Financial Sector Assessment

Rakesh Mohan Deputy Governor Reserve Bank of India and Chairman, CFSA
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What is an FSAP?
The Financial Sector Assessment Program is an IMF-World Bank initiative
A comprehensive health check of the financial system A review of strengths, vulnerabilities and weaknesses Measures compliance with international financial standards and codes Initiated after the1997 Asian financial crisis
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Presentation Outline
Part I: The FSAP and Self-Assessment A. Background and Timing B. Macroeconomic Outlook and Vulnerabilities C. Stability Assessment & Stress Testing Part II: Lessons and Issues from the Assessment D-F. Financial Institutions, Markets and Infrastructure G. Transparency and Developmental Issues Part III: Transparent Reporting H. Peer Reviewers Comments I. CFSA and Advisory Panels Some Differences Part IV: Conclusions and Concerns J. Summary of Assessment K. Main Concerns

Part I The FSAP and Self-Assessment

A. Background and Timing

Background and Timing (1) The Story So Far

IMF-WB FSAP in 2001, self-assessment of international standards and codes in 2002, reviewed again in 2005 Set up CFSA in 2006 India among the first country to undertake comprehensive and holistic self-assessment of financial sector Post-crisis, emphasis by the G-20
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Background and Timing (2) Overview of Self-Assessment

Approach and Methodology Pillar I Macro-prudential surveillance and financial stability analysis Pillar II Legal and institutional frameworks review Pillar III International financial standards and codes: assessment and status of implementation

Background and Timing (3) The Process

Benefits Composition of CFSA: ownership and commitment Regulatory cooperation: GoI, RBI, SEBI, IRDA, other agencies Involvement of experts: advisory panels Peer reviews: Impartiality Learning and capacity-building: involvement of professionals Execution Complex issues approach with humility Broad directions instead of specifics in the current context Focus on Transparent Reporting : Differing opinions of CFSA and Panels covered in the report

B. Macroeconomic Outlook and Vulnerabilities

Macroeconomic Outlook and Vulnerabilities (1) The Growth Story

Growth in recent period contributed by several factors High domestic demand Productivity Credit growth High levels of savings and investment Current global financial crisis: shift from benign outlook to one of uncertainty 8 %+ growth sustainable in the medium-term due to high demand; deceleration in the short-term
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Macroeconomic Outlook and Vulnerabilities (2) Pressing Challenges

Need for revival of growth in agriculture Address restoration of the fiscal reform path Continuation of financial sector consolidation and development Address the infrastructure deficit Complement bank financing with bond market development Insurance and pension reforms FCAC desirable, but with concomitant macroeconomic and market developments

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C. Stability Assessment and Stress Testing

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Stability Assessment and Stress Testing (1) Main Findings Financial Institutions Commercial Banks: financially robust NBFCs and HFCs: healthy financial indicators Some financing concerns UCBs and RRBs: improvements in financials governance concerns Rural Co-operative Sector significant weaknesses
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Stability Assessment and Stress Testing (2) Financial Soundness Indicators

Commercial Banks - Broad improvement in the postreform period 2000 2008

Financial Soundness Indicators

CRAR
Gross NPAs to Gross Advances Net NPAs to Net Advances Return on Total Assets Return on Equity Efficiency (Cost Income) Ratio

11.1
13.1 7.1 0.7 12.7 61.2

13.0
2.4 1.1 1.0 12.5 48.9
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Stability Assessment and Stress Testing (3) Financial Soundness Indicators

Other Institutions - Broad improvement in the postreform period Rural Co-operative Sector some concerns
NBFCs D
2004 2008

Scheduled

HFCs
2004 2008

UCBs
2005 2008

RRBs
2005 2008

StCBs/ DCCBs
2005 2007

CRAR Gross NPAs Ratio RoA*

26.8 22.4 15.0 18.1 12.7 11.9 ---8.2 1.5 3.6

---- ---16.3 14.2 2.2 24.8 14.2 8.5* 5.9* 19.9 18.5

----

2.5

2.9

1.9

2.2

0.3

0.7

1.0

1.1

0.4 0.3 0.7 0.02

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* Ratio to Total Assets

Stability Assessment and Stress Testing (4) Stress Testing

What is Stress Testing Techniques to assess vulnerability of the financial system in the face of shocks; identifies how portfolios respond to changes in key economic variables: e.g., interest rates, credit quality Coverage of stress tests Credit risk Market/interest rate risk Liquidity risk Open positions in foreign exchange much below regulatory limits Exchange rate tests not undertaken
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Stability Assessment and Stress Testing (5) Credit Risk

Concerns about credit risk remain muted at present Need for close monitoring of such risks in the current scenario
Scenario - increase in NPA by:

Without Stress
CRAR (%)

100 per cent

CRAR (%)

150 per cent

CRAR (%)

Mar-08
Sept08

13.0
12.5

11.6
11.1

11.0
10.6
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Note: CRAR = credit to risk assets ratio

Stability Assessment and Stress Testing (6) Interest rate risk

Higher the DoE (duration of equity), greater the sensitivity of banks capital to interest rate shocks Calculates the erosion in accounting capital due to unit increase in interest rate
Period
DoE (yrs)

Mar-06
14.1

Mar-07
12.0

Mar-08
8.0

Sep-08
8.1

The annualised yield volatility is estimated at 244 bps Given a DoE of 8.1 years, a 244 bps shock implies an erosion of 20 per cent of capital and reserves. => Better management of interest rate risk by 18 commercial banks over time

Stability Assessment and Stress Testing (7) An Overview of Liquidity Ratios

Ratio Mar-05 Mar-08 43.9 Sep-08 49.3 (Volatile Liabilities Temporary Assets) / 34.7 (Earning Assets Temporary Assets) (per cent) (High and positive number implies some risk of funding liquidity.) (Core Deposits) / Total Assets (per cent) - 53.8 (Extent to which assets are funded through stable deposit base) (Loans + Mandatory CRR + Mandatory 75.0 SLR + Fixed Assets) / Total Assets (per cent) (Embedded illiquidity in the balance sheet) (Loans + Mandatory CRR + Mandatory 1.4 SLR + Fixed Assets) / Core Deposits (Dependence on purchased liquidity)

49.3

47.7

86.3

86.5

1.8

1.8
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Stability Assessment and Stress Testing (8) Liquidity Risk Management

Gradual, growing dependence on purchased liquidity Increase in illiquid parts of banks balance sheets Greater reliance on volatile liabilities for asset growth
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Stability Assessment and Stress Testing (9) The Way Forward

In Sum: Commercial Banking System Broadly Sound Can withstand significant shocks from large potential changes Possible Next Steps: Need to strengthen liquidity management Stress Testing by individual banks Periodic scenario testing by RBI Setting up of a Financial Stability Unit
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Part II Lessons and Issues From the Assessment

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D. Financial Institutions

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Financial Institutions (1) Regulation and Supervision

Inherent linkages across institutions Inter-bank Bank and non-banks Basel Core Principles not applicable to: Co-operative Sector; Regional Rural Banks; NBFCs; HFCs But, Assessment done for health check Results: Generally satisfactory
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Financial Institutions (2)

Basel Core Principles: A Compliance Summary
Assessment CB UCB StCB/ DCCB RRB NBFC HFC

Compliant

Largely Compliant
Materially Non-compliant Non-compliant Not applicable

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6 1 -

11
4 2 4

10
6 2 4

8
6 2 5

13
2 8 1

10
5 8 -

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Financial Institutions (3)

Basel Core Principles: A Compliance Summary
Major Gaps:

All Institutions: Risk management (for commercial banks the level of compliance is comparatively lower in respect of banking groups); homehost country regulation
Commercial Banks: Exposure to related parties; non-compliance in respect to interest rate risk in banking book for which guidelines have since been issued Rural & Co-operative Banks: Dual Control; internal control; corporate governance NBFCs: Major acquisitions, transfer of significant ownership, internal control
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HFCs: Permissible activities; internal control

Financial Institutions (4)

Commercial Banks Oversight
Government ownership poses dilemmas Possibility of conflicts of interest minimised through even-handed regulation Capital augmentation of PSBs is a challenge, but could be managed through a variety of ways Amalgamation where commercial synergies exist Newer instruments
Through selective dilution of government equity
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Financial Institutions (5) Banking For The 21st Century

Capacity Building: Training Succession Planning Lateral Recruitment Improved remuneration but discourage excessive risk taking Corporate Governance: Improve governance in PSBs Roadmap for foreign banks A well-considered approach within the WTO norms

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Financial Institutions (6)

New Competition Act: Some Issues

Power of Competition Commission to regulate combination

Any combination required to be notified to Commission Maximum period of wait 210 days RBI may be able to give sanction only after getting order of Commission or wait for 210 days Delays the process

Possibility of regulatory conflict as order of any statutory authority not binding on Commission

Could lead to regulatory overlap and conflict

Central Government could give necessary exemption under Section 54 of the Competition (Amendment) Act 2007

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Financial Institutions (7)

Risk Management and Governance

Conservative risk management matters
Counter-cyclical prudential measures by RBI Off-balance sheet items: Better accounting, disclosure Capital charge if reliance on purchased liquidity beyond a threshold

Consolidation
Encourage market-based consolidation

Co-operative and rural banks need better governance

Dual control: improve corporate governance Regulation and supervision of rural financial sector: role for RBI and NABARD
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Financial Institutions (8) Non-Bank Financial Services

NBFCs are key players in financial markets Corporate bond market development would ease funding constraints Development of regulatory structure for financial conglomerates Prudential regulations of NBFCs strengthened some way to go Housing finance: growing and important segment National Housing Price Index, Housing Starts Index a priority Regulation of HFCs should be entrusted to RBI 31 Governments stance status quo

Financial Institutions (9) An Assessment of Insurance

The level of compliance of the Insurance Sector to IAIS Core Principles

Assessment
Observed Largely Observed Partly Observed Not Observed

Number of Principles
5 13 10 32

Financial Institutions (10) An Assessment of Insurance

Significant growth in size, penetration and diversified products Comfortable solvency and capital adequacy But gaps/issues remain
Increase supervisory powers of IRDA Group-wide supervision effective policy to be put in place Risk Management Further requirement of skilled professionals actuaries, treasury managers
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E. Financial Markets

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Financial Markets (1) Regulation and Supervision

Systemic stability Importance of markets other than equity market IOSCO Principles extended to: G-Sec markets; Forex Markets; Money Markets Results: Generally satisfactory
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Financial Markets (2) Foreign Exchange Market

Fastest growing market globally Total annual turnover increased from USD 1.3 trillion during 1997-98 to USD 12.3 trillion during 2007-08 Derivatives: High growth in forward market Forex futures introduced in 2008 Need for monitoring and regulation Customer appropriateness and product suitability
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Financial Markets (3) Sovereign Debt Market

Significant growth in volume and liquidity Further diversification of investor base needed Foreign investor participation: proceed with care Increase in tradable assets desirable

Large proportion parked in HTM category

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Financial Markets (4) Equity Market

Significant improvement in market and settlement infrastructure Functions in robust regulatory environment Very high compliance with IOSCO Principles Risk management by market participants Strengthening of inter-exchange surveillance Need to improve IPO processes Setting up of Central Integrated Platform

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Financial Markets (5) Money Market

Liquid market Increased share of repo and CBLO Need for active interest rate futures market
Being re-introduced

Development of term money market Development of short-end yield curve necessary Under examination in TAC Group Development of the repo market

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Financial Markets (6) Other Market Segments

Need to develop corporate bond market Develop credit risk transfer mechanism But with appropriate checks and balances Capacity building in financial institutions with regard to securitisation and credit derivatives
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Financial Markets (7) Compliance With IOSCO

Markets/ Assessment Fully Implemented Broadly Implemented Partly Implemented Not applicable
Equities Foreign exchange
Govt. securities

Money market

20 8 2 -

16 5 9

19 2 5 4

19 4 5 2
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Financial Markets (8) Compliance With IOSCO

Despite high compliance, some gaps remain Equities Market: Responsibilities and operational independence of regulator; inspection and surveillance powers; capital and prudential requirements for market intermediaries Foreign Exchange Market: Operational independence and accountability of regulator; co-operation and detection of manipulation and unfair trading practices G-Sec markets: Operational independence and accountability of regulator; home-host co-operation; disclosure of financial results Money markets: Operational independence; regulatory cooperation with foreign regulator 42

F. Financial Infrastructure

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Financial Infrastructure (1) Regulatory Infrastructure

Multiple roles of regulators Consistent with financial development Needs effective coordination Principles vs. Rules-based: complementary Develop supervision of financial conglomerates Legislation, a new Act? Develop Self -Regulatory Organisations? Regulatory independence Panels have raised some issues But CFSA considered adequate

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Financial Infrastructure (2) Markets and Liquidity

Large capital movements Volatility in overnight rates Strengthen government cash management Asset liability management of banks Issues related to market integrity participatory notes Term liquidity facility not required at this stage
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Financial Infrastructure (3) Accounting and Auditing

More autonomy for Accounting Standards Board Need to develop sector-specific guidance Issues in auditing about convergence with ISAs Need to give functional independence to AASB

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Financial Infrastructure (4) Payment and Settlement

Payment & Settlement Act of 2007 fills a major gap Sub-optimal utilisation of electronic payment infrastructure Delays in collection of outstation cheques Financial resources with CCIL need strengthening
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Financial Infrastructure (5) Business Continuity Management

Ease of operations during crises Areas for strengthening Human Resources management Business continuity processes of vendors Outsourcing risk Succession planning
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Financial Infrastructure (6) Assessment of Bankruptcy Law Principles

Assessment Number

Observed Broadly Observed Partly Observed Total

Major Gaps:

38 24 12 74

Implementation of bankruptcy laws poor- average 10 years to complete liquidation proceedings Doing Business Report- World Bank Amendment to the Companies Act still pending Setting up of NCLT Issues relating to Competition Amendment Act, 2007 49 Lack of a Central Registry for recording security interests

Financial Infrastructure (7) Depositor Protection

Independence of Deposit Insurance and Credit Guarantee Corporation (DICGC) (recommended by Advisory Panel) Increase flat-rate premium Involvement of DICGC in resolution processdelink settlement of DICGC claims from liquidation process

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G. Transparency and Development Issues

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Transparency and Development Issues (1) Assessment of Transparency in Monetary and Financial Policies
Assessment Transparency in Monetary Policy 40 1 3 Transparency in Financial Policies

RBI
Observed Broadly Observed Partly Observed 32 4

SEBI
33 -

IRDA
29 -

Not Observed
Not Applicable

1
6

Major Gaps/Issues: Need for review of legislations- overhaul of legislations not required Operational independence of RBI Strengthening TACMP requires ongoing review Separation of debt management from monetary management Chairmans dissent Price index for measuring inflation WPI/CPI debate

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Transparency and Development Issues (2) Assessment of Fiscal Transparency

Assessment Observed Broadly Observed Partly Observed Not Observed Centre 36 4 5 States 22 6 15 2

Significant

improvement following FRBM Act and Fiscal Responsibility

Legislations Major Gaps/Issues: Functional overlap by Central Government on issues relating to State Government like health and agriculture Mode of calculating FD does not capture off-budget items separately augmented FD required Need for accrual-based accounting guarded approach
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Transparency and Development Issues (3) Assessment of Data Dissemination Standards

Assessment National Accounts WPI CPI-IW Government Finance Statistics Monetary Statistics Balance of Payments

Observed Largely Observed Largely Not Observed Not Observed

6 13 3 -

15 6 1 -

18 3 1 -

9 10 3 -

22 -

19 3 -

Major Gaps:
Need for proper legal and institutional support for CSO IIP data - need to adjust basket of commodities and weights assigned Multiple agencies in collection of labour data WPI outdated weights
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Transparency and Development Issues (4) Making Financial Inclusion Work

Rangarajan Committee on financial inclusion Exploit synergies between local and national level financial institutions Finance consumption and household expenditure Scale-up IT initiatives Biometric smart cards in rural areas Development of mobile banking Incentivise BCs Urban poor Dilute KYC norms

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Part III Transparent Reporting

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H. Peer Reviewers Comments

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Peer Reviewers Comments (1)

Financial Stability Assessment and Stress Testing
V. Sundararajan Plausible shocks and vulnerabilities arising out of domestic macroeconomic and external sectors should be systemically linked to stress scenarios Growing use of purchased funds need analysis of second round contagion effects Andrew Sheng Creation of secondary mortgage market Setting up of Government sponsored secondary mortgage vehicles On-site examination process should be supplemented by a forensic follow the evolution of the product approach. 58

Peer Reviewers Comments (2)

Assessment of BCP
Eric Rosengren Urgent need to improve co-ordination between regulatory agencies LoLR should have the ability to assess solvency and liquidity risks facing institutions Report should elaborate on aspects relating to Central Governments role in operation of PSBs whether it interferes with the regulatory role of RBI

Corporate Governance and Transparency in Monetary Policy

Sir Andrew Large Higher corporate governance standards for the unlisted sector Mechanism to enable central bank to be adequately informed to handle liquidity related events Improvements in transparency would enhance central bank independence

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Peer Reviewers Comments (3)

Bankruptcy Laws
Thomas Baxter Indian insolvency regime remains an enigma Special Insolvency regime for banks complement access to credit facilities of central bank and deposit insurance

Fiscal Transparency
Vito Tanzi Better classification of expenditure central to fiscal policy Relevant fiscal target should be GFD and not revenue deficit Relatively few countries have made a transition to accrual based accounting
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Peer Reviewers Comments (4)

Accounting and Auditing Ian Mackintosh Exercise caution while developing country specific and sector specific accounting standards Important to give functional independence to AASB N.P. Sarda Determining the role of the Quality Review Board to review and improve the quality of audit service is required
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I. CFSA and Advisory Panels Some Differences

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CFSA and Advisory Panels Some Differences

Regulatory Independence

Panel view : Issues regarding independence of SEBI and IRDA CFSA view: Regulatory independence adequate

Review of Legislation

Panel view : Review of RBI Act needed CFSA view : Requires to be viewed in a more comprehensive manner

Role of HLCCFM

Panel view : Further formalisation and institutionalisation CFSA view: Not consistent with regulators autonomy

Prompt Corrective Action

Panel view : Appropriate time-frame required CFSA view: Any rigidity in timeline unduly restrictive

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Part IV Conclusions and Concerns

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Conclusions and Concerns (1) Summary of Assessment

Financial Sector Has expanded; acquired greater depth and vibrancy Macro economy Short-term - Uncertainty; Medium-term - high growth sustainable Banks Healthy and Robust Financial Markets Resilient and fairly liquid Financial Infrastructure Robust Transparency Significant improvements

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Conclusions and Concerns (2) Main Concerns

Macro economy Fiscal Deficit Agricultural Growth Susceptibility to international commodity price movements Institutions Emerging liquidity concerns Corporate governance in co-operative sector Health of rural co-operatives Funding constraints for NBFCs Lack of timely data to gauge household indebtedness Stress Testing Lack of database, techniques and capacity to conduct appropriate systemic stress tests taking into account 66 sectoral interlinkages as also contagion risk

Conclusions and Concerns (3) Main Concerns

Financial Markets Risk of contagion Development of an appropriate risk free yield curve Corporate bond markets Issues relating to derivatives knowledge concentration and capacity building Transparency Some issues in fiscal transparency; Need to strengthen data collection agencies

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Conclusions and Concerns (4) Main Concerns

Delay in bankruptcy proceedings and credit dispute resolution Time taken for winding up proceedings is highest in the world Improvement in effective enforcement of creditor rights required Faster resolution of stressed assets of financial intermediaries Regulation of financial conglomerates and holding companies Role of SROs Regulatory co-operation particularly cross border Management of capital account Deficiency in retail payment systems
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