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Edited Transcript of WBC.AX earnings conference call or presentation 6-May-19 12:00am GMT

Half Year 2019 Westpac Banking Corp Earnings Call

Sydney Jun 23, 2019 (Thomson StreetEvents) -- Edited Transcript of Westpac Banking Corp earnings conference call or presentation Monday, May 6, 2019 at 12:00:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Andrew Bowden

Westpac Banking Corporation - Head of IR

* Brian Charles Hartzer

Westpac Banking Corporation - MD, CEO & Director

* Peter Francis King

Westpac Banking Corporation - CFO

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Conference Call Participants

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* 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

CLSA Limited, Research Division - Research Analyst

* Jarrod Martin

Crédit Suisse AG, Research Division - Director and Joint Lead Analyst

* Jonathan Mott

UBS Investment Bank, Research Division - MD and Banking Analyst

* Matthew Wilson

Deutsche Bank AG, Research Division - Australian Bank Equity Analyst

* Richard E. Wiles

Morgan Stanley, Research Division - MD

* Victor German

Macquarie Research - Analyst

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Presentation

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Andrew Bowden, Westpac Banking Corporation - Head of IR [1]

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Well, good morning, everyone, and welcome to the presentation of Westpac's 2019 Interim Financial Results. My name is Andrew Bowden, and I'm Head of Westpac's Investor Relations. I'd like to acknowledge the traditional land on which we speak today, the Gadigal people of the Eora nation, and pay my respects to elders, both past, present and emerging.

Present today of course is our CEO, Brian Hartzer; and our CFO, Peter King.

And without any further ado, let's get started. Thanks, Brian.

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Brian Charles Hartzer, Westpac Banking Corporation - MD, CEO & Director [2]

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Thank you, Andrew. Good morning, everybody. Right. Well, this half, we have taken action to deal with a number of legacy issues in an environment where regulatory activity is intense, economic growth has slowed, consumer and business demand have softened, house prices have fallen, and competition has increased. All of this has put pressure on earnings and given us a list of issues to manage.

You've already seen our announcements on the wealth reset and the remediation provisions, which have had a big impact on earnings. And while the impact on customers and the size of the provisions are disappointing, what this does show is we're committed to taking decisive action to complete remediation and simplify our businesses as quickly as we can.

We've seen slow credit demand and aggressive competitor pricing in the market and managed returns and margins carefully. We've recognized that lower revenue makes productivity essential, so we're well progressed on our structural cost reduction. With economic growth slowing, we've maintained our risk disciplines and the balance sheet is in good shape, and we've continued to invest for the long term. At an overall level, cash earnings were down 14% over the half. If we look through the significant remediation and restructuring items, earnings were down 1%.

I said at the full year that our top priority for 2019 was to deal with outstanding issues. This included finalizing our strategy for advice, addressing regulatory concerns and working through remediation.

We've now taken decisive action to reset our wealth business, including exiting financial advice. We've materially increased remediation provisions, with the priority now on getting refunds into customers' hands. We're well underway on our response to the Royal Commission and other regulatory and governance matters. And we're on track to meet this year's $400 million cost target.

Our balance sheet remains strong across all dimensions. And behind the headlines, we've continued to grow the customer franchise and have delivered a number of capabilities that will lead to better service for our customers.

But let's start with the result. In the top Table, you can see that profit -- reported profit was down 19% and cash earnings were down 14%. The result is down significantly compared to the first half of last year when treasury and markets' performance was strong and there were no remediation provisions.

We've kept our approach to cash earnings consistent and all remediation provisions are included, as is the wealth reset. To help you understand underlying performance, we've given you the table at the bottom of this slide, which adjusts for these two items. Together they reduce cash earnings by $753 million this half and $281 million in the second half.

The underlying result was slightly down, which was mostly due to the lower treasury earnings and higher general insurance claims. Together these 2 items took around 3 percentage points off cash earnings for the half. Margins held up well over the half, although the ROE was softer.

So overall, as I said in the headline, this is a disappointing result. The remediation provisions reflect a number of areas where we made mistakes and didn't meet our standards or documentation requirements. It shouldn't have happened. We need to do better, and we will.

As a consequence of mistakes like these across the sector, customers are thinking harder about where they bank, margins and fee income are under pressure, and regulatory and compliance costs have gone up. What I can say though is that our people are working hard to fix the issues so that we get things right in the first place and re-earn our customers' trust.

Each of our business divisions remains well placed. The performance was mixed this half. So let's have a look at that. The Consumer Bank had a solid half given its focus on managing returns and productivity. We recognize that with loan demand slowing and increased competition from foreign banks, we needed to manage margins carefully and continue to drive down costs. Margins benefited from repricing at the end of last year and careful management of volume and return tradeoffs in both mortgages and deposits. However, this was partially offset by competition for new loans and continuing switches to principal and interest.

On the cost side, we're seeing real benefits flowing from network consolidation and customers continued shift to digital channels. As a result, the costs in Consumer were down 3% in the half. Remediation charges in Consumer were materially lower this half, and if you exclude these items, the result was relatively flat.

In Business Bank, we've seen weak loan demand over the half and it particularly declined in auto lending. Borrowing intentions have been weaker across commercial and SME customers in most industries and in most regions, especially anything to do with housing or farming in drought-affected areas. The exceptions have been transport, health and food services. We also usually see a pullback in lending in the lead up to an election, and so hopefully this will improve in the second half.

Given these challenges, Business Bank again focused on managing margins and costs well and keeping a close eye on credit quality. Business Bank also took $131 million of remediation provisions this half, which related to interest-only lending and loans that should have been written under the NCCP. If you exclude these items, cash earnings in the Business Bank were up 5%, which is a pretty solid result considering that loan balance has actually declined in the half.

BT Financial Group had a particularly disappointing half with a $305 million loss in the period. That reflects several large items: remediation and advice, restructuring charges associated with the wealth reset, GI claims for 2 large weather events, and strategic decisions we made to remove grandfathered commissions and reprice our platforms business. Each of these was painful in the short term, but the right decision for the long-term position of our wealth businesses.

If we look behind the earnings result, the position is more positive. For example, Panorama balances grew 38% in the half and today it has over $18 billion in funds under administration. In dollar terms, it's the fastest growing platform in the market and it sets a new benchmark for the industry on both functionality and cost.

The general insurance result was impacted by the Townsville floods and the New South Wales hailstorms. But we've continued to grow premiums, particularly through higher digital sales. We see this category as having a lot of good growth opportunities, especially now that it's more closely aligned with our Consumer business.

Life insurance sales have been affected by the disruption in our advice business and so premiums were lower. This is still fundamentally a good business, so we're continuing to invest and expanding our distribution.

We have had a solid half with improved markets' income combined with a strong focus on returns. We stayed disciplined on return while targeting higher growth areas like infrastructure, M&A and syndicated transactions. Although we've built leading positions in these areas, for example, we were involved in 5 of the last 6 big infrastructure deals, but it still hasn't been enough to grow the book overall.

New Zealand also had a solid performance in both core and cash earnings. Cash earnings were up 4%. New Zealand has been a little ahead of Australia on productivity and you can see that in their sub 40% cost/income ratio. We've been using New Zealand as a bit of a test bed for new technology and new ways of working that improve efficiency and speed to market, and we'll start rolling out these approaches in our Australian business in the second half.

Now let's go back to the group level and have a look at the balance sheet. Balance sheet strength is always our first priority, and once again, we ended the half in good shape. The modest growth in lending and good management of unused limits have contributed to low RWA growth, and that allowed us to keep the CET 1 ratio at around 10.6%.

Liquidity has also been solid, with the LCR higher and the NSFR was stable. On asset quality, the stressed exposure ratio was up just a couple of basis points over the half. Most of this was due to slightly higher consumer delinquencies.

We've held the dividend at $0.94, which reflects our capital positions and looks through the significant items to the quality of our franchise. Given the environment, we decided to give ourselves a bit more flexibility by putting a discount on the DRP. That will mean that the effective dividend payout ratio ends up at around 64% of earnings, and longer term we're still targeting the 70% to 75% range.

So let's take a look now at the progress we've made on our strategic agenda. Over the last 4 years, I've spoken to you a lot about our service strategy. We recognize that to grow value, we need to combine great personal service and great brands with a highly efficient, low cost digital platform. The changes in our environment have reinforced that this is the right strategy, but we need to move faster to get through this period and set ourselves up for the next phase. To do this, I said at the full year result that we have 3 priorities: first, dealing with outstanding issues; second, maintaining momentum in our customer franchise; and third, reducing structural cost.

So let me spend a couple of minutes updating you on our progress on this. Now I've been in banking for 30 years, and when I reflect on the period after the 1991 recession, one big lesson is banks that had a strong starting position that responded rapidly and decisively to the issues were able to get back on the front foot quickly and make a step change in their market position. The period we're in now is an equivalent disruption to 1991, and so we're putting that lesson into practice.

Our first priority this year has been to deal with the uncertainty premium that's been hanging over the sector and over Westpac as we work through remediation and the potential impact of regulatory change. That's driven our decision to reset the wealth business and exit personal advice. This change eliminates a loss-making business with high operational risk, simplifies our divisional structure, and allows us to take out significant cost. But it also gives us a strong position in private banking, insurance, platforms and superannuation, which are now better positioned to grow.

With remediation, we've put aside significant provisions across wealth and banking and have commenced refunding customers. And we're accelerating this process by centralizing oversight of our remediation programs under our Chief Operating Officer, Gary Thursby. We're well underway on our response to the Royal Commission. We fully implemented 10 of the recommendations and work is well advanced on the remaining ones. On top of the Royal Commission, there are other initiatives underway to improve customer outcomes, strengthen our culture and improve accountability, and these will continue into the second half.

We also have a few regulatory and compliance issues to work through. These include things like the responsible lending and general advice cases and an issue we're working through with AUSTRAC on a failure in WIB to report certain domestic payments that we made on behalf of a small number of international correspondent banks.

Our second priority is maintaining momentum in our customer franchise. The long-term value of the bank depends on protecting and growing the revenue that comes from more customers, deeper relationships and better retention, without relying on price as the main lever. At the same time, the key to profitability is to support this revenue with a highly efficient cost structure, with the shift to digital a key component of this.

Last year, we exceeded 11 million banking customers in Australia and so far this year we've grown customer numbers by 35,000. This has been helped by a new digital mortgage front-end in our regional brands and our Life Moments campaign in the Westpac brand. We've also seen an increase in general insurance premiums thanks to the work we've done to lift digital sales. Panorama continues to grow strongly, with more planners and customers on the platform. The response to our new pricing and BT Open Services has been strong and we've been adding around $1 billion a month to this platform.

Our focus on embedding a service culture is also paying off, with Westpac now holding the #1 and #2 -- or #2 positions in NPS scores across each of our business segments. The use of predictive data and life events marketing is improving advocacy and retention, and we've significantly improved the way we handle complaints.

Now turning to our digital agenda. We're making real progress on both sales and service migration. On the sales side, we've seen strong momentum in digital sales, with 36% of sales now fulfilled completely online. On the service side, we launched our new chat-bot called Red, which is backed by IBM's Watson. This goes live to our entire customer base tonight, but to-date it's already responded to over 100,000 customer enquiries. And as an AI platform, the more that Red operates, the better it gets. This means quicker service for customers and fewer calls to our call center.

To make things easier for customers, we've introduced new digital front-end systems for mortgages across our regional brands, a new digital signature process for mortgage documents, and expanded the use of eConveyancing. I should also mention the value that we're seeing from our investments in Fintech, both directly and through our Reinventure fund. Aside for the large financial gains we have achieved, we're excited about the opportunities we're seeing with both domestic and international partners to position us to benefit from disruption in our industry.

So we're making good progress on digital modernization and on our underlying technology infrastructure. Craig Bright has been a great addition to our team, and I'm really pleased with the momentum that he and his team are building in technology. We are now seeing the benefits of the investment program we started 5 years ago to simplify and modernize our technology platforms. System's stability is a great example. In previous years, we were responding to around 16 severity 1 incidents each half. These were system outages with significant customer impact. Thanks to the investments we've made, we have now gone over 12 months without a single severity 1 outage.

The launch of our customer service hub this half is a major milestone for the group. In addition to transforming the mortgage origination process, the system is a critical backbone that helps us modernize and replace our core systems over the next few years. Other major milestones this half include the launch of a new cloud-based HR management system, which gives us new tools for managing productivity; a new risk analytics capability, which is built on our big data platform; and upgrades to our banker desktops that significantly improve productivity and collaboration. We expect bigger cost savings to drop progressively over the next few years as we complete the rollout of the customer service hub, retire old platforms and deliver the benefits that come from product simplification and automation.

And that's a good segue to talk about the progress that we're making this year on our cost base. Structural cost reduction is a critical priority in this environment. We delivered $146 million in productivity savings this half and are on track for our $400 million target for the year.

You can see on the right of this slide, how we're driving productivity across 3 themes. First, under simplify, average FTE were around 800 lower in the half through streamlining of corporate head count and improvements in how bankers are supported. The gross reduction was more like 1,200 FTEs, but we added several hundred back to work on remediation and risk projects. We've continued to remove cash from the network, which reduces handling cost. To put that in perspective, the physical coin that we've removed from the network adds up to about 450 tons.

On the digital front, branch transactions reduced by a further 8% over the half, which allowed us to amalgamate around 40 branches across Australia and New Zealand and remove over 300 ATMs. Along with the shift to digital sales, this reduction in the size of our network and the use of paper has delivered $33 million in savings this half. We've also cut a further $25 million by modernizing our systems and reviewing and renegotiating contracts. Peter will speak a bit more about expenses, but I'm pleased with the progress this half and we have good momentum on this into the second half.

So when I look at the result overall, a few things stand out. We've taken decisive action on remediation, regulation, the findings of the Royal Commission, and our own culture, governance and accountability self-assessment. We've reset our wealth business and have around 400 people working on remediation, with the priority being to refund customers as quickly as we can. We've maintained the strength of our balance sheet, credit quality is good, and we've continued to manage the growth and return tradeoffs well.

We've driven productivity in the short term while continuing to invest in long-term structural cost reduction and better compliance. We're setting ourselves up well for the future by continuing to grow the franchise, improved service and delivering on our digital and technology agenda while keeping our people engaged and motivated in what has been a challenging period for all banks.

With that, I'll ask ,Peter, to take you through the financial results in more detail, and then I'll wrap up with some comments on the outlook. Peter?

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Peter Francis King, Westpac Banking Corporation - CFO [3]

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Well, thanks, Brian, and good morning, everyone. And as I reflect on this half, I'd make 3 points. First, the result was down 14%, but if we exclude the major remediation and restructuring provisions, was 1% lower. Second, while we prioritized return and managed margins well, following a couple of good years, treasury was down 30% in terms of revenue this half.

Significantly high general insurance claims occurred, and our decision to reprice platforms and stop grandfathered commissions also impacted. Together these headwinds took $150 million off earnings this half. Finally, the balance sheet remains in good shape, with credit quality again exceeding expectations.

With the result impacted by the remediation provisions, to show underlying trends I'll focus on the performance excluding these items. And turning to the major items. These both reduced cash earnings and impacted revenue and expense movements. Starting on the top left, earnings were reduced by $753 million as we provisioned for the customer remediation and the wealth business reset. The bottom left table shows how revenue and expenses were individually impacted. The title at the top right is our normal disclosure of infrequent and volatile items, and this was a small positive this half.

Hastings was the other large impact on revenue and expenses. You may recall that last year's exit had a small impact on cash earnings but added $180 million to revenue and $121 million to expenses. Loan growth was modest, with the New Zealand division and mortgages the main drivers. On the left, our mortgage book continued to reshape, with the interest-only now 31% of the portfolio. This sees the I/O book down $70 billion from its peak. The mix change will continue, although the pace of change may slow as lower run-off emerge this half. And Australian mortgages grew 1% this half, with all growth in owner occupied and the investor book pretty flat.

The dynamics of our growth reflect lower demand and competition from foreign and non-banks. The right chart shows run-off has eased from 13.4% to 12.5% in both the interest-only and P&I books, and this is typical of a slowing housing market with lower turnover. Mortgage spreads held up following the pricing changes we made late last year, but generally trends are lower with strong competition and the majority of lending in lower spread products.

So let's have a look at margins in more detail. Given the environment, I was happy with our margin management. Adjusting for remediation and the lower treasury contribution, margins were up 1 basis point. Looking at the components, loan spreads were up 1 as repricing of Australian variable mortgages added 5 basis points. This was largely offset by 2 basis points from competition and retention repricing and 2 basis points from mix.

Deposit spreads increased 1 basis points as we managed pricing for the lower loan growth. And the charts at the bottom show recent movements in short-term funding markets, 3-year swap rates and the balances hedged by the tractor. Margins have many moving parts, but recently there's been queries on how interest rates or lower interest rates may impact the margin. So this data helps you with that question.

The key point is there's always ups and downs with margins. And while short-term costs have reduced, with the 3-year rate falling so much, it will become a headwind in the margin. So overall, margins were steady as we prioritized return over growth, with treasury the main drag this period.

On to markets and treasury. It was a tougher half with income down 5%. You can see on the left that treasury has had pretty good performances in prior halves. The income was down 30% to $235 million. And that's because we saw less volatility and lower interest rates in our core Australian and U.S. markets and this saw less opportunities in the treasury business. WIB markets had a better half as risk income rose $600 -- or $67million, sorry, with all portfolios across FX, fixed income and commodities delivering better results. The right hand chart shows customer income has been pretty steady over the last couple of years. And so in summary, treasury was lower this period, but we did have some portfolio impacts with WIB up a little bit.

In aggregate, non-interest income was weaker. It was particularly impacted by the remediation provision. So I've presented this data excluding remediation to highlight the key operating trends. Starting on the left, net fees were down this half. There's no large item in here, just a number of smaller headwinds, including lower advice fees. WIB was the one positive with higher lending fees. In wealth, the largest driver was the Hastings exit, which had $180 million impact. And insurance income was also lower following the severe storms. We had 7, but there's 2 big ones. And claims were $94 million higher this half from those, particularly those 2 major events.

Last year, we announced the repricing of the platforms and that would seize grandfathered commissions. The grandfathering changes reduced income by $21 million, and that effect is now in the run rate. Platform repricing had around an $8 million impact in the half and we'll continue to see that flow through as customers take up that new pricing. Offsetting this, as we said before, trading income was up in WIB markets, and we did have some assets sales and that was up $90 million. So overall, non-interest income was down and the largest drivers were Hastings, the insurance outcome, and our changes in the wealth business.

In this half, costs were up 1%. But if I exclude the impact of the provisioning, it was down 3%. Our work on structural productivity saw us take out $146 million, which was higher than our BAU cost growth. Hastings was a big contributor to lower expenses given its exit last half. On regulatory and compliance spend, as divisions prepared for the Code for Banking Practice, that lifted. And we also had higher spend on other compliance programs. These were partially offset by lower Royal Commission costs.

Investment spending was $31 million higher, and this mostly related to credit card projects. Following our adoption of AASB 15, we've now got credit card project costs recorded or grossed up in expenses. The other items here were our larger programs in terms of Panorama and the customer service hub.

And this chart sets out how I'm tracking costs and it gives a better perspective of the cost base. At the full year, we shared our plan to increase structural cost to $400 million and effectively see cost decline by 1%. And you can see the saves in the run cost bucket, which is down 1.3%. Given the various changes over the half, including the new accounting standards, I just wanted to reaffirm that our 1% cost reduction target still applies, and for clarity, it does exclude the major provisions or the impact of major provisions on both years.

In terms of the second half, we'll see software amortization increase with the customer service hub in particular going into production. We expect some high compliance costs and higher credit card project spends. And this will be funded by the uplift in productivity.

If you move to credit quality, the book remains in pretty good shape. The left hand chart shows our stressed ratio. There was little change and it again remains low by recent history. The 2 basis point increase in our stressed ratio was due to higher mortgage delinquencies. And within the components of stressed, impaired assets were higher, mostly reflecting one larger facility being -- well, migrating from watchlist into impaired. And the downgrade of this facility was the major factor for the watchlist and substandard category reducing.

The right hand chart shows no significant movements by sector. And while we've seen no significant changes in the credit quality trends, I thought I'd just touch on mortgages. And here, Australian mortgages continued to perform well with realized losses of $51 million this half. There has, however, been an increase in delinquencies, both 30 days and 90 days.

Across the states, WA saw the largest increase at 28 basis points. At 9% of our book, we're underweight WA, but it did contribute 2 basis points to the overall delinquency increase. New South Wales has the lowest delinquencies at 63 basis points. It did increase 10 basis points in the half. Given New South Wales is the largest part of our book, it contributed 4 basis points to the overall increase.

Portfolio mix is another feature here. As P&I loans grow given they have a naturally higher risk rate, we expect the 90-day risk rate to tick up. And properties in possession rose both from a small increase in new items, but also a slowdown in the resolution of -- as the property market has also slowed. The bottom right table shows 69% of customers are ahead on repayments and this includes continued growth in offset balances despite the big switch from interest-only to P&I. So overall, the book looks in pretty good shape given the slowing or the slowdown in the housing market.

And moving to equity backing. These charts give more detail on the equity backing of mortgages. The top left chart shows 80% of new loans have an LVR less than 80%. The bottom chart shows our portfolio is more skewed to low LVRs, with more than 1/2 the book having a dynamic LVR, sub 60%. Declines in property prices are impacting, with 1.6% of the portfolio in negative equity. And the right hand chart shows more granular data there on the state outcomes and that's the dynamic LVR by state. The key point here is despite the recent price falls in Sydney, just 1% of the New South Wales portfolio is in negative equity. So overall, the book has pretty good equity backing.

And the outcome from the good asset quality was a low impairment charge of 9 basis points of loans. On the left, new individually assessed provisions of $173 million were down 13% on last half and flat on the same period a year ago. This reflected fewer newer impaired assets in New Zealand and the Business Bank. The fall in write-backs and recoveries related to the Australian unsecured portfolio.

And moving to write-offs direct, there was little change as we had lower write-offs in cards and personal loans, while auto finance was a small increase. Other movements in collective provisions have a few moving parts. The overlays reduced by $38 million and this reflected lower overlays from manufacturing and mining, and this was mostly offset by a rise in agricultural overlays. Improvements in the quality of the business on unsecured consumer portfolio also saw capital releases, and these more than offset some additional provisions for mortgage delinquencies. So in summary, trends here have also been good.

The CET1 ratio ended at 10.6%, which I was happy with given the 25 basis point impact from the major provisions. Organic capital generation was 27 basis points as risk-weighted assets reduced, which saw cash earnings and dividends add to the CET1 ratio. Credit risk-weighted assets were largely flat this half with FX translation and loan growth, offset by the transition to AASB 9 and some modeling updates.

On RBNZ changes, we estimate the impact of $3.5 billion and $4 billion on our portfolio at the end of March, and our response will depend on the returns that we can secure on the capital.

So looking ahead, we expect credit and deposit growth to continue to ease. With slower growth, we'll also -- we'll remain focused on return. We'll continue to actively manage margins, but expect competition, lower interest rates and mortgage mix changes to flow through. And with non-interest income, the decision to exit planning will be the main headwind. On the positive side, we hope general insurance claims will be lower as major storms normally happen in the first half of the year.

On expenses, we're holding to our 1% reduction on cost excluding the major provisions. And we expect $70 million in wealth reset costs in the second half. Finally, on asset quality, it's in good shape, but unlikely to get better from here.

So thank you and let me hand back to ,Brian, to sum up.

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Brian Charles Hartzer, Westpac Banking Corporation - MD, CEO & Director [4]

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All right. Let me wrap up with a few comments on the outlook. Now it's true that economic conditions in Australia are softening, but overall the economy is still in reasonable shape.

The world economy is growing above trend, with China in particular are seeing continued growth. Australian GDP is growing at around 2.2%, which is being supported by increased government spending on infrastructure and growth in services. Wage growth has been modest, but unemployment remains near historical lows. And the dollar has eased a little, which is good for exports, particularly in services, which employ lots of people. However, inflation continues to sit below the RBA's preferred band, so we're expecting 2 cuts to the cash rate this year.

To be clear though, interest rates are not the problem. Certainly, a reduction in interest rates will help a bit on consumer spending, but the question we should be asking is how do we get businesses to invest to grow and employ more people, which would raise wages and supports spending. We must try policy changes that incentivize investment, improve productivity, and build business and consumer confidence. That means tax reform, reducing red tape, providing policy certainty, and having regulations that make it easier for businesses to borrow. This will give businesses and investors the confidence to invest.

On the housing market, we expect house prices to fall a bit further over the next few months, after which, supply and demand dynamics should come back into balance. And while we are seeing a bit of stress in certain pockets, we shouldn't forget that even with the recent falls, house prices in major markets are still materially higher than they were 5 years ago.

If we turn to what this environment means for banks. Lower demand for credit and lower interest rates will put continued pressure on margins. Earnings growth will therefore be challenging. We'll need to remain disciplined on margins and costs and targeted on where we grow. There is some continued uncertainty about regulation. And elevated risk and compliance costs will persist for some time. Pressure is increasing both from customers and new competitors, so having a strategic response to disruption is imperative.

On the positive side, credit quality continues to be good across all our businesses. While we are never complacent on credit quality, at this stage there are no major sources of concern. The challenge for banks like Westpac is to navigate this difficult transitional period as quickly as possible so we can refocus on competing in the marketplace.

All of which means our priorities for the second half of 2019 remain the same as the first half: first, to deal with outstanding issues like our wealth reset, the findings of the Royal Commission and customer refunds; second, to build momentum and value in our customer franchise, adding more customers, improving service, and continuing to roll out new technology like the customer service hub; and third, we'll drive structural cost savings of $400 million this year by simplifying, digitizing and modernizing our business.

While it is a challenging environment, we are clear and disciplined in executing our strategy and I'm confident of the quality and value that we're building here at Westpac.

With that, I'll invite Peter back up and we'll be happy to take some questions.

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Questions and Answers

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Andrew Bowden, Westpac Banking Corporation - Head of IR [1]

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Jarrod in the front there.

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Jarrod Martin, Crédit Suisse AG, Research Division - Director and Joint Lead Analyst [2]

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Jarrod Martin from Crédit Suisse. A question on capital and dividend. So your capital position is unquestionably strong, 10.64%. You rightly highlight that 27 basis points of organic capital generation and obviously offset by the major items. You wouldn't be expecting those major items to be as big in the second half? Or maybe you should comment if you are. So there should be some organic capital generation. And that core equity Tier 1 should push closer to 11%. So I'm curious about your decision to put a discount on the DRP. Are we effectively saying that 10.5% is no longer the unquestionably strong level, it needs to be 11%, 11.5% to get ahead of potential changes?

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Brian Charles Hartzer, Westpac Banking Corporation - MD, CEO & Director [3]

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Do you want to have a go at that?

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Peter Francis King, Westpac Banking Corporation - CFO [4]

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Yes. No, no, I think -- Jarrod, I think the short answer is it was about capital management. And if I look into the second half, we know we've got a new model for derivatives coming in and that's a 20 basis point headwind. That's the 1st of July. So that's our estimate for that. We also know that APRA will make, hopefully, some announcements on the final capital rules. And that's why we thought we wanted some additional flexibility on capital because we're getting closer to the hard date for APRA's requirements and we wanted some flexibility in terms of that piece. In terms of the second half, we will see that and we'll see earnings and we can make decisions again at the full year.

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Andrew Bowden, Westpac Banking Corporation - Head of IR [5]

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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 deposits. It was a reasonably good...

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Peter Francis King, Westpac Banking Corporation - CFO [7]

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On what, sorry, Andrew?

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Andrew Triggs, JP Morgan Chase & Co, Research Division - Research Analyst [8]

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On deposits. It was a good half there with the basis point tailwind to the margin. Just 2 questions there. Firstly, in the short term whether you think you can still leak out deposit spread benefits into the second half? And then the sort of more -- sort of medium-term question. How far do you think cash rates would need to fall before you start to find it difficult to reprice deposits sufficiently when you start sort of meeting that lower bound on deposits on at least, say, your online saving portfolio, where there's a 50 basis point base rate, but most customers would be on a sort of retention price north of 2%?

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Peter Francis King, Westpac Banking Corporation - CFO [9]

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Yes. Andrew, I think on margins -- so I'll just highlight -- one thing I was highlighting is there's been big moves. So the short-term rates are down, the 3-year rate is down. They are very important rates for us in terms of the margin. One will help, one won't help in terms of that.

In terms of your question on where does -- where the interest rates -- I think you've answered it, because some of those products are at 50 basis points. So if you're getting down to that level, you're at 0, then you're starting to get a floor under some of your deposit price.

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Andrew Bowden, Westpac Banking Corporation - Head of IR [10]

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Jon?

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Jonathan Mott, UBS Investment Bank, Research Division - MD and Banking Analyst [11]

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Jon Mott from UBS. Just following up on the comment you just had then on the tradeoff between BBSW and also the 3-year going the opposite direction. I think previously you said that every 5 basis point movement in BBSW adds 1 to NIM. So you get a lot more leverage from that than you would given the hedge on the tracker from the 3-year. So effectively, if rates aren't moved, I would have thought the benefit that you get from the BBSW will be much larger than the offset from the tracker. Just clarify that? And so another, yes, just as a follow on. The other question I had was, on Slide 18, you talked a bit more about the run-off in the portfolio. I just wanted to get a feel for, is the run-off falling because less people are refinancing externally. So you're seeing less new volume, but also less run-off from refi? Or is it actually that as people are going I/O to P&I, they're just finding it a little bit harder, it's not paying down the loan faster as to moving...

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Peter Francis King, Westpac Banking Corporation - CFO [12]

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So on the run-off, it's less sales of property. That's the big move.

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Jonathan Mott, UBS Investment Bank, Research Division - MD and Banking Analyst [13]

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Less turnover?

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Peter Francis King, Westpac Banking Corporation - CFO [14]

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Less turnover in the market. So you get it on the new lending side, you get it on the run-off side. So that's -- on margins, so a couple of things. The exit margin is about flat with the half. So that gives you a sense of where we're at right now. And then I think the piece -- so you spoke about short-term housing cost. You spoke about the 3-year swap rate. Competition and switching within the mortgage portfolio. So you put all those things together -- I just think you focused on 2 of the issues, not the third one.

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Jonathan Mott, UBS Investment Bank, Research Division - MD and Banking Analyst [15]

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So that would mean if rates get cut, then you lose the BBSW benefit, NIM will come down substantially?

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Peter Francis King, Westpac Banking Corporation - CFO [16]

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No, I'm not giving you a forecast for NIM. I'm just saying there's a third driver in it.

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Jonathan Mott, UBS Investment Bank, Research Division - MD and Banking Analyst [17]

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Okay. Hypothetically speaking, that would be a...

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Peter Francis King, Westpac Banking Corporation - CFO [18]

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Up to you to model.

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Jonathan Mott, UBS Investment Bank, Research Division - MD and Banking Analyst [19]

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Easy.

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Andrew Bowden, Westpac Banking Corporation - Head of IR [20]

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Victor?

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Victor German, Macquarie Research - Analyst [21]

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Victor German from Macquarie. Two related questions, one on expenses. Brian, you talked about some of the initiatives that you're putting in. And obviously, we have guidance for this year, but just interested in the observations. If challenging revenue environment continues -- and you're getting lots of questions on low interest rates and all that sort of stuff that does to revenue. Just in terms of your thoughts on expenses as we go out into 2020, '21. One of your peers obviously is talking about significant reduction in the expense space?

And second related question on dividends. I appreciate that this year lots of volatility. But on an underlying basis, earnings are down 1% and dividend is flat. You're issuing more shares. And that's obviously continued to put pressure on your payout ratio. How you're thinking about dividend more broadly? Is it you're trying to sort of return as much franking credits to your shareholders and that's the key driver? Or do you think as we go out 2, 3 years, you will be able to get into a more reasonable payout ratio because either revenue improves or you'll be able to do a lot more on costs?

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Brian Charles Hartzer, Westpac Banking Corporation - MD, CEO & Director [22]

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Well, I might take the cost and you can comment on the dividend side. So when we're thinking about the cost issue, as I said in my remarks, cost is an enormous priority at the moment given the environment. I think one thing to remember about our position is, this isn't a new thing for us. We've been focused on productivity for multiple years. It's embedded in the way that we run the company in terms of internal productivity targets every year. That's why our starting position from a cost to income ratio point of view has been strong relative to some of our peers.

The balance that we're striking is, we've set the target around $400 million in productivity improvement. That's an increase on what we did in the previous years. But I'm not going to sacrifice compliance or risk management in this environment and I'm not going to sacrifice the long-term simplification and modernization of the underlying platform.

So we have some flexibility in terms of the timing of our investments, but we are driving through a program that is all about driving that cost to income ratio down below 40%, which is still our target.

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Victor German, Macquarie Research - Analyst [23]

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Sorry, Brian, just if I can push my luck up. Completely appreciate. And shareholders would certainly not want you to sacrifice that investment. One of the things that's difficult for us is how far progressed are you? I mean are we -- is it still another 2, 3 years of further investment or we're getting towards the end of that?

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Brian Charles Hartzer, Westpac Banking Corporation - MD, CEO & Director [24]

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Well, we'll probably maintain this level of investment for a couple more years. The modernization of our platforms is a big program. But as you can see from the result this half, we're starting to see real benefits coming out of that.

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Peter Francis King, Westpac Banking Corporation - CFO [25]

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Victor, on the payout ratio, I think the important thing for this period was we looked through the major provision. So that's the first thing. But when you then look at it, it was an 80% payout ratio versus we think 70% to 75% in the medium term, and that's why we've had the DRP issuing shares. We were hopeful that over time the earnings growth would pull that ratio down. The new information this time is RBNZ. So we're going to have to stand back once we know what RBNZ is actually doing and look at the settings of the company.

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Andrew Bowden, Westpac Banking Corporation - Head of IR [26]

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Andrew?

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Andrew Lyons, Goldman Sachs Group Inc., Research Division - Equity Analyst [27]

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Andrew Lyons from Goldman. Like your peers, your fee fell somewhat in the half. And while you did provide a lot of disclosure around this ahead of the result, these headwinds did seem more significant than expectations in both banking and wealth management. Just with this in mind, can you perhaps talk about -- a bit about the trajectory for fees in both banking and wealth going forward?

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Peter Francis King, Westpac Banking Corporation - CFO [28]

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Yes. So I think yes, the biggest impact -- putting aside Hastings, which I think everyone knew about, the biggest impact was insurance. So we had a $94 million increase in claims. If you go and have a look at the BT section, which shows cash earnings by division, our insurance provision basically made no money. So we paid all revenue out in claims, which is good for customers but wasn't great for shareholders.

Putting that to one side, we've got the reset of the business. So we've dealt with the grandfathering piece, that's in run rate. Then we've got the platforms reprice to come through. I said that's -- that was about [8.5]. We're probably about a quarter of the way through in terms of that impact. And then on the banking side, we did well. Probably a few headwinds in Business Bank mostly related to merchants. And then the cards piece was moving around mainly because of customer activity. So they did less on FX in particular.

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Andrew Bowden, Westpac Banking Corporation - Head of IR [29]

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Brian?

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Brian D. Johnson, CLSA Limited, Research Division - Research Analyst [30]

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Brian Johnson, CLSA. I had 2 questions if I may. The first one is that we've seen the DRP discount 1.5%. We know that APS 180 sucks about 20 basis points out. Where does this -- and on RBNZ your commentary today is that we'll wait and see how we respond, but I think -- which is kind of telling us you're going to reprice up. But the other issue that's kind of floating around there is we're yet to get APRA's response to basically bail. And prima facie, you guys would appear to have a low risk-weighting than your peers, but probably a more capital-intensive book. Could we get some feel about whether this captures that potential risk?

And then the second one is you're saying today that you expect property prices to fall for a few more months. But we do know that your existing book has got a little bit of negative equity. Could you -- and I'm sure you've got this number and I'm sure you probably won't answer, but could you share with us -- if you're going to talk it, you may as well explain it. But could you just explain for us the sensitivity on that negative equity book because presumably there's some kind of cliff effect at some point? So could you just give us some guidance? It either alarm us or make us feel better with some kind of sensitivity on the negative equity piece?

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Peter Francis King, Westpac Banking Corporation - CFO [31]

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So on your risk-weighted asset question, I think you've hit -- you've picked all the areas. In relation to APRA's upcoming likely announcement on final bail rules, we know that some parts of the mortgage portfolio get high capital. I don't know how much. So I can't sit here and say I know. So we thought about that. That was part of the decision in terms of the 1.5% for the discount for the DRP. But you've got the right thematics.

In terms of the impact of lower property prices on capital, given we've got an LGD that's fixed at 20%, that's where you'd naturally have it flying through. It's not that big at this point.

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Brian Charles Hartzer, Westpac Banking Corporation - MD, CEO & Director [32]

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And you've got -- you've seen in the chart that we gave you the breakdown of the ranges of over 100% dynamic, 90% to 100%. So you can kind of look at that piece and make a judgment.

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Brian D. Johnson, CLSA Limited, Research Division - Research Analyst [33]

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Sorry, my question wasn't about the capital. I was just wondering could you -- it was just the dynamics of what happens to that dynamic negative equity. If you can give us just a range of property prices, so we can look at whether there lies a concern or not.

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Brian Charles Hartzer, Westpac Banking Corporation - MD, CEO & Director [34]

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We're not overly concerned.

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Brian D. Johnson, CLSA Limited, Research Division - Research Analyst [35]

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Could you share with us the dynamics of how you get to your lack of concern?

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Peter Francis King, Westpac Banking Corporation - CFO [36]

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That's not in the pack, so we'll think about it in the future.

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Brian D. Johnson, CLSA Limited, Research Division - Research Analyst [37]

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Okay.

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Brian Charles Hartzer, Westpac Banking Corporation - MD, CEO & Director [38]

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But there is quite -- if you look in the back, there is quite a lot of breakdown of the portfolio on a number of areas. And we do that because we think that if you look at the components of that, you'll see that it's a pretty high quality book.

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Andrew Bowden, Westpac Banking Corporation - Head of IR [39]

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Okay, Brett.

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Brett Le Mesurier, Shaw and Partners Limited, Research Division - Senior Analyst of Banking and Insurance [40]

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Brett Le Mesurier from Shaw and Partners. A question on your impaired. So your disclosure on impaired shows the portfolio of managed impaired increasing from about $400 million at the end of September to about $700 million at the end of March. Can you comment on the factors that created that?

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Peter Francis King, Westpac Banking Corporation - CFO [41]

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Yes, I think part of it's our transition to AASB 9. So we've applied a new framework or methodology in the small business where we pick up the facility, not the loan, and some data improvement in mortgages. That's about 1/2 the increase. And then the other 1/2 is the mortgage delinquencies increasing. That's the biggest factors. So about 1/2 related to methodology changes, 1/2 related to the economics.

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Andrew Bowden, Westpac Banking Corporation - Head of IR [42]

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We'll take a call from the phone from Matthew Wilson.

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Matthew Wilson, Deutsche Bank AG, Research Division - Australian Bank Equity Analyst [43]

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My question has been answered.

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Andrew Bowden, Westpac Banking Corporation - Head of IR [44]

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Okay. Next one on the phone is Azib.

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Azib Khan, Morgans Financial Limited, Research Division - Senior Banks Analyst [45]

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Another question from to me about the lower run-off coming through the home loan portfolio. So Peter, have you increased -- have you lengthened the loan life assumptions in accounting for the deferred acquisition costs associated with mortgages?

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Peter Francis King, Westpac Banking Corporation - CFO [46]

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No, we look at those every 6 months. It hasn't moved. So we need to...

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Azib Khan, Morgans Financial Limited, Research Division - Senior Banks Analyst [47]

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And just one more question from me if that's okay. So if I take a look at the interest on the flows, that's remained pretty stable from the last half despite APRA now lifting the cap, the 30% cap. So the 19% that the flows running at, at the moment, is that more driven by your risk appetite or by lack of demand?

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Brian Charles Hartzer, Westpac Banking Corporation - MD, CEO & Director [48]

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I'd say it's driven by pricing and flowing into customer demand.

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Andrew Bowden, Westpac Banking Corporation - Head of IR [49]

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Okay. I think he is done. Richard?

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Richard E. Wiles, Morgan Stanley, Research Division - MD [50]

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Rich Wiles, Morgan Stanley. I've got a couple of questions. Firstly, on Slide 109 you said there's a potential 20 basis point impact on group capital from New Zealand. Can you explain how you get to that given it's $3.5 billion to $4 billion within the New Zealand entity?

Second question. Brain, when you announced 14 basis points standard variable right rate pricing back in September, you said that funding costs would remain high for the foreseeable future. That doesn't seem to have continued to play out as you expected. So could you talk about some of the factors that you would take into account when thinking about pricing of your standard variable rates?

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Brian Charles Hartzer, Westpac Banking Corporation - MD, CEO & Director [51]

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Do I take the first one?

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Peter Francis King, Westpac Banking Corporation - CFO [52]

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Yes, you do that.

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Brian Charles Hartzer, Westpac Banking Corporation - MD, CEO & Director [53]

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Okay. Well, I'm not going to talk about obviously what pricing changes we may or may not make. As a general point, on your thing about the elevated costs there, we had watched the BBSW move for -- around 6 months we had warned that cost. There are swings and roundabouts. Those numbers can be relatively volatile. So we don't like to make a lot of changes if we can help it. But at a certain point, you come to a conclusion. There are, as Peter said in his presentation, a number of different factors moving in opposite directions at the moment. As a general statement, we manage the overall net interest margin of the company, and so we think about the funding costs and the mix of funding as well as the mix and demand of loans. There is a variety of different product categories within that, that the mix shifts can change. And so we're thinking about that the whole time. And obviously, competition is a really important element as well.

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Peter Francis King, Westpac Banking Corporation - CFO [54]

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And Richard, on the first one. That's a net impact, so that's the gross impact of the capital after -- and then after we've taken some actions to implement it. I would say that that is based on current APRA rules. It's quite important that's above that. But it's a net impact.

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Richard E. Wiles, Morgan Stanley, Research Division - MD [55]

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So that's not assuming any change to the size of the balance sheet in New Zealand or any change on repricing?

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Peter Francis King, Westpac Banking Corporation - CFO [56]

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No. So it's that...

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Richard E. Wiles, Morgan Stanley, Research Division - MD [57]

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You're just saying that net impact at the group level would just be 20 basis points?

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Peter Francis King, Westpac Banking Corporation - CFO [58]

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Based on the rule -- APRA rules today and based on that estimate of capital, that's a net impact.

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Andrew Bowden, Westpac Banking Corporation - Head of IR [59]

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We'll take a call from the phone. It's from Brendan.

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Brendan Sproules, Citigroup Inc, Research Division - VP [60]

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I just got a couple of questions on the treasury result in this half, just referring to Slide 20. Treasury had probably one of the weakest results on the slide there, but obviously the markets, non-customer actually had a better half. Could you maybe talk about how they manage risk differently between those two given they're obviously facing the same market conditions? And my second question is that the volatility that we're getting there, the revenue from treasury seems to have picked up since 2017. Has there been changes in the way -- or the risk taking activities within that division?

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Peter Francis King, Westpac Banking Corporation - CFO [61]

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Yes. I should just say on treasury, the result was lower, but I'm actually okay with that. To me the way that we run treasury is you take risk when it makes sense. So that's important context. Brendan, while we put them together as risk income, they're really different businesses. So WIB is there to support customer flow and interest rates, FX in particular, and it runs the book. Treasury is there to manage long-term structural mismatch in the balance sheet. So treasury's major risk areas are Australian and U.S. interest rates related to the group's house of funding and the balance sheet mismatch in Australia. So they're quite different businesses.

I'd just say on the treasury performance, it's been a flattening of the yield curve and less opportunities because less volatility. And then over the last sort of 5 years as we move the liquids book to being government and semi-government debt, it has provided less opportunities. So they leveraged the opportunities back in '16 and '17 and early '18 pretty well. It's been a tougher period for them more recently with some of the changes in the markets.

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Andrew Bowden, Westpac Banking Corporation - Head of IR [62]

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And with that, we're done. Thank you very much, and good morning.