2004 Half Year Financial Results - Analyst Briefing Transcript

This is an edited transcript of the analyst presentation by National Australia Bank Chief Executive, Mr John Stewart, and Chief Financial Officer, Mr Richard McKinnon, on 12 May 2004 for the 2004 Half Year Financial Results.

The transcript is comprised of five sections:

Introduction by John Stewart 
Group Commentary by Richard McKinnon 
Business Commentary by Richard McKinnon 
Conclusion by John Stewart
Q&As

Introduction by John Stewart

Host:  Mr Callum Davidson, Head of Group Investor Relations.

Callum Davidson:

I'd like to welcome you all here this morning.   Thanks very much for joining us.   As usual, we've got people in person with us in Sydney, people joining us via the teleconference line, and people viewing the presentation via the webcast. 

Following the presentation this morning, we will take Q&A both from the floor here and also via the teleconference line.
 
With that, I'd just like to hand over to John to begin proceedings.   Thank you.

John Stewart:

Thank you Callum.   Just before I start, what I would like to do is to introduce the top team because we've got everyone here today apart from Ross Pinney, who is in Europe.   So let me just introduce them.  

Peter McKinnon, who runs the CEO's office
Peter Thodey, who runs the New Zealand Business
Ian Crouch, who is in charge of technology
Peter Scott, who runs the wealth management business
Lynne Peacock, who is now running people and culture
Graeme Willis, who is the acting head of risk
John Hooper, who is acting as head of CIB
Mike Laing, who is in charge of strategy and communications
Ian MacDonald, who is in charge of FSA

Let me get started.   These are disappointing results.   We have had a lot of distractions over the first part of this year.   These results are about more than just those distractions.   These results are about things that we have to fix in the business.   And what I'll be sharing with you over roughly the next half-hour, at least after Richard's presentation, is my diagnosis of what I think is wrong with the business.   And certainly, in general terms, how we have to fix it and roughly how long that's going to take.

The good news is I think we have fabulous franchises here.   We have businesses here that can rebound, can do really well, can deliver good shareholder value in the future.   The bad news is that I have spent probably the majority of my time, certainly more than half of my time since I arrived, on the distractions which add little if any shareholder value.   That is, of course, the PwC and APRA reports, the board issues and so on.  So I am not as far advanced as I hoped I would be after three months and I am not in a position to say to you, this is exactly what we're going to do.  

So let me set the expectation level for the day.   I will not today be laying out a grand plan of where this bank is going for the next three to five years.   I will, however, be telling you what I think is wrong with the bank, how in directional terms we're going fix it and how long I think that's going to take.   But I'm also going to spend some time telling you what's right about this bank and the huge opportunities we have got if we take advantage of them to consistently produce good shareholder returns.  

Now I will stop there and Richard is going to go through the details of the results and then I'll pick up the story from there.

Group Commentary by Richard McKinnon

Richard McKinnon:

Thanks John.  

Let me begin by reiterating this is a disappointing result.   Cash earnings per share is down 7.6 per cent and diluted cash EPS down 7.8 per cent compared with the March 2003 half.   The performance of our European operations and Corporate and Institutional Banking have been below expectations, whilst our core Australian and New Zealand retail and wealth management businesses continue to perform well. 

As foreshadowed in our pre-close statement, the dividend has been maintained at September levels.   This represents a three cent, or 3.8 per cent, increase on last year's interim dividend.   Return on equity remains strong.   Our capital ratios are also sound and we will be underwriting the full interim dividend to accommodate the impact on our ratios of the requirement to use the standard method to calculate the market risk component of risk weighted assets.   I will give more detail on the movement in our capital ratios later in the presentation. 
 
Asset quality remains sound with the ratio of non-accrual loans to gross loans and acceptances at 17 year lows.   The result has been affected by the strength of the Australian dollar and higher pension charges.   However, those effects were largely anticipated.   What was not in our plans was the low volume growth in Europe and the extent of the margin decline.   Neither did we anticipate, of course, the primary and secondary impact of the losses incurred on our foreign exchange options desk in Corporate and Institutional Banking.  

Financial Services Australia produced cash earnings growth of 10.5 per cent.   This was slightly below plan due to the prolonged anticipation of a further rate rise by the market which has seen the spread between the 90 day bank bill rate, where we fund our business, and the cash rate, where we price our loans, tighten for most of this half.    
 
Volumes have been strong and credit quality continues to improve.   Growth in Financial Services New Zealand slowed, but not unexpectedly.   Cash earnings were up 4.7 per cent on the second half of last year.   Wealth Management continues its rebound off the back of strong equity markets and good performance in the insurance business.  

The Corporate Centre function showed a significant increase in net costs, reflecting higher expenses related to Group-wide projects and lower income for one-off transactions.   Within the capital unit, we saw reduced earnings as a result of the buy back of excess capital.   In addition, we ceased booking a tax benefit on the interest expense of the ex caps following receipt of an ATO assessment.  

A further write down of $22 million has been taken on the ISI program, bringing the total write down for the 12 months to March to $55 million after tax.   Let me deal with the significant items here.  

We indicated in the pre-close that they would amount to $110 million and have come out at $127 million.   These items relate to the profit on the sale of St George, AMP and HHG being $315 million, foreign currency trading options losses of $252 million and the reversal of a HomeSide non-lending loss provision of $64 million.  

The remainder of my presentation will focus on the results prior to significant items, increased pension costs and the translation impact of the higher Australian dollar. 

Within the banking operation, we have seen modest growth in income across the regions offset by substantial expense increases, particularly in Europe but also in CIB.   The majority of this expense increase occurred in the second half of last year and I spoke about this in November.   Banking expenses have actually declined from the second half of last year by 0.8 per cent prior to pensions and the foreign exchange impact.   Net interest income growth has come from strong growth in mortgages across all of our regions and reasonable growth in business lending being offset by generally lower margins.   But let me first deal with the expense growth.  
 
The Group experienced a large expense increase in the September half of last year and in the November briefing I noted that this was driven by higher regulatory and compliance spend across the group at around a $100 million of non-core expense growth.

Financial Services Europe and CIB have been the main drivers of expense growth in this half and I will deal with this growth in detail when I discuss the divisional performance.

Now turning to income.   Over the 12 months, volumes have grown 11 per cent across the Group, driven primarily by housing lending, which was up 17 per cent.   Lending and retail deposits showed healthy growth of eight per cent and six per cent respectively.   The continued strong growth in housing relative to higher margin and term lending has caused a mixed impact on margins.  Housing now comprises 49.9 per cent of our total lending book, compared to 46.5 per cent 12 months ago.

Despite strong volume growth, net interest income was down 4.3 per cent on the March half of last year.   Foreign exchange movements account for the decline and, in local currency terms, net interest income saw a modest increase of 1.5 per cent.  Since September, net interest income is down 2.4 per cent in Australian dollar terms, and is flat in local currency terms.  The main driver of this subdued outcome has been margin contraction, and I would like to spend some time on this.  This is an important part of the result, as I know a lot of you are interested in the margin decline.  I hope you'll bear with me over the next couple of slides.   I know for some of you this will be teaching grandma to suck eggs, but I think it's important to understand that there are some market-related factors impacting the margin in the group.

There are five factors that impact the margin at the group level.  The first is product mix.  This reflects the significant shifts in our balance sheet composition towards lower margin lending and deposit products over the last 12 months. 
 
The second factor is the shape of the yield curve.  This impacts us in two ways.  The first of these is the basis risk that all banks run.  Over the last six months in particular, we've seen our funding cost move up, as the market anticipates rate rises, without a corresponding increase in official rates.  This has squeezed our margins in both Australia and Europe.

Secondly, all banks have liabilities that re-price more quickly than their assets.  We borrow short and lend long.  If the yield curve flattens, then as liabilities re-price more quickly than assets, there'll be a narrowing of the margin.

The third factor is the capital and core free funds we hold in our business.  This earns a rate along the curve.  The reduction in excess capital due to the share buy back has reduced the margin benefit from free funds.

Fourthly, we have product margins.  Competitive pressures and the risk profile of our customers influence this.  This has had little impact in Australia, but a larger impact in Europe.

Finally, margins are impacted by an increasing reliance on relatively more expensive wholesale funding.  With the rapid growth in loan volumes in recent times, banks have seen an increase in the proportion of their funding sourced from wholesale markets.

I want to illustrate this by looking at the impact on Financial Services Australia of the market-related issues.  The yield curve impact on Financial Services Australia's margin is illustrated in this slide, and it reflects the environment impacting all Australian banks.

First, let's look at the basis risk that I spoke about.  We've had two official rate rises this half.  As you can see, the market priced in these rises around the time that they were made.  However, the market immediately priced in a third rise, which we have not yet had.  This has squeezed our lending margins.
 
Now let's look at the mismatch income.  You can see that at the beginning of the first half last year, there was around an 88 basis point difference between the short end and the three year point on the curve.  This narrowed only slightly during the half, so there was opportunity to earn income from the mismatch.  During the second half of last year, the curve flattened by around 33 basis points, so that at the beginning of this half there was around 55 basis points difference between the 90 day rate and the three year point on the curve.  That differential entirely disappeared during the current half.

The third factor is the earnings on our capital and core free funds.  These are effectively invested at the three-year swap rate.  This averaged 5.6 per cent during the second half of last year and 5.3 per cent over the first half of this year.  This accounted for around five basis points with a decline in margins.
 
These three factors – basis risk squeeze, mismatch income and earnings on core free funds, combined with the increase in the proportion of wholesale funding – has accounted for around half the margin decline in Financial Services Australia.  The remaining two factors, product margin and product mix, are directly influenced by competitive pressures and I'll talk about these later during the divisional presentations.

The UK environment is similar to the Australian rate environment and consequently impacted net interest income in much the same way, although not to the same extent.  The margin squeeze resulting from basis risk has been more limited, and there is still opportunity in the UK to earn mismatch income.  The main drivers of the reduction in margin in Financial Services Europe, have been the competitive factors.

Total banking level non-interest income was down seven per cent on the September half, or 5.5 per cent excluding currency impacts.   Transfer fees are down 3.9 per cent, reflecting pricing reductions in Europe, while other regions of experience flattened in this line. 
 
Fees and commissions are up, despite the impact of the loss of income as a result of RBA interchange reform of $17 million.  Trading income is also up.  Other income in the September 2003 half included a number of one-off gains not repeated in the March 2004 half. 

Restructure of hedge swaps on TrUEPrS produced a one-off benefit, and some large structured finance deals completed in the second half of last year.

Turning to asset quality, we are continuing to see improvements in the credit risk profile of our balance sheet, with non-accruing loans falling to the lowest level for 17 years.  They now represent only 0.46 per cent of gross loans and acceptances.  Particularly pleasing is that improvements in non-accrual loans have occurred across all regions except the US. 

The $305 million charged to the P & L was largely in line with the September half, and it compares favourably to net write-offs of $217 million.

The general provision increased slightly in local currency terms, but fell $10 million in Australian dollar terms.

I don't wish to dwell on this slide.  In previous presentations, I've provided you with this information to demonstrate the movements in the drivers of provisioning levels and loss outcomes. 

In summary, the level of investment grade rated customers continues to increase across the Group, and in Australia and Europe we continue to see the average credit quality of our customers improve in the business bank, and we are seeing our security position improve.  It's these factors that continue to drive the improvement in our credit quality.  As I've noted in previous presentations, this improvement in quality also has had an impact on margins and fees and it's reflected in our charge to provide for doubtful debts.  John's going to say a little more about this later.
 
Coverage levels have improved and we've focussed very much on coverage levels.  The Group has strong coverage ratios, impaired assets are almost two times covered, and the ratio of specific provisions to impaired assets is 41 per cent at 31 March.  This is one of the highest levels we've seen in recent times.

Again, I don't wish to dwell on this slide.  In previous presentations I've provided you with this information to demonstrate that average net write-offs have been below the average annual level of provisioning over the cycle.  Provisioning is designed to anticipate and mitigate the lumpiness of the actual net write-offs.  In better years, provisioning might be above write-offs and in worse years, below.  But over the cycle, they should at least smooth out.

Our history has been better than our peers in this regard.  It's also worth noting that over the past seven years, The National has had, on average, lower net write-offs to risk weighted assets than our peers. 

Now looking at the capital position.  The Group's capital ratios remain sound.  As a result of its investigation of the foreign currency options trading losses, APRA has required us to increase our target total capital ratio to 10 per cent.  Previously the total capital target ratio was nine per cent to 9.5 per cent.  There has been no change to the Group's other target capital ranges.  However, APRA has also required us to use the standard model to calculate the market risk component, of risk weighted assets, for the near term.   This change increased risk weighted assets by approximately $18 billion, at 31 March 2004.   We've announced a full underwriting of the dividend reinvestment plan and this will offset the impact of these additional risk weighted assets on our tier one and adjusted common equity ratios.   The increase in total capital to above 10 per cent is expected to be achieved in the near term through a combination of fully underwriting the interim DRP and a tier two subordinated debt issuance of around $2 billion.   Sub-debt issuance will replace senior debt, and is not expected to have a material profit impact.   It is important to understand that this sub-debt issuance will be part of our normal debt-raising program.  What it will do is increase the proportion of sub-debt to senior debt.   A DRP underwriting agreement has been signed with Merrill Lynch.
 
The resulting increase in ACE and tier one of $1.2 billion (equivalent to 45 basis points on the ACE ratio) has been reflected in the half-year capital position.   The underwriting will be facilitated by a number of changes to the DRP plan, principally, the reintroduction of the 2.5 per cent discount and the removal of the current participation cap of 15,000 shares.   Overall, our key ACE ratio has increased from 4.95 per cent at September 2003, to 5.36 per cent at March 2004.   The net increase in the core tier one ratio of three basis points reflects five major items: growth in retained profits, which has had a 17 basis point impact; the profit on the sale of the stakes in St George, AMP and HHG, increasing core tier one by 12 basis points; and underwriting the DRP, which will increase core tier one by 45 basis points.   These impacts have been largely offset by two items: a 44 basis point adverse impact from the increase in the market risk component of risk weighted assets; and general business growth in risk weighted assets, and other factors, which have accounted for 27 basis points.

Compared with the core tier one ratio there is a significantly larger increase in the ACE ratio, due primarily to the differing treatment of the sale of the strategic shareholdings.   Our core tier one ratio is now a better determinant of surplus capital.   We were in the difficult and unenviable position previously of having our capital limits determined largely by the ratings agency ratios.

We are now back to having our regulatory ratios determined of surplus capital.

The Board has declared an interim dividend of 83 cents per share, fully franked.   This is in line with our final 2003 dividend, which provides a three cent or 3.8 per cent increase on the 2003 interim dividend.   The pay out ratio to diluted cash EPS, before significant items, was 69 per cent.   You should note that over the next two years cash EPS will converge towards diluted cash EPS as the ExCaps convert.   Future presentations will highlight diluted cash EPS.   We anticipate the dividend will at least be maintained in the second half, and will be franked in the range of 80 to 100 per cent.

Business Commentary by Richard McKinnon

Richard McKinnon:

Let me now turn to the divisional results.   FSA has delivered solid cash earnings growth of 10.5 per cent.   Average interest earning asset growth was 14.4 per cent, while average retail deposits grew 9.5 per cent, compared to March last year.   Asset growth rates have declined marginally when compared to September, while deposit growth has increased.   Total income was up 4.8 per cent on the March 2003 half.   Expenses increased 3.3 per cent.   This included the benefit of a superannuation contribution holiday in the current half.   Excluding this, expenses grew 4.3 per cent.   This accommodated three months' impact of the enterprise bargaining rises and the consolidation of all Australian based property costs into Financial Services Australia.   Asset quality remains very sound.   Looking at the result in the two halves, cash earnings grew seven per cent in the September half, and increased by 3.3 per cent in the March half.   Other operating income fell 1.1 per cent from the September half.   There is some noise in this number, generated by prior period asset sales and internal recharging, but there are three main factors.   Firstly, a $17 million adverse impact arising from the RBA interchange reform.   Secondly, a fall in penalty fees as a result of increased charges and changed customer behaviour.   And finally, as we have concentrated on higher quality customers, particularly in business lending, our share of the higher risk segments, which have both higher margins and higher fees, has fallen.

Expenses reduced by 2.6 per cent, driven primarily by favourable personnel expenses from lower average staff numbers and the superannuation contribution holiday I previously mentioned.   The improvement in the charge for doubtful debts primarily reflects the specific provision taken against companies associated with the King Brothers Bus Group exposure in the prior year.

Net interest income within Financial Services Australia fell by 0.6 per cent on the September half.   Average interest earning asset growth in the March 2004 half was 6.2 per cent, driven predominantly by housing and term lending.  However, the net interest margin fell 20 basis points.   Growth of lower margin product outstripped higher margin products and the requirement to increase wholesale funding resulted in a mixed impact on margin of six basis points.   Product margin is flat. 
 
You ought to understand though that there are competitive factors in that mix component – both the mix and the margin component that represent the competitive factors.   Repricing initiatives on the broker mortgages have been offset by favourable deposit margins.   The impact of basis risk removed a further five basis points from net interest margin.   The ALM mismatch, which I spoke about earlier, has been a strong contributor to net interest income in recent periods and has fallen due to the flatter yield curve in the current half.  This had an impact on net interest margin by six basis points.   The capital and core free funds impact arose from reduced capital and a lower earnings rate.   This reduced the contribution by three basis points.

Our housing market share has fallen 0.5 per cent in the last 12 months, with the decline skewed to the last half.   We took a view that parts of this market had become overheated.   We undertook a review of our inner city apartments exposure, as well as a wider review of our housing portfolio.  The outcome of these reviews led us to reduce our loans to valuation ratios on inner city apartments to 70 per cent and LVR's for other investment properties to 75 per cent.   We also ceased writing low document loans.   This has had an impact on our growth.   FSA continues to maintain its relative performance on a share of wallet measure.   We remain number one in both business and consumer share of wallet.   Our market share in business has remained stable over the past 12 months.   There has been a decline in the market share at the sole proprietor end of the small business market, and consequently we are revisiting our distribution strategy for this segment.   That said, we have made gains in our market share for the middle market segment, so that overall business market share has remained stable.   This has occurred in circumstances where we have shed more than $3 billion of relatively high lending over the last two years.   Now, the de-risking strategy has been pushed quite hard.   We've potentially missed some opportunities as we've focused on a segment of the market with particular credit quality characteristics and the ability to provide certain levels of security.   Opportunities exist to pursue these customers and John will talk more about this later.  
 
Financial Services Europe has performed below expectations.   Compared to the March half last year cash earnings are down 27.5 per cent, or 17.5 per cent prior to the pension impact.   The pre-pension result is down 11.9 per cent on the September half.   Mortgage volume growth has been good, but most other lending categories have seen low growth or declines in volume.   Margins have also declined.   Fee income is down and the investment program has seen expenses lift sharply.   Asset quality continues to improve.  

The story is very similar comparing consecutive periods.   The income decline has occurred mainly in this half, with net interest income down 2.2 per cent and other operating income down 2.8 per cent.   On the expense side, the growth has occurred in both the second half of last year and the first half of this year and I'll talk more about this later.   Credit quality has continued to improve and this is reflected in a slightly lower charge for doubtful debts.   Whilst margins have been impacted by the interest rate environment, the major contributor to the decline has been competitive factors.   Mortgage growth has been good but at the cost of margin.   This is primarily a mixed impact as we've had continued success with our Rapid Repay mortgage product.   This carries a lower margin than the standard variable rate mortgage.   A significant contributor to the decline in net interest income has been declines in our stock of high margin unsecured personal loans.   Business lending volumes have been below system growth and margins have declined.  

In relation to the detail about the expenses, what I've tried to do here is break out the core expenses from some of the one-offs and some of the re-investments spend or spend for growth that is going into the European operations.   Core expense growth in Financial Services Europe over the March half has been reasonable, at 4.5 per cent.   Most of this occurred in the second half of last year.   As I indicated at the November briefing, this had to do with increased spend on regulatory and compliance issues, which are now embedded as core costs.   There were also some non-recurring expenses and some timing differences.
 
The increase in expenses this half has related to two primary issues.   Firstly, we have expenses of £13 million relating to growth initiatives.   The major items include the front end teller platform, the Clydesdale Bank and Yorkshire Bank integration program, the establishment of Integrated Financial Solution centres in Liverpool, Bristol, Reading, and South Hampton, and the spend on our SME project.

The main driver of increased expenses has been £17 million of provisions we have taken in relation to regulatory costs – potential exposure from mis-selling of endowment mortgages, which is an industry issue, and a provision to cover additional expenses associated with medical benefits provided to retired officers.   John will talk more about Europe at the end of my presentation.  

Our operations in New Zealand continue to perform well in the local environment.   Cash earnings were up 2.9 per cent on the March half of last year but improved 4.7 per cent on the September half.   Net interest income was up 5.8 per cent on the March half, with most of the growth occurring in this half.   Volumes increased 14.3 per cent on the March half and a pleasing 8.4 per cent against the September half.   There was some margin reduction driven primarily by growth in lower margin fixed rate mortgages.   Other operating income fell 1.1 per cent on the March half and the decline was relatively equal over the two halves.   The primary driver of this is the continuation of customer migration to lower cost channels in response to recent price changes to encourage efficient banking.   Expenses have been contained and the cost to income ratio improved 120 basis points to 49.6 per cent.   Asset quality remains amongst the best in the Group.  

CIB's cash earnings have been affected by both the direct and indirect impact of the foreign currency options trading losses.   Cash earnings fell 12.8 per cent from the March 2003 half or 6.5 per cent prior to the impact of foreign exchange rate movements.   Our formal value at risk limit for CIB is now set at $40 million.  
 
Over the last two months of the March half the bar for the market's provision has been an average of $15 million.  This is down from the $25 million prior to the foreign currency options trading losses.   We expect to return to more normal levels in the medium term.   Income has shown a small increase in local currency terms.   Sales in Debt Markets have fallen, particularly in Europe and the US.   Corporate banking income is also down.   Foreign exchange sales have shown good growth along with income from Transactional Banking and national custodians.   Expense growth has been impacted by the acquisition of the CBA custody business and higher staffing and volume costs in transactional banking.   Three specific provisions have seen the charge for doubtful debts increase.   Management in CIB has remedial work to undertake as a result of the reports by APRA and PricewaterhouseCoopers.   This will be distracting for the business and until it is completed we do not expect to see the business return to significant growth.   We expect the second half result in Corporate and Institutional Banking to be down on the first half. 

Wealth Management has improved its operating profit after tax result, with growth of 37 per cent over the March half.   The insurance business increased operating profit by 22 per cent, driven by growth in inforce premiums and continued focus on claims management.   The insurance result also benefited from the favourable impact of the receipt of profit share commission income on the creditor insurance business in the UK.   Growth in the investments business of 33 per cent reflects the strong performance of equity markets with growth in average funds under management driving increased fee income across all regions.   Private Bank continued to experience solid growth in underlying profit from its operations.   Our strategic investment programs in Australia and the UK have continued to progress, with the launch of AdviserCentral as part of the Amazon program.   The Wealth Management revaluation profit was $148 million after tax.   Wealth Management retains its position in the Australian market as the number one provider of total retail risk insurance, with a market share of 15 per cent.   Annual inforce premiums in Australia and New Zealand increased 13 per cent to $469 million from March 2003, reflecting the combined impact of favourable lapse experience and stable sales.
 
Additionally, in the investment business we continue to be the number one provider of retail platforms in Australia, with market share of 19 per cent.   Both average and spot funds under management increased approximately five per cent in September 2003, reflecting improvements in the equity markets despite the loss of approximately $1 billion of funds under management as a result of the divestment of non core businesses.  

In summary, this is a disappointing result but asset quality remains sound, we're well capitalised, and return on equity is at acceptable levels.   Performance in Europe is below expectations and we face some tough competitive challenges.   Corporate and Institutional Banking are addressing remedial actions and this will take some time.   Wealth Management has had a good half and, most importantly, our core franchises in Australia and New Zealand have performed satisfactorily.  

Let me now hand you back to John and I will welcome your questions at the end of the presentation.

Conclusion by John Stewart

John Stewart:

Thank you, Richard.  

I think yesterday was my 100th day in the job.  I want to recap the first 100 days.  Appointed CEO on 2nd February, flew in about 6:30 in the morning and a press conference at 9:30.  On 16th February, the chairman resigned.   The 12th of March, we released the PwC report and later that month, the 24th of March was the APRA report.   Around the 26th of March, we made our first statement about the board impasse.

I'm now an expert on currency options, culture, corporate governance, and I can bore for Scotland on how to call an EGM if you want one.   But with all of those distractions, I have managed to find the time to speak to people and more importantly to listen to people.   I've listened to our shareholders in all the geographies where we have shareholders.   I have spoken a lot with the staff on the basis that if you want to know what's wrong with a company, ask your own people.   I have had hundreds, if not thousands, of e-mails on what's good about this company and what's bad about this company from our staff.   I've met with the management teams in every jurisdiction, every part of the business in Australia, in New Zealand and, of course, in the UK.  

So what I want to talk to you about in this session is what's wrong with the organisation; how do I think in directional terms I can put it right; how long it's going to take and specifically I want to talk about a certain number of areas.   I want to talk about culture.   I want to talk about risk management and APRA and I want to talk about our businesses in New Zealand, Europe and in Australia.

So let me start off by talking about culture because I know from personal experience that if you can get the culture right in an organisation, you can make a huge difference to performance.   So two of the most important things I can do for shareholders is to get the senior management team right and then create for them a culture that will allow them to be successful, allow them to play their game.  

So, contrary to perhaps public speculation, we have a lot of very good and talented senior managers in the National.   And I am pleased to say we have even more coming through the organisation.   But having said that, they will benefit and this company will benefit by them working alongside the top class, world class people I intend to recruit over the next few months.   We have a fabulous franchise here and that deserves a world class team to lead it.

Now not all about the National's culture is bad.   A lot of it is good.   A lot of it – a great majority of it – you would want to retain.   We have people with a strong work ethic and people who really want to go out there and do the right thing for customers and for shareholders.   But PwC's report made some comments about culture.   And they were pretty well on the mark.   What they said was that we have a focus of process rather than on the substance of the issue.   They said there was a lack of clear responsibility and accountability.   And they said that we have a good news culture – we paint the coals white and we don't admit the blemishes and the problems in the company.

Now if you add to that we have a strong bureaucracy, a tendency to over complicate things and a tendency to be slow, then you can see why change has to take place.   So I believe it is so important to get this right that I intend to lead this cultural change myself.   But what I have done is I have brought in Lynne Peacock, one of the most talented executives I have ever worked with.  I have brought her in to mastermind the implementation of this because, once it's settled, the top management team and myself will have to live the values, will have to change the culture if we are going to get the response we need.

Now let me make it absolutely clear, I didn't choose Lynne by accident.   Lynne is not a pink and fluffy HR type; Lynne is a no-nonsense implementer, which is exactly what we need to address the issues that we have within this organisation.

Now I mentioned bureaucracy a minute ago, and that is a problem we have.   Sometimes it is referred to as the 'dead hand of Melbourne' and basically this is a sense of living off a bygone age that actually prevents some of the businesses doing business.

It's also costly and we, by attacking that, can do something about our cost base.   And our cost base is something I want to spend a bit of time on over the next six months because, looking back, we're pretty good at spending money.
 
But when I look at how we spend money, it tends to be a big project or it tends to be on compliance issues or sometimes worse than that, the compliance issues are actually compliance for remediation as opposed to preventative work.   And there isn't enough going into growing the business – there isn't enough good cost.   The good cost is cost that you invest and it brings you profit because it increases your income line or because it reduces your cost in a sustainable way because the costs go down and stay down.   So we're going to be having a good look – we can't turn the clock back but we're going to have a good look in going forward as to how we structure this organisation and get the spend out of it.

Let me talk about risk management and APRA and start off by assuring you that risk management in this bank is not broken.   In fact, it's alive and well and effective all over the bank.   There's an argument that in credit risk management we have been too effective.  I will talk about that a little bit later.   But there is no doubt that in our markets division we did drop the ball and we did that big time.   We are working actively and we're fully engaged with APRA on the remedial actions.  We know exactly what has to be done, who's responsible for doing it and by when.   Now we expect that program to be complete in about 12 to 18 months.   We've already met APRA's first set of deadlines within the milestone that they asked, which was to confirm the trading limits, the new market risk management policy, and the application of the standard model.  

It is probably worth saying that there has been a fundamental change in the way we now deal with our regulators.  In the past, we pushed back and kept our regulators at a distance.   What we've been doing more recently is willingly getting into dialogue with our regulators and that is proving helpful and beneficial to both parties.

Let me move now to our business in New Zealand.   This is a terrific business.   If you look at the results that New Zealand has produced over the last few years you can see compound there, the franchise and the management teams in New Zealand are excellent.   We are one of the biggest in the business sector, in the agribusiness sector and we are the biggest in cards.   We probably have the best asset quality of the Group in New Zealand.
 
But if you look at the results you'll see that operating income has been slowing into it.   That is not by accident.   We've been doing that deliberately because we have put up some of our charges too far and we wanted to improve our customer proposition and make sure that we got that right because that related directly to customer satisfaction, and customer satisfaction relates directly to customer loyalty.

This is BNZ.   You can see that we have customer loyalty ongoing about a year ago.   The team got on to that and the staff has taken a number of actions and I'll explain it a little bit later and you can see the difference there.   We are overtaking NBNZ and starting to come up on ASB.  

Now why am I telling you this?  Why am I talking to you about customer proposition?  The reason is because there's a great opportunity in New Zealand.  There's not a lot that happens in New Zealand and you have truly static market shares.  But that's not the case now, because we've got a merger going on with ANZ and with NBNZ and we believe we've got customer attrition there.  We believe that if we can get our customer propositions right, we can get the Bank on the front foot as you can see it is.  We could be a net beneficiary in New Zealand over the next couple of years, because there will be a period of intense competition and we want to make sure we win that, not be a net loser.

Let me move now to Europe, which I'm sure will be top of your minds.  We've enjoyed over the years very high ROEs in Europe – much higher than the average of industry.  That's where we are with our banks and there's the average of the industry there. 

Now we haven't achieved this by good management, or by luck.  We've achieved it by charging the customers more.  We've achieved it by having high margins, and you can see where our margins are up there, again compared to the average.  The same thing pretty well goes for costs.  If you add that to a number of investments, you've got a situation where you do that for a few years, and it becomes unsustainable.  What then happens is that you start to suffer from customer attrition and your growth falls. 
 
And the other aspect I probably should mention is that in Europe our costs have been heavily skewed towards regulatory costs again, often in compliance, and often where something's gone wrong in compliance (ie.  investigations or remediation work).  There has been little spend on enhancing the customer experience and on creating growth, especially in income.

Now it was obvious when I joined that the UK banks had stalled, and if you look at our banks in terms of profit here and you look at what the other banks were doing, you can see what's going on there.  And that is because it is a direct result of short-term margin management starving the banks for investment, and this has been going on for several years.  So let's be realistic guys – this is not going to get turned around in a year.  Can it be turned around? Absolutely.  Can we create shareholder value? I'm in no doubt.  But it isn't going to happen in five minutes.

Now, we have a fantastic executive team now in Europe.  I'm really pleased with the people we've got.  Some of them are young ex-pats that we've taken across there.  Some of our best from Australia and New Zealand, but we've done exceedingly well over the last six months in recruiting real talent on the ground.  Locals with an exceptional track record, and we've tried to put them into the growth areas of the business.  And we're not finished.  We're going to keep recruiting talent there, and one search that we have at present is to find a senior banker in Europe to work alongside Ross Pinney and strengthen that team.

This is the biggest strategic issue we have in the Group and therefore, even though I'm based in Australia, I will be working closely with Ross to make sure we get this right, not just in terms of the strategy, but more importantly, implementation.  It is all about implementation.
And despite the poor results that you see in front of you today, there are some early signs that are promising. The customer attrition is slowing, and that is especially true of the customers that we want to keep.  We're keeping the right customers, and that is beginning to turn around.  We've put in a lot of effort into sales training and lead generation and that's beginning to show in some of the sales figures with mortgages now up 12 per cent.
 
I believe that in Europe we can create real value, but it will take time.  So I anticipate that you would ask me the question, "John, these businesses, given the condition they are in, given the fact that you are saying there are things you want to do in Australia, why not just sell them? Why not sell some of them?"

Now if you have a look at my track record, I think you will find that I'm not shy about selling businesses, if that will create more shareholder value.  I worked for Woolwich for 25 years.  I was CEO, I got to the highest rated bank in the country and I took a nice 35 per cent premium, and we sold it and I gave up my job to do it.  That's what you do when you're a professional to get real shareholder value.  As I stand here today, I think we can create more value in these businesses by developing them and by repairing them, than by selling them.  We promised you some more detail on that, and by the end of this financial year, by the end of September, we will speak with you in some detail about the strategic options, and why we're developing the businesses and the specific initiatives that we're working on.

Let me speak now about Australia.  Now not only do we have Financial Services Australia, but I want to talk in this section of Wealth Management and CIB because the majority is also in Australia. 

So let me start off by talking about Wealth Management.  Wealth Management had a good half - it's going well.  As Richard said, it is number one in the protection business, and that isn't just business inforce.  It's also number one in terms of new business share, and number two in terms of retail funds and management.

But we do not see ourselves as a retail funds manager.  That's not what we want to do.  We see ourself as focussing on providing the platform that goes to the advisers and the advisers give the advice.  They all tend to give the advice and to move on.  We are number one in that platform market.

However, the huge opportunity for MLC in wealth management is actually to penetrate the Bank's customer base and distribution system.  And whilst we've done some things well, over the last few years we have not really made in-roads in this. 
 
There are some signs though.  There are some signs in Australia that the silo mentality is starting to break down and that we're starting to get some higher cross-sale rates. 

But let me just share something that we have done in Europe, and that was over the last six months. I think in practice, it's probably been three or four months.  But if you just take a bog standard product, this is not rocket science, this is building a concept, and life insurance.  The penetration rates in Europe were nine per cent.  What that means is if we lend 100 mortgages, we're only getting buildings and contents insurance from nine customers.

In six months, less now, we've moved to 32 per cent.  The same thing across here with life insurance, which is just really mortgage protection.  We've doubled it from 15 per cent to 30 per cent.  Now where we're heading with that trajectory is to get to about 70 per cent – that's where we want to get to. 

Now if you look here, roughly, Australia is in about the same starting place, and whilst those figures are nice in Europe, they're not going to make a lot of difference in terms of Group figures.  But I tell you what will guys, is if we can do the same thing in Australia with the amount of mortgages we write, then we could earn more fees in other income.  And what we have to do is bring the know-how that we've used in Europe across here and make sure that we get that done.

So that is one of the big prizes that is getting Wealth Management closer to the retail bank.  Not easy, but it's something that I'm determined to do, and the whole of my top team are determined to do it also. 

Let me talk now about CIB – the Corporate and Institutional Bank.  Clearly it's still reeling with the effects of FX trading.  What I want you to know is that there will be no knee-jerk reaction.  The focus on the short term is to retain the customers and staff.  So in other words, we will  protect the franchise.  And the guys under John Hooper have been doing a terrific job in protecting that franchise and by making sure we hold onto our customers, and that we hold onto the key staff.
 
Now, in the medium term, we will be basing our growth on client income.  That's where this business was going, that's where it will continue to go.  And it's doing that in all of the jurisdictions.  It's growing in Australia, New Zealand and in the UK.  In the UK, it's coming up pretty quickly.

We will also be looking at selected niche markets where we think we have a competitive advantage and lastly we will be looking at how we can improve our distribution.   We have got a pretty good acquisition machine but we are not quite so hot on distribution.   And by that I mean bringing the business in the front door and having it already sold out the back door.   So we don't have to hold what we sell, neither do we have to sell what we wish to hold.

Let me move now to Financial Services Australia, because Financial Services Australia is really the jewel in the crown of this organisation.   It is by far the best franchise in Australia and it has delivered great results over recent years.   It has got a leading place in the business market and in the agribusiness market, and you can see there some of the market share figures and some of the share of wallet figures.   The CRM capability in FSA is some of the best, if not the best I've seen anywhere in the world.   And I will tell you something else, it is not fully leveraged yet, so the capability of using that facility is still big.   However it is not all good news.   In my opinion, FSA is coming off the boil.   I think that is also the opinion of Ian MacDonald and the rest of the team, because we haven't invested over the last few years to the extent that we should.   Now, why do I say that?  And you say, "John, do what you want, you've got a 10.5 increase in profit", but I don't like the shape.   It's an ugly shape – bad debts are going down, expenses are going up, and then in the main you've got only about four or five percent increase in income.  But that isn't the shape I want to see as the engine of this organisation going forward.   Now, what are the reasons for that?  Do we know what to do to put it right?  I think we do. 

The first thing is to get the risk balance right, and I'll talk about that a little bit later.   But there are soft spots in our operation that our people have already identified and are already working on.   We don't punch our weight in personal loans or credit cards, as we should do with the franchise we have.   We have lost a major position in the sole proprietor part of business and we intend to get it back again.   We haven't been investing to the extent that we should in customer propositions, and some of the people who are closest to the business, and of course a more recent issue is that we have to make sure that we minimise the brand damage that has been going on over the last four months.   And be in no doubt that we have no intention of giving up our franchise.   For the businesses out there competing, Ian can really tell you later exactly what people are doing – they are out there in front of the customers, protecting that franchise.   The franchise is more important to me than short-term profit.

But let me talk a little bit about risk, because business banking is the powerhouse of FSA.  It provides about 50 per cent of its profit, and post the September 11th event, we at the National believed there would be an economic slowdown and therefore what we wanted was to carefully de-risk our books to make sure that we were not vulnerable.   Now what this slide here shows across the horizontal axis is the type of security.  On the left hand side is fully secured, the right hand side unsecured – that is probably the best thing to remember.   And coming down here is the quality of the counter party, the first six are investment grades and then it works its way down.   So clearly, selectively we will play all over the pitch.   But our whole focus was to be in the yellow part there, so that is the safest part of the pitch.   Unfortunately, this is one of the few times where we implemented well, and we got too enthusiastic, and actually what we did was manage for the majority of our business that has been so strong.   That results in this, remember what I said a minute ago, that grades one to six are actually investment grades, and look at the amount of our lending that is in investment grades.   What we have done by doing that is we have under represented the bank in this area here.   And as you will know, if you are playing in this area here, that area is going to give you high margins, and is going to give you higher fees.  
 
So what we intend to do is to ease off our risk profile.   Now let me make this absolutely clear here guys – we are not reversing our de-risking initiative.   What I am talking about here is touches on the tiller to get where we wanted to be in the first place, and to have our offers out there as a competitor, because we have tightened ourselves up so much that we have got great customers out there that we are not doing business with because we are too tight.  So what you want to get to is the optimum level at any time, given the economy, and that there, roughly speaking, is where we believe the optimum level is.   And I've got to share another thing with you.   I would rather be going there, in this direction, which means I'm coming off a solid based, so I'm able to increase my margin and my fees, therefore some other people are out here, who are coming in from the other direction.  

Now, that is not the only thing that we have to do in FSA.   I mentioned we also have to get the customer propositions right, and we have to get the service right.   Now the good news is I think we can fix this relatively quickly.   I drew attention earlier to that customer loyalty graph in New Zealand.   That was quite deliberate because that was something that we did over the last 12 months in New Zealand to pave the way to see if we could take customers away from the merger.

Now we have got some of the same problems.   And let me explain what happened in New Zealand.   Across here is customer loyalty, so what is the best way to define customer loyalty?  It is where your customer would be an advocate for you.  So this is not customer satisfaction; this is where your customer would actually recommend you to a friend or to a colleague.   Down here is the value of the proposition that you are offering to the customer.   Now how do we get that?  What we do is we look at every product and every segment and we measure it.   And we measure it by asking the customer.   So we ask them how important is pricing to you?  How important are all aspects of the service?  And usually you end up with about 10 features, and you put a weighting on those features and the customer tells you what that weighting is, so we know very accurately what they value in the experience that they are trying to get.   You can then see the areas where you have to improve.  You can also see the areas where a small improvement can actually make quite a big difference.
 
Just by improving the overall value from just under seven, to 7.5, because of the steepness of this curve as you can see, more than doubled the customer loyalty, and ended up with that graph that I showed you earlier in New Zealand.   Various work continues to go on in New Zealand.   We are now doing the same work in the UK, and I'm pleased to say FSA is now employing exactly the same techniques into this sector and into this segment that it believes haven't been effective and that is going on as we speak.   So this is not rocket science, it is a technique that we know that we can use and get our market share back.   And in those one or two segments where we believe we have lost it over the last couple of years.   Now, I think I should also tell you that even after the stresses of recent months, the Australia franchise is still incredibly strong, and it is an absolutely wonderful platform on which to build.  

Let me just sum up.   In New Zealand there is little wrong, but of course we can do better.   FSA has gone off the boil a bit.   It will probably take us, in my opinion, 12-18 months, given the recent brand damage, to get FSA back to where I would like it to be, or where Ian would like it to be.   The CIB team faces short term challenges.   It will get through those short-term challenges, and I would say you will see that business really motoring in about the same timeframe, about 12-18 months.  Europe, as I mentioned earlier, is more likely to take something like two to three years.  Now to make real inroads into the culture and into the corporate centre, I would say that will probably take 12-24 months.

So, looking at that and looking at the fact that we have to get on with these things, I would see the second half, at best, being flat.   After that I see a period of continuous improvement, slowly at the beginning as a lot of the activities that we are doing starts to kick in, and then getting faster and faster.  I would see these banks really motoring in a time frame of about 12 to 24 months.  The good news here is that there's nothing I'm talking about that's rocket science; this is about running banks better and getting quality people in to make sure that we do that.

So, what can you expect? Well over the coming months, I will provide each of you or collectively with more detail on what we're doing with risk management, and what we're doing specifically on the APRA work.  We'll be talking to you again in detail about how we're going to take on these cultural challenges. 

I've already mentioned the European strategy.  We'll be talking about that in the next few months, and I hope later this year we will be talking to you about an exciting strategy for really getting the whole of Australia running as opposed to the silos that we have the business in just now.

So, I mentioned at the beginning my 100 days and I've got to tell you, it has not been fun, but I am enthused, truly enthused with what we can do with these businesses when we stop the sideshows going on.  And let me tell you what I mean by that.  If you just take New Zealand, which is a great bank, and I've told you about that, and Europe, which we're working on, and put them to one side, the real game, the thing that makes the big difference to this organisation is what we do in Australia.  That is, can we get Australia right, and can we get this franchise right.  Now I believe this is the biggest financial institution in Australia, but I don't think it's the best one.  I certainly am interested in it being the best one – I want it to be one of the best ones in the world, against world class competition.

Now giving a personal opinion, do I think if we can get the right hires, and put in some hard work, we can become one of the best banks in the world? Absolutely. 

Now what would that mean? That would mean instead of this sluggish TSR that we've been providing over the last few years, the bad customer satisfaction, partly engaged staff, that would be turning that around?  Top tier TSR, fully engaged staff, happy customers and growing the business by selling, getting more customers and selling more products to them.
 
There is not much wrong with this Bank, but it will not be turned around in five minutes.  It's going to take a year to two years.  But when it is turned around, it will be a powerhouse for providing shareholder value.

Thank you.

Questions & Answers

Callum Davidson:

Okay, we'll now go to take some questions from the floor. 

Question:

If you could just talk a little bit about product pricing in the UK versus Australia.  Just from your experience, particularly retail products, do you see products here being competitively priced in a global sense?

John Stewart:

I think probably the product pricing is keener in the UK, and I don't think that's surprising.  I mean we have four majors here – we are certainly getting challenged by St George, but you've got a limited amount of banks.  You've got a lot more top class banks in the UK, and you get banks that do sometimes take real pricing initiatives.  The most recent one, which has gone on for some years now, has been HBOS.  Obviously the quality's not bad either, that's why they have tended to try and be the price leader and the price setter.

But do I think that you can never extrapolate that and say our margin is going to go further down here? No not necessarily.  But what is for sure, this is going to happen anywhere in the world, is that the customer is going to get a better and better deal, so you had better get a more efficient at doing what you do. 

What was your second question?
 
Question:

John, the comment you made about the timing of the fix, the 12 to 24 months, just how optimistic or pessimistic are you? Is the risk on the down side or the upside in terms of timing?

John Stewart:

You're going to know that the worst thing I can do is over-promise and under-perform, so I think you probably know what that answer is.  I think that these are realistic and I don't think it's got too much down side.  A lot will depend on getting the right people into the right jobs and getting the culture switches turned, because the franchises here are terrific.  We just have to empower them and get them out there doing the right things.

Question:

This is a question for Richard.  The bad and doubtful debt balance sheet provision cover fell another seven basis points.  We're now below the 50 bp post-tax general provision minimum from APRA and I know in the context in John's comments about not re-risking, but potentially reverting some of the re-risking, can you comment on future BDD charges and the adequacy of the balance sheet cover?

Richard McKinnon:

The first point is we've got 18 billion of additional risk weighted assets that have gone onto the balance sheets simply as a result of the change of the model, so there's an impact there.
 
Secondly, we've had lower write-offs to risk weighted assets and our emphasis has always been on our coverage ratio.  Our provision is to cover our impaired assets nearly twice, and I think the third thing to be said and that everyone needs to bear in mind is the impact on general provisions of the introduction of international financial reporting standards, and the impact on general provisions there.  The likelihood is that general provisions across the industry in Australia will fall and will be matched by higher capital levels.  As we spoke about in November, our approach and our statistic provision models have been there.  The general provision is for expected loss and the expected capital is therefore an expected loss.

We've had Oliver Wyman in looking at the model so our belief is that the model is giving us the expected loss and we now have strong capital ratios.  That said, John and the team will be undertaking strategic review in the second half, and I have no doubt that that issue will be addressed.

Question:

A lot of what you're planning to do both in terms of culture and execution is contingent on getting the team right.  Can you give us an update given that you're looking for a CFO, a head of the Corporate and Institutional Bank and a helper for Ross Pinney in the UK, how far progressed you are, and what's the balance looking like in terms of internal/external appointments?

John Stewart:

Good question.  We're making good progress.  I'd love to be able to tell you that we were just about to appoint someone, but I can't; I'm not that far down the road. 

We've been very selective; we've done a global search, so that's why it takes a bit longer in speaking to the people.  I would hope that we can make appointments or at least announce the appointments over the next couple of months – maybe three months at the most.  But one of the reasons for my caution in talking about how long it will take to turn this Bank around, is once we find people, if they're an external appointment it's usually six months before they can join us.  So you've got a three, maybe six month time lag then the person has to get into the seat, then they start having to pull the right levers, so that is why this doesn't turn around quite so quickly.

We are of course looking internally as well as externally, but I think I will definitely want some external appointments, let me be absolutely clear about that.  I've been fair to the team about that, because we need some new blood.  Also I want to get people at a certain level, because it pulls the rest of the team up.  This is something I've done in the UK in the past; you bring people in, you play at a higher level and you find the rest of the team go up and start playing at that level.  That's one of my motivations for making sure I'm bringing in at least a couple of external appointments.

Question:

Given the likely lead-time, is it going to be a challenge getting the organisation focussed in the interim?

John Stewart:

No.  When you lose your CEO and you lose your chairman you don't have to look for a call to action.   I mean, we definitely have a strategic inflection point and the senior team understands that, now that the distractions are behind us, we can get on with it.   Believe me, the staff up and down this organisation is absolutely fed up with what's going on and basically they want to get on with it to show how good they are. 

Question:

Could I get some commitment on when you make an outlook statement or some kind of guidance that it will actually be done in the stock exchange announcement going forward?
 
John Stewart: 

Yes.

Question:

Would you agree that today, what's written here is very different to what you said on the stage?

John Stewart:

I don't think I'd use the words woefully inadequate but you made your point, you're right.   And we should get that right.   And that's really important to the market and we dropped the ball on that. 

Question:

The second question is for Richard.   Richard, if you were to have a look at APRA basically running and effectively being the dominant force in determining the capital position, when do you expect to go back to the rating agencies being the constraint? 
 
The second one is when should we look to move from using the standardised model to the advanced model on the market risk?  At the moment your hybrid to core ratio is running at about 16 per cent.   When could we expect to see you optimise that back to 25 per cent and, given those three questions, it would appear that your capital position is right under the current regime which poses a bit of problem if we're going to see any very big write-offs in the second half of the year, with the alternative being that you really can't do them until APRA backs away and you become the rating agency constrained.

Richard McKinnon:

What was the first one? 

Question:

Sorry.   When does APRA move away and the rating agencies become …  When do we see the market risk reversed, when do we see you optimise the hybrid to core ratio which could liberate something like $2 billion in capital, and how do you fund your write-offs in the second half with APRA still being annoying?

Richard McKinnon:

The major difference between the ACE and the tier one measures were the strategic investments.   And with them gone I would see going forward the core tier one remaining as the key determinant of surplus capital.   It was the fact that we were deducting 100 per cent of those strategic investments from the ACE ratio and therefore the full amount of the sale has come in and brought it back up.   So it's a healthier situation to have your regulator being the core determinant and I would anticipate that would continue.   In terms of the standard investment of funds, the issue for APRA in the markets decision has been the control environment.
 
And really having us move from an internal model to a standard model was really part of the fact that they were not confident about the control environment in the markets provision generally.   Now, there were some issues with the model itself.   We believe we can fix the calculation of that up fairly quickly so the timing will be when APRA is again confident about the control environment in the markets provision and that depends on the speed at which we work through the requirements.   No, I would anticipate that what would happen is that there will be a one-off approval to go back to the internal model.

John Stewart:

That will be based not much so on the model itself, it will be based on APRA's view of the operational risk that we're taking.

Question:

How much of the $18 billion of risk assets is simply the mechanism of how it is calculated?

Richard McKinnon:

The vast majority of it is shifting to the standard method.   Now, we can go into a little bit of the detail but the principal difference between an internal model and the standard model is that under the internal model you get credit for the portfolio effect that you have.   What happens under the standard model is that all of your portfolios get split out and calculated separately.   So let me give you some sort of a simplified example.   If you have a plus one risk position and a minus one risk position in a portfolio and the portfolio impacts, they offset one another and you have a zero position under the internal model; under the standard model they get split apart.   There is a plus one and a minus one and for risk the sign is irrelevant whether it's plus or minus.   It's irrelevant so you go from zero to two, two risk units. 

And then even when you split them apart they are then further split into sub components and so you may come from a starting position of zero and end up with 2.5 risk units, if you like, under that system.   Now, there is some potential for a little relief on that because under the standard model you can do some matching, some offsetting that will reduce the risk weighted assets.   Given the short time frame that we had to implement the standard model we weren't able to complete that matching fully and we anticipate to have that fully completed by June.   So, as of June there may be some reduction in that risk weighted asset position.  I can't give you a quantification as we stand here at the moment, it will depend on the pairs, finding the pairs within thousands and thousands of trades.   And so between now and June there may be some relief.   The figure that you get around June and will be released in September will be a solid standard risk weighted assets and that won't change until we move back into the internal model.   When we move back into the internal model, as John says, will depend on when APRA gets satisfied with the control environment around the markets risk division.

The hybrid core will be opportunistic going forward effectively.   But in terms of fine tuning those capital ratios we've just got a bit of work to do to get through, to make sure that we get APRA satisfied and comfortable with the position in the markets provision before we start getting too fancy about fine tuning the capital ratios.   We've used a blunt instrument to start with; we will probably stay there until APRA gets comfortable with the markets environment.

Question:

And this is the final one with the write offs given that the capital is right in this regulatory environment?

Richard McKinnon:

Well again, write-offs will come out of any strategic reviews in the second half.   And whether there are or are not write-offs will depend on what that strategic review produces.
 
John Stewart:

Whilst we would never say never, let me just take one risk off the table and as I sit here I don't see us having to raise extra capital with any sort of issue to fund write-offs, whether there are things that we see, how we are going to run this business.  If there were any, and there may be none, but as Richard says, if there were any we would be seeing that as a part of the overall strategy for the organisation.  

Question:

Just some questions around the clarity around the near term guidance at least.   Am I right in assuming that the baselines for the first half are before significant items and after distributions for cash impact?   And can I also get a feel for what your assumptions are around exchange rates given we've seen a weakening in the Australian dollar only in the last month or so.   And as a final question for John, in relation to hanging in with the European assets, am I right in assuming that applies to all four banks?

John Stewart:

Yes, it does apply to all four banks.   Just remember what I said in my presentation, that at this moment in time I can see everything we are doing we are adding to the value of them, because we had been running the banks down.   We've got the bank's staffing and their different stages to grow, and eventually over a period of time we will really be producing growing shareholder value.  

Now, that is a calculation that you have to do, compared to what the alternative is, and compared to what someone might pay for the bank, and if any of these assets are worth more to someone else than they are to us, then I will look that one in the face.   But as I say here just now, that is not the case and we are repairing the banks.
 
Richard McKinnon:

The guidance is pre-significant items, after distribution, and it is at the plan rate of 41p, and that is the key currency.  

Question:

I guess one of the points about the bank sector at the moment is that the sector has had good times in terms of credit growth and low bad debts.  You have squandered that and your profit is well down relative to your peers.  Why should investors back you now, and won't the environment decline as you undertake internal improvement? 

John Stewart:

We are always prisoners of the environment.   There is nothing that we can do.   We don't stop trading because the economy goes up or the economy goes down.   All you ever do is you keep trading; you just change the things you do.   What I'm talking about is underlying capability here and underlying franchises.   And I guess what I'm saying to you is that Europe is broken; it is going to take us a bit longer to fix it, but it is fixable.  The rest of it isn't broken at all.   It is off the boil; we need to do a bit of work, but we can turn these banks around. 

The Wealth Management business has grown to an exceptional extent that it will deliver much better shareholder value going forward than it has been over recent years.   All that happens is that if the economic cycle in anyway changes, then the type of game we play changes.  

Question:

A number of your competitors have indicated double digit, or even 20 per cent growth in SME lending annualised for their latest six month results.  I note that you have got a market share graph in the pack, but I think a lot of banks are assuming very strange system growth for SME.
 
Can I clarify what your SME loan growth was in Australia for the six months, and also commercial lending growth or market share in New Zealand, in the last six months?

Ian MacDonald:

Well it is difficult – SME is not a definitive number.  Every bank has got a different version of what SME relates to, but what we are clearly doing is losing market share at the sole proprietor end.   And so our growth in the last six months has been negative. 

Question:

But overall, would eight per cent be a ball park estimate on the entire SME business?

Ian MacDonald:

Yeah, we would see between eight and 10 for the market growth for SME.

Question:

And New Zealand?  Because we had Westpac last week saying their lending growth was running at 16 per cent, so someone is losing share in that market.  

Peter Thodey:

Again in New Zealand, there are no definitive measures for market share, but we are soon to get growing very strongly in business banking, and certainly our asset volumes would suggest that we are outgrowing most of our competitors.
 
Question:

I've got two questions unrelated, if I could.   The first one is in relation to Europe.  Today you have nominated that it will take two to three years to turn around that business to your satisfaction, and one presumes in that process there are risks involved, there will be a lot of investment to achieve that outcome.   At the end of that process are we really back to the beginning?  I mean, you might end up with a three or a four percent market share in a national context, which is the very issue that your predecessors once faced, and the view that they took was that scale was important in the UK, and that having achieved a position of say, two to four percent market share nationally, was an unsustainable position.   So against that backdrop I've got two questions.   Firstly, you have made clear that you felt that it was not the right strategy to sell the UK businesses, but how would you react in that two to three year period, if there was indeed an unsolicited bid for all or part of your businesses?  Secondly, assuming that scale will once again become important, when do other positive strategies come into play, such as achieving scale through an acquisition, and we understand Abbey National may well be in play in that period.   I'm just trying to understand the broader thinking as to when your current state of strategy might change, under what circumstances it might change?

John Stewart:

Thanks, those are really good questions.   It wasn't that I said divestment, or whatever you want to call it, was not the right strategy.   What I said was that it wasn't the greatest value creator.   That leads to your second question, which is if someone came along and offered a stack of money for something, and if that stack of money is worth more than I think I can get by developing it, I will snap their hands off, right?  But I will also do that with just about every asset that we have got in this business, because at the end of the day that is where it is shareholder value.   And if I have to look at it in the eye and say, look, there is no way I can get that value out of the businesses, then, trust me, I will do it.   Because you are right, this is complex.  
 
And the other thing that we are doing in the UK is we are running an old bank/new bank.   And so what I mean is we are fixing up the old banks, because we have let them get into the state that I have been talking about, and we have got some really exciting stuff on a new business model going on in the south of England.  If you like, that's the new bank.  

As for acquisition, let me take another risk off the table here.   We do not see acquisition as a major plank of our strategy going forward.   And now again, I'm going to say, 'never say never', because if we have a strategy to go in a certain direction and an acquisition could get us there more quickly, of course I'm going to look at it.   But we are not going to set discovering Britain looking for possible acquisitions.   We are going to run our banks better, run them organically.   So, what will happen in the UK is I can create maximum value by fixing them; I can create even more value by getting into the south of England with a different business model, that we will tell you about in a few months time, and show you the early results.   And I remain open minded, and then if you can persuade us if there is anyone you know that wants to make me a silly offer, I'm your man.    But if it is a silly offer can it be obese and disgusting?

Question:

So are you confirming then that at the end of your two to three year process, that you will have a self-sustaining business with adequate scale?

John Stewart:

Well, the way we are going scale isn't important.   Scale would only be important if we were going to go and try to buy Abbey National and become a me-too bank.  
 
But if you remember in my Woolwich experience what we did is we got into a space, into a bit of the market that the other big banks couldn't follow us.   And those are the business models that we will be talking to you about later in the year.   How we can compete with the big banks and actually have a competitive advantage, not a competitive disadvantage.   Now if we don't get that right, then all bets are off.   You are absolutely right.  

Question:

Very briefly, on my second question, it seems based on previous questions, that it is almost an inevitability that there will be some sort of balance sheet adjustments in the second half.   And it seems, I don't know if that is even the case, but if that is the case, and certainly analysts seem to be of a view that it might well be the case, to the extent that it hasn't been effective in the first half, is that purely a function of your capital position? Because if it relates to events before the first half it is almost misrepresenting the actual position of your balance sheet at 31 March.

John Stewart:

Nothing as sophisticated as that.   It comes down to two things: firstly we have tended to have our eye off the ball for a lot of that time, and have been doing other things and not being able to do that work properly; and secondly, Richard here has decided to retire, and therefore  one of the hires that I'm trying to get is a CFO and the sensible thing is to let that guy or girl, whoever it happens to be, get their feet under the table and give me a view.

Question:

Two questions for Richard.   Firstly, on Wealth Management and secondly, on asset quality.   In relation to Wealth Management, you talked about the drivers of success.   So when we have a look at the change in the value of inforce business we see that there's a 10 per cent fall to experience issues.   Can you take us through some of the issues that occurred there? 
 
And secondly in relation to asset quality, your disclosure is good enough to let us conclude that in relation to the bad debt charge for the Australian Institutional Business that it's increased from $4 million in the first half 2003 to $38 million to first half 2004.   Now I think it was halfway between the second half 2003.   You've been talking about improvements in asset quality, yet that sort of increase indicates that there are some problems emerging.   Can you give us some more details on what's happening there?

Richard McKinnon:

I'm going to put the Wealth Management question to Peter.   You're talking about the bad debt charge in CIB?

Question:

What I'm talking about is you have a regional bad debt charge and obviously in FSA you have the Australian bad debt charge and the difference I would presume would be the Australian CIB charge.

Richard McKinnon:

Yes, that's right.  

Question:

And the charges have gone up ten fold in the last 12 months. 

Richard McKinnon:

I'm going to take that off line and talk to you about that.   I'll have to get the details.   I don't have the answer to that.   I am happy to talk to you after.
 
Peter Scott:

Could you just ask the Wealth Management question again so I make sure I understood?

Question:

On Wealth Management, I was looking at the change in market value or change in inforce business.   It started out the half at 2.4 billion and it fell by 240 million in relation to experience changes.  

Peter Scott:

This is revaluation you're talking about.

Question:

Yes, page 41, which is a significant fall.   If you could give us some of your impressions as to why that occurred.

Peter Scott:

A couple of things in terms of the inforce book.   We've been building an inforce book by getting better distribution and putting it on the platform.   But the experience when you look at the changes and assumptions, a lot of that is a whole range of different things which we can take you through.  It is not one particular issue; it's a whole range of different issues.   But there isn't anything in relation to claims or anything like that that's causing that.   But happy to take you through the detail which we have.
 
Question:

John, I was wondering if you could comment on the revenue outlook for the UK, particularly how you think the superior margin of the National banks will play out versus the industry given you're starting to grow a loan portfolio again running off some high margin business, putting on some low margin business with declining revenues there and how long will that persist?

And the next question is probably more for Ian MacDonald.   You put down the slowing of momentum in business banking into the sole proprietor segment and have some adjustments on your risk reward trade off and your risk appetite.   But to what extent would you put down the slowing momentum to the significant build up in capacity and investment in distribution by every other bank in the market?  And is it just as simple as risk reward or can it be enough to recapture momentum, or do you have to in fact invest more in the distribution and perhaps have high costs to serve like some other banks are doing currently?

John Stewart:

Good question.   Let me start off with the first one, which was about revenue in the European banks.   Good question, because as you saw from the slide I showed earlier we have unsustainable margins.   What that means is often when you're getting new business you have to put on roughly about three new customers for every one customer that you lose in the back book.   Therefore, you can get a situation if you're not careful where you're actually motoring very fast in terms of market share.   You're also showing year on year growth but your NII line is actually spinning its wheels, it's standing still.

That is something that we're addressing just now.   We have no intention of unilaterally adjusting the back book.   That is just to give away shareholders funds – techniques employed before in previous lives is that we start to do predictive modelling on the books and that can get very accurate whereas that predictive modelling will tell us in advance which customers are the most vulnerable to attrition.    And then what we do is we go back to those customers with much better propositions and we make sure we keep them on a lower margin and then we grow the back book effect while we've got the new business running very quickly.   This is quite complicated but it's a stage we have to go through, we've got no choice.

Ian MacDonald:

We are seeing roughly eight per cent growth in total business lending across the total book.   We are losing in the sole proprietor end and that's all we are seeing leakage on.   There will be some tweaks I think to the distribution as we go forward.   We've about three and a half thousand people in the business bank.   And you can see from the numbers our FTE numbers have gone up in the last six months as well.   We have taken on about 120 graduates in the last few months.  That's mainly in the business bank.   We've also got a number of people on what we're terming electronic consumer lending and business lending conversion.   So there is about 100 temporaries in those FTE numbers deliberately to take our bankers away from that arduous chore of converting the files.   So yes, there will be an increased cost of service and increased number of people.    We're also putting in place a platform to enable them to access service better.   So I think we will have a slight increase in numbers but not material.

Question:

We perhaps also could get some comments on the outlook for the pension expense and also to what extent re-approving a $40 million VAR limit is inconsistent with the desire to focus on customer income, because that's like multiples of other banks VAR limits in this market that are focussed on customer income.
 
John Stewart:

One thing about the VAR, I would be a lot happier if they are using more of the VAR limit.   As Richard mentioned earlier, we have got a 40 million VAR limit and we are using about 14 or 15 million of it.  We believe the risk that we've got in CIB (we had a good look at those over the last few months as you would imagine) for a business of our size is not unreasonable.

Question:

Pension expense, Richard?

Richard McKinnon:

We'll have the formal review in June of this year.   And obviously, depending on market movements, that will determine the outlook.   It's important to remember that probably the three key variables are the movement in the risk free rate, the movement in the equity markets, but importantly also the movement in the outlook for inflation.   And those three have a complex interplay that determines the deficit.   So we actually have had some increase in the inflationary expectations in Europe and when you apply that to salaries going out for 30 years, then it can have an impact on the liability calculations.   So it's not simply looking at the movements in the FTSE to give you an indication what might happen there.   I would not be particularly optimistic for significant reductions in the pension charge in Europe.

Question:

I've got a question for each of the gentleman on the stage.   The first one for Richard.   When I take a look at your funding position and your average balance sheet, I notice that the savings deposits in Australia and other demand deposits in Australia, both your cheapest forms of funding showed flat growth over the six-month period.   However your most expensive form of funding which is time deposits, term
 
deposit, TDs and like that grew at a very good pace about six per cent over six months.  And in fact the cost of that, the margin paid on those, grew by a fantastic 119 basis points.   Can you give us an insight as to what's going on in your funding position and how that's driving your margin?

Richard McKinnon:

I can certainly talk about the impact of the margin, which is probably fairly obvious that it's part of the adverse mix component on the deposit side.  As to what's driving the differential growth, perhaps I'll ask Ian to comment on that.

Ian MacDonald:

We've been particularly keen on the time deposits over the last three or four months.   When the branding impact hit in January, we decided to give our people some tools.  We've been very keen that they could talk to our customers in terms of mortgages.  We took the fee off mortgages over $200, in terms of application fee, and we've been very keen on the time deposits.  It's been attractive, as I say.  Deposits have been growing at six per cent for the last half, but it's the conversation tool that then enabled us to get into deeper conversations with our customers and their full needs.

Question:

Richard, you mentioned $17m interchange impact.  Was that pre- or post-tax or post-reform that you made internally, that is changing point structures etc?

Richard McKinnon:

No, that's pre- the reforms and that's a pre-tax number.

Question:

Trailing on from your UK experience, obviously you had the joy of experiencing over a million Americans coming into the UK market on credit cards and basically cleaning the clock of all the UK banks.  One of the experiences that came out of that was Abbey National, that we can't compete.  The dynamics and the economics of this industry have changed significantly, and yet I notice today that you're flagging credit cards and personal loans as key growth areas you'd like to jump into.  Do you think you have the skills set at the National to do this, given the risk averse culture, and also would you say you have the skills set to go it alone, or would you look to partner or sell it to someone else?

John Stewart:

Again, good question.  I actually made the comment in relation to Australia, and what I meant is that we're not punching our weight.  This was for our distribution; we don't have enough personal loans, nor do we have enough credit card penetration.  Now whether we make the product, manufacture the product or whether we joint venture with someone will depend on whether we can be world class.  In my time at Barclays for example, they didn't quite clean out the UK, because Barclay cards is one of the biggest credit card companies in the world, and that is something at which we were able to be world class.  But we felt at the time, or at least I took the decision, that we couldn't be world class at wealth, for example, as Barclays, so we sold Barclays Life, Woolwich Life, and brought product in and did a supplier arrangement.  That's something that we would look at in the normal part of the business.  The main thing is that we should look at distribution as being separate from manufacturing.  Manufacturing you do if you can be world class.  You're right, the credit cards business is a specialist area, but that shouldn't stop us on the distribution side getting the appropriate share wallet.

Question:

You've spoken about key executive hires, just in terms of focussing on your own arrangements, could you let us know where you're placed in terms of contract negotiations, what changes in structure of incentive payments we might see versus  your predecessor, and when is the likelihood of base time frame from which your benchmarking for incentive payments is likely to commence?

John Stewart:

As far as details of the contract are concerned, I haven't got a clue, because up until last Friday, when eventually the mass of the distractions went away, it didn't get high enough up the priority list, because we had to deal with the really important things, and learning about the businesses was part of that.  It's obviously something that I've got to do and do quickly; I would imagine literally over the next few weeks, so I'll see what is offered, and I have no strong views. 

As for the starting point, I would love it to be the low point of the share price, but somehow I don't think I'll get away with that – I've got a feeling that may well be the day I started, but that's only a guess.  We'll get that sorted out over the next few weeks.  It's on the agenda now.

Question:

Firstly, from your comments about FSE and FSA, it sounds like you will been investing more in the businesses than in recent history.  Assuming this investment spend impairs near term momentum as the businesses recover, what would be your attention regarding the 2005 dividend levels?  Will you be looking through this investment spend?  I'll do the second question after.

John Stewart:

Again, I am going to caveat, 'never say never', but I would not be happy if we ever had to reduce dividend.  I see the dividend as being something that we will do our very best.  We can't guarantee it, but we'll do our best.

Question:

Just regarding the comments earlier about not needing to raise capital to fund any write-offs as a result of the half year strategic review, does this include ruling out underwriting the final DRP for this purpose?

John Stewart:

Well, again, 'never say never' but it's not our intention at this stage to underwrite the final dividend.

Question:

In an environment of subdued growth in institutional business across the board, why were costs allowed to blow out 16 per cent in local currency terms?

My second question in regards to FSE.  Can you let us know the margin you're writing on new business?

John Stewart:

I think it was probably a product of what happened last year wasn't it?

Richard McKinnon:

Yes, we are slowly caught with where we are on cost so we've invested in parts of our business and actually where we have invested, we've done rather well.  So we've increased our custodial services business and that was a significant investment for us buying that from CBA, however we've also put quite a lot of business investment into the middle market business in the UK.  Both of those areas have produced well for us.  It's our more traditional businesses in which we've got slower growth, which has led to the cost increase percentage being out of kilter with the revenue increase percentage.

John Stewart:

Okay I think the second one was margin on new business on FSE.  Clearly it's a lot lower than the margin on the back business, and that was exactly the point I was making earlier.  But I don't think there are any banks in the UK that are price setters; everyone is a price taker, so there are set margins that are competing on mortgages, on personal loans, on credit cards and those margins are tight, but they're still profitable.  And it means that point that I made earlier about getting the other income moving.  If you're going to price keenly on a mortgage you have got to make sure that you get a bit better than nine or 10 per cent penetration on the other products, and that's why we got straight onto that business, and that's why we're heading for about 17 per cent penetration.

Question:

New Zealand had 2.9 per cent year on year growth, and it was highlighted because of the improving customer satisfaction results.  In your experience John, how long does it take for that customer satisfaction to translate and to be sustainable above system as profit growth?

John Stewart:

That 2.9 per cent growth was in Aussie dollars and I think it was closer to six per cent, 5.8 per cent, is that right?  4.7 per cent sorry, I'm exaggerating a bit then.  Okay, nearly five per cent then in Kiwi currency.  Peter, you probably have more first hand experience of where you see the customer satisfaction figures that you're using, transferring into revenue.

Peter Thodey:

If you look at our mortgage results, we've been doing very well over the last 12 months or so.  We started the customer satisfaction drive 2.5 years ago, so the first 12 months was very hard work because it involved changing a lot of internal attitudes about how our customers saw us.  But after that we started to get significant traction in the second 12 months, and I think the results demonstrate that.

John Stewart:

I think the point was where do you see that coming through in the revenue line?

Peter Thodey:

I think the revenue line is starting to show already.  I mean, we're outgrowing system in mortgages and obviously the revenue is coming through there.  We're selling more products to more customers, we're growing customer numbers.  They're certainly coming through in NII and we think the OII lines will start to show some growth in the next 12 months as well.

Callum Davidson:

I think that's all for questions.  But just before we go, John do you have any concluding comments?
 
John Stewart:

Yes.   Probably really just to reiterate what I said - I guess it was about an hour ago now - that with the exception of the UK where there is a stack of work we need to do, most of the rest of these businesses are just detuned.   We need good people, we need a good culture and we can get moving.   I'm totally confident about that.   The more I look the more I see, that excites me.   Thank you.

END