosures around the business bank. Could you maybe talk about the type of returns that you're generating on that new business? My second question is on the BOQ Specialist. Business inflows or growth on Page 18 show that mortgages are kind of 5x or 6x the volume, I guess, on business lending within that channel. Is that the right sort of mix that you would expect from that business looking forward?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [17]

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So maybe I'll touch on the BOQ Finance first and let you add to it, and then we'll go back to the BOQ Specialist. The same point from my perspective. If I look at that business from what I've seen in being there for 6 weeks is that this is an attractive business that we've done pretty well in. So again, it kind of shows that if we've got a clear value proposition for customers, we can grow successfully. So that, I'm comfortable with that business, I'm comfortable with us growing that business.

Obviously, with the change in the provisions, that has changed the collective provision, and we need to think through the right pricing and margin management on that business. And I'll say more generally our approach to better making that trade-off between margin and volume is going to be a focus, particularly in the short-term for us. That does not mean that we won't continue to go after growth on BOQ Finance. Do you want to add anything to that, Matt?

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Matthew Baxby, Bank of Queensland Limited - CFO [18]

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Yes, probably just the absolute focus on maintaining risk savings in that portfolio. What led to the growth, and I mentioned this in my presentation, was the customer proposition absolutely lining up with the market need. And the team took some great steps to ensure that there was a true partnership with our customers and our brokers. That resonated well. And I think it's a really good demonstration of when we can line up behind the market in a particular target niche that we can generate good growth. And that wasn't at the expense of margin in that particular business line. Yes, there was a bit of collective that came with it because of the nature of the model, but that's likely to sort of settle down I think over the next few periods but yes, I'm comfortable with the return profile there.

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [19]

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If I look at BOQ Specialist, I'll have to say that's an example of what we need to do more of. Effectively, what you've got is an absolute focus on the customer segments. As a smaller player in the market, we're not -- we're not going to win by being generalists. It is all about specialization. And the critical success around that is how good our bankers are and how good our credit people are working side by side to make sure they're delivering on a value proposition to the customers that is really compelling. Within that whole model, it's all about how do we meet the broader needs of that segment. So we're indifferent to if it's their personal needs or assisting them to finance their practice. It is all about being responsive to all the needs of that segment. And that's an example of a successful strategy that we need to expand on.

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Brian D. Johnson, Jefferies LLC, Research Division - Equity Analyst [20]

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Brian Johnson, Jefferies. I had 2 questions. The first one is if we look at this concept that you see an opportunity to ramp up the housing volume growth, but we've got front book prices below back book, you're saying there's an opportunity in interest-only. But if we have a look at the most recent cuts, they're far bigger in interest-only than they actually are on P&I. Housing has got a lower margin than business loan. How can that possibly not basically come at the expense of margin?

And the second one is, unfortunately, banking is very much a scale game. And when you move into the digital space as a small bank, you probably just do not have as much investment power as basically some of the major banks. Looking at it, not to be too rude about it, but the operational execution for many years has probably not -- has probably been lacking. I'd just be intrigued if you could explain why we should suddenly be so confident that this digital bank that we rebuild under Virgin will work?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [21]

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Thanks, Brian, and congratulations on your new role. Look, if I take the housing volume first, the critical thing in terms of the way we're going to approach growing housing is definitely not on margins. So -- and we've seen the impact in terms of the front book, back book. We've shown the half-on-half impact of that which is around about 4 basis points per half. That will continue. So that dynamic is not going to change.

And in terms of how we priced on interest-only, if you think about the margin and the return that we get on interest-only, particularly on investors, that is a very attractive segment compared to the rest of the portfolio. So we chose to pass on that full rate as a result of that.

If I look at the digital bank and Virgin Money, there's 2 things I would say. Firstly, on the blue side, so on the BOQ side, we have already launched a new mobile banking app for BOQ Specialist. So we've shown under this new platform we're capable of executing and delivering. This is into a segment that is growing, so we'll support that growth. And as I said, it includes Apple Pay. So it's quite a strong proposition for that segment.

On Virgin Money, the difference I see on Virgin Money is that starting point is that business has a really clear understanding of what's required for that customer segment to develop something that's appealing. So the first thing I would say is that what's been designed is based on real clarity on what the customers need.

If you think about what's happening with technology going forward, if we were doing this some 6 years ago, it would have cost us 4x the amount and taken us twice as long. So new technology in terms of cloud-based approach, which is what we're taking on this, and not customizing is what's going to reduce the execution risk on that. Now we've got a program in place over the next 12 months to deliver on that. The stage 1 of that, which is a proof-of-concept, has been very successful.

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Edmund Anthony Biddulph Henning, CLSA Limited, Research Division - Research Analyst [22]

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It's Ed Henning from CLSA. Just looking at the capital consumption and reducing ROE, you've talked today about repricing potentially in leasing. Are there any other segments that you're looking at through your business that you're worried about the returns on that's been dragging obviously the capital consumption and the falling ROE?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [23]

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So I'll -- maybe I'll start and then let you, Matt, add to that. The same point I would say is that our objective in terms of the growth going forward is to rebalance between the finance business and the bank itself. That's not to say that we're not comfortable with the growth on the finance side, but we definitely have to start improving our growth rates on the retail and the business bank in general. I'm going to hand over to you.

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Matthew Baxby, Bank of Queensland Limited - CFO [24]

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Yes. No, there was a little bit of noise in what led to a step-up in risk-weighted asset growth beyond just pure bringing in, for instance, commercial and BOQ Finance customers on the balance sheet. So traded market risk, a bit of noise on securitization and some off-balance sheet items. So I think if you look back half-on-half over the periods, it was a step-up in terms of the drag, from risk-weighted asset growth as a result of a number of those moving parts. I think the return profile across our product lines, as George has called out, there's always opportunity. I think what's dragging returns around is structurally getting the cost base to where it needs to be to service the business that we've got. And one of the reasons George just called out as a priority simplifying our business, addressing costs, launching an operating model review is to achieve exactly that.

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [25]

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And that -- sorry, there was one more thing I wanted to add which slipped my mind, we are looking at what's the appropriate pricing for all of our business banking products. And in fact, that's an exercise across the board.

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Edmund Anthony Biddulph Henning, CLSA Limited, Research Division - Research Analyst [26]

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And just one clarification. In the last 2 halves, you've adjusted your models for the collective provisioning for AASB 9. Are all those reviews now finished? Have you gone through all your products essentially?

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Matthew Baxby, Bank of Queensland Limited - CFO [27]

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Yes. So I think it's important just to call out the different aspects of those model adjustments. So there's obviously a transitional adjustment on the implementation of AASB 9, I called that to stop on 1st September. I think the second half is much more around continuing to improve the model. And in particular, things like loss given default rates that we've observed in our vendor finance portfolio, ensuring that they're lined up to the model. I think in respect to the agribusiness, given the conditions that we're operating in, that was really around adding some additional resilience. That's a relatively small part of our overall commercial portfolio. I think it's less than 5%. So it's small. But again, I guess, it demonstrates a prudent approach.

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Daniel Ryan, Bank of Queensland Limited - Head of IR [28]

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Okay. We'll go to our first question on the phones.

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Operator [29]

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Your first question from the phone today comes from the line of Victor German from Macquarie.

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Victor German, Macquarie Research - Analyst [30]

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Thank you. George, I appreciate it's only 6 weeks in your seat. But throughout the presentation, you talked about improving customer offering and customer proposition. And obviously, in your previous role, you would have had a view on the issue around front-to-back book. For BOQ, that issue has been arguably bigger than for peers and probably resulted in flow of volume growth in that channel as well. Just be interested in your observations on how you're thinking you can manage this without significantly impacting shareholders.

And second question on credit quality. In the past, BOQ has consistently told us that you have very strong focus on credit quality. And it appears that in the retail channel, it certainly holds true. But the increase in impaired assets that we've seen in this half kind of potentially suggest that you've taken a little bit more risk than probably market expected in channels outside of retail. Is that something that you need to review and potentially tighten risk standards, which will impact your growth going forward in channels outside of retail?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [31]

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Thanks, Victor. I might take the first one and hand over to Matt for the second one. If I think about the 2 key impacts in terms of our mortgage growth, it's not been about our pricing. It's been about our onerous processes. So to be frank, we would be close to the slowest to market when it comes to providing a decision to customers. As you can imagine, particularly on the broker channel, that has a huge impact in terms of how successful you can be on that or not. And it impacts your customers more generally. So that's why one of my key priorities for short-term and medium-term improvements is to actually streamline that process. And there's many opportunities and I've got experience having done that. And so that's going to be our objective.

On margin, we -- the other thing I said is a key priority, short- to medium-term is for us to maximize and manage that margin carefully so we optimize revenue. So that will be our approach.

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Matthew Baxby, Bank of Queensland Limited - CFO [32]

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And Victor, on your question on credit quality, I think the starting point is all of our portfolios continue to perform as expected and we're comfortable with those. And in terms of what led to the result in terms of the lift in impaired assets, it was 2 single-name exposures for $40 million. So that almost represents the entirety of that step up. During the presentation, we included some material around provision coverage. We're comfortable that we're fully covered there and it is the right level of focus on those connections.

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [33]

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The only other thing to add to that, if you look at those 2 exposures, there were very specific circumstances that related to those. So...

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Victor German, Macquarie Research - Analyst [34]

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Sorry, George, just if I could just follow-up on your earlier response. I appreciate -- completely appreciate around the time of approving application, that's what's driving the flow. But I just still -- if I can push my luck and just get your thoughts on this issue, that has -- this week been -- or last week, I should say, been pointed by the (inaudible). Looking into this front-to-back book issue of mortgages, it has been something that's been fairly large for BOQ historically. Like, do you think you can manage margins given everything that's going on in the regulatory space?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [35]

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So Victor, as you said, it's 6 weeks in. So that is something I'm going to be looking at in a lot of detail. The thing I would state is our view is that we have had a migration from back to front book. So we're dealing with customers all the time in terms of dealing with that. That has impacted our margin previously. Our view is that it will continue impacting our margin. The way we're looking at optimizing margin, this is something we're carefully looking at to make sure that basically, we're doing the right thing by all of our customers. As you would expect, many of our customers are on discounts. We -- this is something we're going to carefully navigate through. But our starting point is that we've got to return to profitable and sustainable growth. We want to do that through service as opposed to through price, and we'll have to manage the price issues over time.

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Operator [36]

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Your next question on the line comes from Andrew Lyons from Goldman Sachs.

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Andrew Lyons, Goldman Sachs Group Inc., Research Division - Equity Analyst [37]

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Just a follow-up on James' question on your broadly flat revenue guidance in FY '20. You provided some great detail on net interest income, but noninterest income looks to have some reasonable headwinds heading into FY '20. Just dealing with each of them, firstly, fees have continued to step lower and even annualized in the second half outcome you've got a couple of million dollars headwind there. Secondly, you've had your best half in trading income in the second half since the first half '17. And thirdly, your insurance income remains under structural pressure and like fees, even if you just annualize the second half outcome, there's another couple of million dollar headwind there. So just wondering, are there any offsets to these -- to this headwind?

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Matthew Baxby, Bank of Queensland Limited - CFO [38]

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Yes, thanks for your question. I think it is important to call out what some of the elements that led to an adjustment in noninterest income. So you've called out St. Andrew's. I think we've provided clarity in terms of what we think the shape of that line is likely to be through FY '20. I think there were a number of other sort of one-offs in terms of the transition -- the transition into AASB 15, some changes around the equipment sales income and BOQ Finance business, and also the migration to a new merchant arrangement. As we said, we think that's now fully embedded in the number that we printed in the second half.

In terms of offsets to that, I think it's obviously one of the things the team is working through in terms of the segment-by-segment review. But Virgin Money is making a greater and greater contribution to that line over time. They saw a good step-up in income from their partnership-related business during the half. And then we've also talked in previous periods about the opportunity in financial markets. That's an area we've invested in the last couple of years. And in terms of the outlook, I think, meeting more needs of those SME and commercial customers through financial markets business is important, too.

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Operator [39]

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Your next question comes from the line of Josh Freiman from Macquarie.

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Joshua Freiman, Macquarie Research - Analyst [40]

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So just a bit of an extension to Victor's question, I noticed you guys mentioned that you're expecting the front-to-back book impact to continue moving forward. I think it's about 4 basis points. I just wanted to double check if you guys were willing to provide the quantum of the current front-to-back book gap? And in addition, second part, if there's any change in the average duration of the mortgage book?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [41]

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In terms of disclosure, as I said, we've given the impact previously. Our view is that, that impact will continue over the next 12 months. Look, we're probably not going to disclose any more than that in terms of the average duration.

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Matthew Baxby, Bank of Queensland Limited - CFO [42]

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Yes, yes. So maybe just to add to the sort of margin part, what -- part of the reason that George mentioned that it is obviously the front-to-back book element, obviously, transparent around that. Just an average rate across the portfolio, given the way segmentation across the home loan portfolio, has emerged, there's obviously different price points across all of those. So I think that's probably a bit less meaningful.

In terms of average duration on the home loan portfolio, we actually saw in the half an extension of the average tenor of their mortgage portfolio. So contributors to that could be maybe a perception that credit's been a bit more difficult to get. It's potentially one driver, a slightly less certain economic outlook. And we've only, in recent months, seen the housing market begin to show signs of life. So we have seen duration extend slightly. And yes, that's one we'll continue to monitor closely.

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Joshua Freiman, Macquarie Research - Analyst [43]

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Sorry, just on the extension of duration, is the average duration around 5 years or...

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Matthew Baxby, Bank of Queensland Limited - CFO [44]

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Longer than that, actually.

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Joshua Freiman, Macquarie Research - Analyst [45]

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A bit longer?

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Matthew Baxby, Bank of Queensland Limited - CFO [46]

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Yes.

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Operator [47]

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Your next question comes from the line of at Richard Wiles from Morgan Stanley.

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Richard E. Wiles, Morgan Stanley, Research Division - MD [48]

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I've got 2 questions on your approach to capital management. Firstly, today, you flagged higher capitalized software, the impact of AASB 16. You expect loan growth to improve next year but earnings to be lower, and you've also talked about the Virgin investment that you intend to make. So if we put all those things together, it suggests that your common equity ratio will hit below 9%. Could you remind us of your targets for Common Equity Tier 1? And can you explain why you're not topping up the capital as well as cutting the dividend today?

Secondly, on the dividend, you've cut it. It seems to be that you've decided to keep the payout ratio steady at 82%. Is that too high for a bank with an ROE of around 8.5%? Is there any strong reason why the payout ratio shouldn't be 70% or below?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [49]

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What if I start and then hand over to Matt and I'll take those questions in reverse? Again, if we think about the dividend decision, that's something that the Board takes every reporting period and a number of factors are taken into account. The Board has taken a prudent action, as I said, to keep the payout ratio the same. We are going through a full strategic review. The objective is to get this bank back to a sustainable and profitable growth. We'll have more detail around that once we complete that review.

In terms of our capital target, our starting point is that, as I said, a key objective of mine is to make -- ensure we've got a strong balance sheet. It is going to take quite a bit of focus of mine and attention. At this stage, where we stand is that we are well-placed. We're unquestionably strong so we're comfortable with our position. But Matt, over to you there.

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Matthew Baxby, Bank of Queensland Limited - CFO [50]

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Yes. I think, Richard, during the presentation, we called out some of the volatility that led to the print of CET1 in the second half. We called out the known items in terms of the investment in Virgin and the accounting standard change. And also, as George mentioned, how we're placed against it is unquestionably strong. And the levers we have available to continue to manage capital. I think, obviously, February is critical in terms of the team coming back with the business strategy. And that will provide clarity, I think, in terms of the outlook. And the Board obviously consider a range of factors in setting the dividend each half and will continue to do so based on the shape of the business that is in front of them.

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [51]

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And Richard, the only other thing to add, obviously, when we're looking at growth, we're very conscious of the risk-weighted asset impact of that. So -- and that will form part of our strategy in terms of where we want to grow.

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Richard E. Wiles, Morgan Stanley, Research Division - MD [52]

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Just a follow-up regarding capital. There's a slide in here. I can't find which one it is for the moment, but it shows that in your -- in this half, you had 7 basis points of capital usage. And I acknowledge that you didn't quite get the DRP participation that you expected. But going forward, you expect earnings to decline, that's your guidance. You've also said today you expect to get some volume growth. Those 2 things together mean that your organic capital generation will weaken. Then you've got software capitalized balances going up, you've got an 8 basis point hit from AASB 16. You've said you're going to make this investment in Virgin Money. All of those things suggest that the payout ratio will be low -- sorry, the capital ratio will be lower. And I acknowledge you've got the strategic review coming up and that you'll make some decisions on the back of that. But what's the capital you're targeting? Is that -- do you just need to be above 8.5% or do you need a buffer?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [53]

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Well the same point is our first position, are we well-positioned for unquestionably strong? And our view is we are. In terms of the buffer going forward, that will depend somewhat on the realignment of risk-weighted assets that we'll get clarity from APRA at some point. And also, we'll have to take into account our ability to organically grow our capital. The thing to note is that our earnings forecast is for in-line FY '19 results and not a reduction in total earnings. And our views in terms of that mix of risk-weighted assets, we'll be tilting it more to the lower end of the risk-weighted asset products as opposed to what we've achieved in the last 12 months. Matt, on the...

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Matthew Baxby, Bank of Queensland Limited - CFO [54]

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No. I think that says it all. Yes.

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Operator [55]

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Your next question comes from the line of T.S. Lim from Bell Potter.

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T.S. Lim, Bell Potter Securities Limited, Research Division - Head of Research and Banks & Insurance Analyst [56]

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A question for George. I guess you have sat at the bank to some extent. Can you briefly tell us what BOQ's competitive advantages are?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [57]

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Thanks, T.S. Again, it's 6 weeks in, but I have to say I'm pleased in terms of what I see as a fundamentally sound business. And what we've also shown is examples of how we can really differentiate. I've touched on those, for a bank our size, being all things to all players is not going to be the way we're going to win. It's all about really specializing and going after niche segments where we can provide a compelling and differentiated offering. Examples of that are Virgin Money Australia. So that is attracting a younger aspirational customer base, which is really a valuable approach to have in terms of increasing the customer franchise going forward.

Again, on the BOQ Specialist side, we've shown that when we go deep down segments with specialized bankers and credit people, we can be really successful. So that's going to be our approach. There are some fundamental things we have to fix, as I said, like processes that will help our performance. The other thing I would say is that I think our OMB model potentially has -- and I think strongly has the opportunity for us to differentiate. And it is all about making sure that we're leveraging the strong relationships those OMB managers have with both commercial customers, business customers and retail customers.

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Operator [58]

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Your next question comes from the line of Azib Khan from Morgans Financial.

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Azib Khan, Morgans Financial Limited, Research Division - Senior Banks Analyst [59]

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A couple of questions from me. So firstly, I have to follow-up on Richard's question about the CET1 ratio. So George, I mean, you're clearly emphasizing that one of your focuses going forward will be balance sheet strength. BOQ's CET1 ratio has trended down from about 9.4% 2 years ago to now a touch over 9%. At the interim result, CET1 target range of 8.25% to 9.5% was laid out. And correct me if I'm wrong, but it looks like that target range has now been dropped or it's disappeared. So can you please tell us how low the Board is comfortable with the CET1 ratio dropping to? I acknowledge you're saying that you're well-placed for unquestionably strong, but in light of that, can you confirm that you're operating on the basis that you're down questionably strong benchmark for BOQ is 8.5%? More importantly, what I'd really like to know here is how low is the Board comfortable with the CET1 ratio dropping to? So that's the first question.

The second question is about business simplification going forward. You said you'll look to simplify and reduce the number of products on offer. George, do you see potential for banking fee income to be rebased to a lower level as a result of this? And the second part on simplifying your business, George, you've said you'll embark on an end-to-end mortgage lending transformation program. You're obviously coming across from Westpac's retail bank. Westpac at the moment is in the process of digitizing its end-to-end mortgage origination process, which they hope to complete by the end of next year. Do you have a similar transformation in mind for BOQ? And how long do you think that will take? And again, I know you're only in the job for 6 weeks but I think this will be an area where you've got some very good foresight.

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [60]

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Yes. So if I touch on both of those. The same point is, as I said, we're comfortable that we're well-positioned in terms of unquestionably strong. There's no doubt the next 12 months is going to be a transition period. And we'll be looking at how we approach in terms of our buffers. During that transition period, after developing our strategy, we're comfortable that we will be unquestionably strong. At this stage, there isn't a target that the Board has set, but through that strategic review, we'll be looking at where our target range will be in terms of capital.

In terms of simplifying the business, if I think about the noninterest income fees, effectively, a lot of the rebasing in our business has already occurred. So our expectation is that -- that we'll get some growth out of that but not significant growth. But in terms of the drag, it's had, it's unlikely to continue going forward.

On mortgages, the digital transformation of mortgages is important. So it's all about saying how do you actually create an end-to-end process that's streamlined. I'll have to say, we're in the position right now where there's a whole lot of improvements that we can achieve that don't require digital transformation of our mortgage process. So what we're going after initially will be all the low-hanging fruit which will then start providing results for our customer experience fairly quickly.

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Matthew Baxby, Bank of Queensland Limited - CFO [61]

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Probably the only thing I'd add, you mentioned 8.25% to 9.5%, but that is set out in our Pillar 3 as the management-endorsed capital range. I guess the moving parts are when they -- when APRA released their unquestionably strong discussion paper back in 2017, they talked about 50 basis points of additional capital beyond prudential limits. I guess the uncertainty for the industry has been how are they likely to calibrate risk-weighted asset in the run into 2022. So I think across the industry, that's what's created a little bit of uncertainty as to where is the precise landing zone.

I think probably the part I'd emphasize is that there were some things that contribute to a step down in CET1 in the second half. We talked about some of the levers that are available to us to manage capital organically. And George has said that balance strength is a key priority with a Strategy Day coming up at the end of February.

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Operator [62]

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Your final question today comes from the line of Brett Le Mesurier from Shaw and Partners.

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Brett Le Mesurier, Shaw and Partners Limited, Research Division - Senior Analyst of Banking and Insurance [63]

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A couple of questions on expenses. What do you think the average life of your current software -- capitalized software expenses is going to be?

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Matthew Baxby, Bank of Queensland Limited - CFO [64]

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I'll take that, Brett. So it obviously varies. We do a case-by-case analysis of each asset based on its expected useful life. I think like everyone, things like digital assets that have a shorter life because they're more likely to cycle through is obviously shorter. But we are investing in, for instance, the core banking platform that will have a longer useful life. So it's probably not that meaningful for me to just give you an average across the range. I gave pretty strong indication of what we saw the amortization uplift into the first half of '20 likely to be if that's sort of where your question was going. So I think that should be relatively clear.

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Brett Le Mesurier, Shaw and Partners Limited, Research Division - Senior Analyst of Banking and Insurance [65]

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My question's really going to what happens after that because if you're looking at 232 capitalized software assets and that's growing and you've got an average life of, say, 3 years, then your amortization charge is heading to 80 -- $80 million per year and it was $40 million this year. So it looks to me like the $10 million to $15 million is just the first step on the way to a more painful journey.

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Matthew Baxby, Bank of Queensland Limited - CFO [66]

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You're right. The intangible asset balance is going up. I think an assumption around a 3-year life across that whole portfolio that I mentioned is too short. So it would be spread over a longer useful life of class of assets that we have there.

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Brett Le Mesurier, Shaw and Partners Limited, Research Division - Senior Analyst of Banking and Insurance [67]

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Yes. On the comment you made before about the regulatory uplift, you said it was going to be $10 million in the first half and then $10 million in the second half. Does that mean increase of $10 million from second half '19, first half '20 and then $20 million increase from second half '19 to second half '20?

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Matthew Baxby, Bank of Queensland Limited - CFO [68]

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I think the way to think about it is for the second half of '19, we had $7 million of regulatory uplift. I think back that out to an underlying cost base and grow that by $10 million per half. So $10 million in the first half for RAC and $10 million in the second half for RAC.

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Brett Le Mesurier, Shaw and Partners Limited, Research Division - Senior Analyst of Banking and Insurance [69]

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So increments of $10 million in each half.

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Matthew Baxby, Bank of Queensland Limited - CFO [70]

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$10 million over the top of that underlying expense base.

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Brett Le Mesurier, Shaw and Partners Limited, Research Division - Senior Analyst of Banking and Insurance [71]

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Right. So by the time you get the years’ time, you're increased by $20 million relative from the start of the year.

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [72]

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No. You go through the $7 million.

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Daniel Ryan, Bank of Queensland Limited - Head of IR [73]

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It doesn't go up...

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Matthew Baxby, Bank of Queensland Limited - CFO [74]

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It doesn't go up twice, no. It's $10 million exactly.

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Brett Le Mesurier, Shaw and Partners Limited, Research Division - Senior Analyst of Banking and Insurance [75]

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Okay. Good. And just related to that, are you going to have any more regulatory expenses not included in your cash items? Or is this a consolidation of the regulatory expenses that you haven't included in your cash expenses?

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Matthew Baxby, Bank of Queensland Limited - CFO [76]

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Well, I think the non-cash items are obviously assessed each period. The point of having some noncash items is to ensure comparability between periods. This period had the tail end of the external legal costs associated with the Royal Commission are the true onetime regulatory cost aspects. Introduction of BEAR as an example. But I would expect that to begin -- that to be tailing off, as we've called that pretty transparently, through operating expense is what the RAC uplift is likely to be.

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Daniel Ryan, Bank of Queensland Limited - Head of IR [77]

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Okay. That was the last question on the phone. So one final question in the room.

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Brian D. Johnson, Jefferies LLC, Research Division - Equity Analyst [78]

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Brian Johnson, Jefferies. George, you've been in the gig for 6 weeks. Is this your result or will we basically get your real view at the update in '20? Like the past and new CEO, I'd be hammering everything, but it seems to kind of self-hammered it. If you have a look at basically a lot of the narrative there today, and it's not lost on me, George, that you did say under pressure, then you said earning's flat, but Slide 33 clearly says next year's earnings expectation is down. But I'm trying to get a feel George, is whether we get a new CEO coming through at the -- in February '20, is that when -- is that what you're accountable beyond that point? Or is it because you're sitting here in front of us today, is this your result?

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [79]

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Yes. Brian, the starting point is if you look at the outlook I've provided, that is our expected BAU outlook for the year. As I said, it's 6 weeks into the business. We are going to do a full strategic review. I'm looking at every part of the business. We will come back in February in terms of what the strategy go-forward position will be. That will have some input -- impact on 2020, but the majority of the impact will be in the following years after that.

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Daniel Ryan, Bank of Queensland Limited - Head of IR [80]

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Okay, that brings an end to today's briefing. Thanks for joining us.

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George Frazis, Bank of Queensland Limited - MD, CEO & Director [81]

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Thank you.