INTEREST RATE RISK MANAGEMENT IN BANKS

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INTEREST RATE RISK MANAGEMENT IN BANKS

  1. 1. Management Of Interest Rate Risk In Banks Presenter: Dr. Vighneswara Swamy
  2. 2. Agenda Items for the Session: What is Interest Rate Risk What are the types of Interest Rate Risks Effects of Interest Rate Risks Measurement of Interest Rate Risks Strategies for Controlling Interest Rate Risks Basel Committee Recommendations Sound Interest Rate Risk Management Practices 12/17/2009 Presenter: Dr. Vighneswara 2
  3. 3. Interest Rate Risk (IRR) • Definition: – It is the potential loss from unexpected changes in interest rates which can significantly alter a bank’s profitability and market value of equity. 12/17/2009 Presenter: Dr. Vighneswara 3
  4. 4. Interest Rate Risk .. explained • The amount at risk is a function of the magnitude and direction of interest rate changes and the size and maturity structure of the mismatch position. • If interest rates rise, the cost of funds increases more rapidly than the yield on assets, thereby reducing net income. • If the exposure is not managed properly it can erode both the profitability and shareholder value. 12/17/2009 Presenter: Dr. Vighneswara 4
  5. 5. Interest Rate Risks - Types Interest Rate Risks Yield Curve Embedded Repricing Risk Basis Risk Risk Option Risk 12/17/2009 Presenter: Dr. Vighneswara 5
  6. 6. Repricing Risk • Arises on account of mismatches in rates • Can be measured by the measure of risk in different time buckets • Information needed – Balance sheet -on & off on a particular day – Business plan & expected income/ exp. ignored – Static vs Dynamic Liabilities Assets Spread Capital @ ROI Maturity Investment @ Maturity (Crore) (Crore) ROI Scenario-1 Profit Rs100 9% One year Rs100 10% Two year 1%(1crore) Scenario-2 Loss Rs100 11% 2nd year Rs100 10% Two year 1%(1crore) 12/17/2009 Presenter: Dr. Vighneswara 6
  7. 7. Mismatched Repricing Periods of Assets/Liabilities Illustrations: Liabilities Assets Spread Capital @ ROI Maturity Investment @ ROI Maturity (Crore) (Crore) Scenario-1 Fixed Rate Profit Rs100 8% 91 days Rs100 10% 91 days 2%(0.49crore) Scenario-2 Fixed Rate Profit Rs100 9% 91 days Rs100 11% 91 days 2%(0.49crore) Scenario-3 Float Rate Profit Rs100 8% 91 days Rs100 10% (1st month) 30 days 2%(0.164crore) Float Rate Profit 11%(2nd month) 61 days 3%(0.5crore) Asset Sensitive Total: 0.664 Crore Scenario-4 8% 91 days Rs100 Fixed Rate Rs100 10% 5 years 9% 91 days Liability Sensitive 12/17/2009 Presenter: Dr. Vighneswara 7
  8. 8. Basis Risk • Interest rates on assets and liabilities do not change in the same proportion. • When Bank Rate was raised by 2%, PLR was raised by 1% and deposit rates by 1.5% • Interest rates movement is based on market perception of risk and also market imperfections. • Therefore, basis risk arises when interest rates of different assets and liabilities change in different magnitudes. • The `basis’ form of IRR results from the imperfect correlation between interest adjustments when linked to different index rates despite having the same re-pricing characteristics. 12/17/2009 Presenter: Dr. Vighneswara 8
  9. 9. Basis Risk – An Illustration Repricing Liabilities (Rs Crores) Repricing Assets(Rs Crores) Savings Deposit 50 Call Money 50 Fixed Deposit 50 Cash Credit 40 Total 100 Total 90 Gap(-) 10 Calculation of Standardised Gap Fall in Rates Fall in Amount (Rs Crores) Call Money 50 * 1.0% 0.50 Cash Credit 40 * 0.7% 0.28 A. Decrease in Interest Income (-) 0.78 Savings Deposit 50 * 0.5% 0.25 Fixed Deposit 50 * 0.4% 0.20 B. Decrease in Interest Expense (+) 0.45 Loss in Net Interest Income (A-B) (-) 0.33(Rs 33 Crores) 12/17/2009 Presenter: Dr. Vighneswara 9
  10. 10. Embedded Option Risk • Risks arising out of prepayment of loans and bonds (with put or call options) and / or premature withdrawal of deposits before their stated maturity dates. Liabilities Assets Spread Capital @ Maturity Loan @ ROI Maturity (Crore) ROI (Crore) Scenario-1 90 90 Profit Rs100 8% days Rs100 10% days 2%(0.49crore) Scenario-2 90 90 2%(0.164crore) Rs100 8% days Rs100 10% days for 30days Int. Rates 60 1%(0.164crore) decline after days for 60 days 30 days to 9% Total 0.328 crore 12/17/2009 Presenter: Dr. Vighneswara 10
  11. 11. Yield Curve Risk • Risks caused due to the change in the yield curve from time to time depending on the repricing and various other factors. Yield Curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. 12/17/2009 Presenter: Dr. Vighneswara 11
  12. 12. Yield Curve Risk .. What is shape of Yield Curve Yield Curve Yield Curve yield curve Risk The shape of the The risk of Yield Curve is yield curve is the relation TEXT experiencing influenced by supply an adverse between the and demand. The interest rate shift in yield curve may also (or cost of be flat or hump- market borrowing) and shaped, due to interest rates the time to anticipated interest associated maturity of the rates being steady, with debt for a or short-term investing in a given borrower volatility in a given fixed income outweighing long- instrument. currency. term volatility. 12/17/2009 Presenter: Dr. Vighneswara 12
  13. 13. Yield Curve Risk – An Illustration Liabilities Assets Spread Capital @ ROI Maturity Loan @ ROI Maturity (Crore) (Crore) Scenario-1 3 year Loan 3 year Profit Rs100 13.5% fixed(quar Rs100 16% float(qua 2.5% Reference: terly Reference: rterly (2.5crore) 91 day T-Bill repriced) 364 day T-Bill @13% repriced) @12.5% Scenario-2 90 90 Profit Rs100 15% days Rs100 16% days 1.0% Reference: Reference: (1crore) 91 day T-Bill 364 day T-Bill @13% @14% Date 91 T-Bill Deposit 364 T-Bill Loan Spread 22.05.2008 4.48% 5.48% 4.62% 7.62% 2.14% 08.08.2008 4.93% 5.93% 4.85% 7.85% 1.92% 08.12.2008 12/17/2009 4.71% 5.71% 4.24% Presenter: Dr. Vighneswara 7.24% 1.53% 13
  14. 14. Interest Rate Volatility Impact of Interest Rate Volatility on the Net Interest Income IMPACT OF INCREASE / DECREASE IN RATE OF INTEREST ON NII COL1 COL2 COL3 COL4 COL5 Maturity pattern RSL - OUTFLOWS RSA - INFLOWS GAP - RSA - RSL CHANGE IN NII FOR 0.25 % DECREASE 1- 14 DAYS 18785.27 15920.09 -2865.18 7.16 15 - 28 DAYS 31772.55 31161.34 -611.21 1.53 29 DAYS - 3 MTS 68403.39 77914.78 9511.39 (-23.78) 3-6 MONTHS 87629.72 90673.27 3043.55 (-7.61) 6-ONE YEAR 101260.22 98917.23 -2342.99 5.86 ONE - 3 YEARS 108310.71 106316.51 -1994.2 4.99 3-5 YEARS 114558.21 124538.91 9980.7 (-24.95) 12/17/2009 ABOVE 5 YRS Presenter: Dr. Vighneswara 134964.33 137905.36 2941.03 14 -7.35
  15. 15. Measurement of IRR Approaches to Measure IRR Maturity Duration Gap Simulation Value at Gap Analysis Risk Analysis 12/17/2009 Presenter: Dr. Vighneswara 15
  16. 16. Maturity Gap Analysis MGA distributes interest rate sensitive assets, liabilities and OBS positions into a certain number of predefined time bands according to their maturity(if fixed rate) or time remaining to their next repricing(if floating rate) 12/17/2009 Presenter: Dr. Vighneswara 16
  17. 17. Maturity Gap Analysis .. How is it done? The risk sensitive What is the Gap? Objective: assets and risk The gap is then To improve the sensitive liabilities calculated by net interest are grouped into considering the income in the ‘maturity buckets’ difference between short run over based on maturity the absolute discreet periods and the time until the values of the RSAs of time called the first possible and RSLs. gap periods. repricing due to RSG=RSAs-RSLs change in the interest rates Relative differences in each maturity bucket – represents the sensitivity in that band. 12/17/2009 Presenter: Dr. Vighneswara 17
  18. 18. Maturity Gap Method (IRS) Three Options: • A) RSA>RSL= Positive Gap • B) RSL>RSA= Negative Gap • C) RSL=RSA= Zero Gap 12/17/2009 Presenter: Dr. Vighneswara 18 Swamy
  19. 19. Maturity Gap Analysis … Option-1 Liabil Rate Increase Decreased Asset Rate Increase Decreased ity % d Rate% (Crores) % d Rate% (Crores) Rate% Rate% 200 200 1800* 10 11 9 800* 12 13 11 3000 11 11 11 1000* 14 15 13 1000* 16 17 15 2000 18 18 18 5000 5000 Int 510 528 492 Int 756 784 728 Expe income nse NII= 246 256 236 A case of Positive Gap: RSAs= Rs2800, RSLs=Rs1800 GAP=Rs2800-RS1800=Rs1000 12/17/2009 Presenter: Dr. Vighneswara 19
  20. 20. Maturity Gap Analysis … Option-2 Liabil Rate Increase Decreased Asset Rate Increase Decreased ity % d Rate% (Crores) % d Rate% (Crores) Rate% Rate% 200 200 1800* 10 11 9 800* 12 13 11 3000 11 11 11 1000 14 15 13 1000 16 17 15 2000 18 18 18 5000 5000 Int 510 528 492 Int 756 784 728 Expe income nse NII= 246 256 236 A case of Negative Gap: RSAs= Rs800, RSLs=Rs1800 GAP=Rs800-Rs1800=(-)Rs1000 12/17/2009 Presenter: Dr. Vighneswara 20
  21. 21. Maturity Gap Analysis … Option-3 Liabil Rate Increase Decreased Asset Rate Increase Decreased ity % d Rate% (Crores) % d Rate% (Crores) Rate% Rate% 200 200 1800* 10 11 9 800* 12 13 11 3000 11 11 11 1000* 14 15 13 1000 16 17 15 2000 18 18 18 5000 5000 Int 510 528 492 Int 756 784 728 Expe income nse NII= 246 256 236 A case of Zero Gap: RSAs= Rs1800, RSLs=Rs1800 GAP=Rs1800-Rs1800=0 12/17/2009 Presenter: Dr. Vighneswara 21
  22. 22. Inferences from above options: SCENARIO STRATEGY Rising Interest Rates Maintain a positive gap Declining Interest Rates Maintain a Negative gap Uncertain situation Maintain a Zero gap (May not occur in reality) No benefits 12/17/2009 Presenter: Dr. Vighneswara 22
  23. 23. Factors Affecting Net Interest Income: An Example • Consider the following balance sheet: Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost Rate sensitive $ 500 8.0% $ 600 4.0% Fixed rate $ 350 11.0% $ 220 6.0% Non earning $ 150 $ 100 $ 920 Equity $ 80 Total $ 1,000 $ 1,000 NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220) NII = 78.5 - 37.2 = 41.3 NIM = 41.3 / 850 = 4.86% GAP = 500 - 600 = -100 12/17/2009 Presenter: Dr. Vighneswara 23
  24. 24. Factors Affecting Net Interest Income • Changes in the level of interest rates • Changes in the composition of assets and liabilities • Changes in the volume of earning assets and interest-bearing liabilities outstanding • Changes in the relationship between the yields on earning assets and rates paid on interest-bearing liabilities 12/17/2009 Presenter: Dr. Vighneswara 24
  25. 25. Examine the impact of the following changes • A 1% increase in the level of all short-term rates? • A 1% decrease in the spread between assets yields and interest costs such that the rate on RSAs increases to 8.5% and the rate on RSLs increase to 5.5%? • Changes in the relationship between short-term asset yields and liability costs • A proportionate doubling in size of the bank? 12/17/2009 Presenter: Dr. Vighneswara 25
  26. 26. 1% increase in short-term rates Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost Rate sensitive $ 500 9.0% $ 600 5.0% Fixed rate $ 350 11.0% $ 220 6.0% Non earning $ 150 $ 100 $ 920 Equity $ 80 Total $ 1,000 $ 1,000 NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220) NII = 83.5 - 43.2 = 40.3 NIM = 40.3 / 850 = 4.74% GAP = 500 - 600 = -100 With a negative GAP, more liabilities than assets reprice higher; hence NII and12/17/2009 NIM fall Presenter: Dr. Vighneswara 26
  27. 27. Maturity Gap Method – Mathematical Expressions RSG = RSAs - RSLs 1 Gap Ratio = RSAs / RSLs 2 3 NII = Gap x r Where, NII = Change in Net Interest Income r = Change in Interest Rates NII = Earning Assets x NIM 4 12/17/2009 Presenter: Dr. Vighneswara 27
  28. 28. Maturity Gap Method – Mathematical Expressions .. • NII = Earning Assets x NIM x C • Where, C = % change in NIM • Since, NII = Gap x r • Gap x r = Earning Assets x NIM x C • Therefore, • Earning Assets x NIM x C • GAP = ----------------------------------------------- 5 • r • Where; Earning Assets = Total Assets of the Bank • NIM = Net Interest Margin • C = Acceptable Change in NIM •12/17/2009 r Presenter: Dr. Vighneswara = Expected Change in Interest Rates 28
  29. 29. Maturity Gap Method – Illustration • Bharat bank has earning assets worth Rs. 3000 crores and a Net Interest Margin(NIM) of 3%. In a swift move Bharat Bank decided that a 2% increase/decrease in the NIM can be the acceptable limit. It further forecasts that a 0.75% increase in the interest rate. Now you are required to calculate the target gap which the bank can maintain to remain within the acceptable limits of NII. • Answer: • Earning Assets x NIM x C • GAP = ------------------------------------------------------ • r • 3000 x 0.03 x 0.02 1.8 GAP = --------------------------------------------- = ----------- = Rs. 240 Crore 0.0075 0.0075 12/17/2009 Presenter: Dr. Vighneswara 29
  30. 30. Maturity Gap Method – Mathematical Expressions .. Gap Ratio • Consider the Following Illustration of two banks which have a same Gap Ratio; Parameters Bank A Bank B RSA 2900 1005 RSL 2000 695 GAP 900 310 GAP Ratio 1.45 1.45 NII 830 390 Decrease in Interest 0.5 0.5 Change in NII (GAP * Change in R) 4.5 1.55 %change in NII (Change in NII /NII) 0.54% 0.40% • Inference: Gap level is more helpful than the Gap Ratio in taking Positions 12/17/2009 Presenter: Dr. Vighneswara 30
  31. 31. Maturity Gap Method – Mathematical Expressions .. Rate Adjusted Gap Rate Adjusted Gap = ( RSA1 * WA1 + RSA2 * WA2 + ……. ) • - ( RSL1 * W1 + RSL2 * W2 + ……. ) 6 • Where, • WA1 , WA2, …. are Weights of the corresponding RSAs • WL1 , WL2, …. are Weights of the corresponding RSLs • Illustration: The case of a Positive Gap turning Negative Increased Increased Liability Rate% Weight Rate% Assets Rate% Weight Rate% 200 200 1800 10 0.75 10.75 800 12 0.5 12.5 3000 11 11 1000 14 0.25 14.25 1000 16 0.5 16.5 2000 18 18 • Rate Adjusted Liabilities = 1800 x 0.75 = 1350 • Rate Adjusted Assets = [(800 x 0.5) + (1000 x 0.25) + (1000 x 0.5)] = 1150 • Rate adjusted Gap = 1150 – 1350 = (-) 200 12/17/2009 • Inference: By assigning weights the Positive Gap has actually become Negative 31 Presenter: Dr. Vighneswara
  32. 32. Statement Of Interest Rate Sensitivity • Generated by grouping RSA,RSL & OFF- Balance sheet items in to various (8)time buckets. RSA: • MONEY AT CALL • ADVANCES ( BPLR LINKED ) • INVESTMENT RSL: • DEPOSITS EXCLUDING CD • BORROWINGS 12/17/2009 Presenter: Dr. Vighneswara 32
  33. 33. Balance Sheet looked at from Interest Rates: Balance Sheet looked at from Interest Rates: Whether Interest Fixed / Floating Balance Sheet Items bearing Rate Remarks Liabilities Capital No Reserves & Surplus No Deposits - Current Deposits No - Savings Deposits Yes Fixed Discretionary pricing for High Value deposits & Inter bank - Term Deposits Yes Fixed items Borrowings - From within India Yes Fixed Sometimes, floating, linked to - From Outside India Yes Generally Fixed LIBOR Other Liabilities - Interest Payable Yes Fixed In a few cases, this is floating - Subordinated Debts Yes Fixed rate item - Others NO 12/17/2009 Presenter: Dr. Vighneswara 33
  34. 34. IRS & Interest Rate Scenario Impact of Interest Rate Changes on NII Rising Interest Stable Interest Falling Interest Rate Scenario Rate Scenario Rate Scenario Negative Mis Matches in IRS Adverse No Impact Favourable Mis Match in IRS is NIL No Impact No Impact No Impact Positive Mis Matches in IRS Favourable No Impact Adverse 12/17/2009 Presenter: Dr. Vighneswara 34
  35. 35. Limitations of Maturity Gap Analysis To a larger extent depends on the accuracy level of the forecasts made regarding the quantum and the direction of the interest rate changes While gap measurement is easy, gap management is quite difficult. It assumes that change in interest rates immediately affects all RSAs and RSLs Ignores Time Value of Money 12/17/2009 Presenter: Dr. Vighneswara 35
  36. 36. Duration Gap Analysis Duration Gap Analysis – What is it? Duration Analysis: Duration Duration Duration is a Analysis: Analysis: measure of the It concentrates It also measures percentage on the price risk the effect of rate change in the and the fluctuation on economic value reinvestment the market value of a position that risk while of the assets and occurs given a managing the liabilities and small change in interest rate NIM with the help level of interest exposure. of duration. rate. 12/17/2009 Presenter: Dr. Vighneswara 36
  37. 37. Duration Gap Analysis ..Illustration Assets and Liabilities chart of Bharath Bank is presented here below along with their durations and interest rates. Based on the information, identify the RSG and the NIM. During the forecasting period of one year, if the interest rates rise/fall by 2%, what would be its implication on the NIM of Bharath Bank? Liabiliti Amount Duration Int. Rate Assets Amount Duration Int. Rate es (Crore) (months) (%) (Crore) (months) (%) Equity 200 Cash 200 ST ST Depo 1800 5.5 11.5 Loans 1800 2.75 12.5 LT LT Depo 2500 23.7 15 Loans 2000 23 16.5 Others Invest 500 11.5 11 ments 1000 10.5 13.5 5000 5000 12/17/2009 Presenter: Dr. Vighneswara 37
  38. 38. Duration Gap Analysis … Answer: RSG = RSAs – RSLs = (1800+1000) – (1800+500) = 500 Liabi Amount Duration Interest Increased Decreased Assets Amount Duratio Interest Increased Decreased lities n (crore) in Mnths Rate(%) Int. Int. (crore) in Rate(%) Int. Int. Rate(%) Rate(%) Mnths Rate(%) Rate(%) Equity 200 Cash 200 ST ST Depos 1800 5.5 11.5 13.5 9.5 Loans 1800 2.75 12.5 14.5 10.5 LT LT Depos 2500 23.7 15 15 15 Loans 2000 23 16.5 16.5 16.5 Others 500 11.5 11 13 9 Investm 1000 10.5 13.5 15.5 11.5 5000 5000 Int. 637 683 591 Int 690 746 634 Expe Income NII 53 63 43 NIM 0.010 0.0126 0.0086 6 12/17/2009 Presenter: Dr. Vighneswara 38
  39. 39. Duration Gap Analysis … • Using the Duration analysis to assess the sensitivity of the market value of Assets and Liabilities. • Ds x S = ( D x A ) - ( DL x L ) 7 • Where, • Ds = Duration Gap / Duration of Surplus • DA = Duration of Assets, DL = Duration of Liabilities A = Assets L = Liabilities • S = Surplus / Gap 12/17/2009 Presenter: Dr. Vighneswara 39
  40. 40. Duration Gap Analysis …. Substituting L = A – S in the above eqn. We get Ds = DL + ( A / S ) x ( DA - DL ) 8 When there is a market fluctuation, -D( r) x Current MV MV = ------------------------------------------ 9 (1+r) Where, MV = Change in the market value D = Duration of assets or liabilities r = Change in the interest rate r = Current interest rate MV = Market Value Then, New MV = Current MV + MV 9 12/17/2009 Presenter: Dr. Vighneswara 40
  41. 41. Duration Gap Analysis ….. Then, -D( r) x Current MV MV = ----------------------------------- (1+r) An Example: The following is the information about Bharath Bank. Market value of liabilities is Rs1800 crores, MV of Assets is Rs2000 Crores, Duration of Assets is 5 years, Duration of Liabilities is 4 years, the ROI is 10% and Change in the ROI is +2%. You are required to asses the change in the MV of the bank whose Equity is currently Rs200 crore. Answer: Parameter Change in MV Original MV New MV Assets -5(0.02) x2000 182 2000 1818 (1+0.1) Liabilities -4(0.02) x1800 131 1800 1669 (1+0.1) Equity 182 – 131 51 200 149 12/17/2009 Presenter: Dr. Vighneswara 41
  42. 42. Simulation What is it? Data Requirement Simulates performance under alternative interest rate Maturity and repricing scenarios and assesses the Rate scenarios resulting volatility in NII / NIM Alternative management / ROA / ROE / MVE response under different A financial model scenarios incorporating inter- Yield curves relationship of assets, Prepayment tables liabilities, prices, costs, Behavioural pattern of assets volume, mix and other and liabilities business related variables Consistency of assumptions Computer generated scenarios about future and response to that in a dynamic way 12/17/2009 Presenter: Dr. Vighneswara 42
  43. 43. Simulation- other information • Risk-Return policies - management appetite for risk taking • Regulatory framework – Ward against practices which are considered unsafe and unsound • Capital strength and profitability • Experience and track record of management • Other risks embedded in the balance sheet - Liquidity / Credit / Forex risks • Business plan 12/17/2009 Presenter: Dr. Vighneswara 43
  44. 44. Simulation -Advantages -Disadvantages Forward looking Dynamic Accuracy depends on quality of data, strength of the model Lessens the role of crisis and validity of assumptions management Time consuming Increases the value of strategic planning Huge investment in computer Enhances capability of Requires highly skilled analysis Personnel Interpretation easy Analysis paralysis Timing of cash flows captured accurately 12/17/2009 Presenter: Dr. Vighneswara 44
  45. 45. Interest Rate Risk Management 12/17/2009 Presenter: Dr. Vighneswara 45
  46. 46. Interest Rate Risk Management INTEREST RATE RISK MODELS Risk Measurement Systems GAP EARNINGS ECONOMIC VALUATION REPORT SIMULATION Short-Term Yes Yes Generally does not distinguish short-term Earnings accounting earnings from changes in Exposure economic value. Long-term Yes Limited* Yes Exposure Repricing Risk Yes Yes Yes Basis Risk Limited* Yes Limited* Yield Curve Limited* Yes Yes Risk Option Risk Limited* Limited* Yes * The ability of these types of models to capture this type of risk will vary with the sophistication of the model and the manner in which bank management uses 12/17/2009 Presenter: Dr. Vighneswara 46
  47. 47. Benefits from IRR management •Defined financial targets based on corporate risk tolerances •Reduced earnings volatility •Improved cash flow forecasting •Improved corporate credit ratings •Defined risk management and hedge methodologies 12/17/2009 Presenter: Dr. Vighneswara 47
  48. 48. Conclusion • Based on the quantity of interest rate risk and quality of interest rate risk management, we can evaluate the adequacy of the bank’s capital. • Determine the component rating for sensitivity to market risk. • Determine further the effect of interest rate and earnings on the business in a macroscopic view. 12/17/2009 Presenter: Dr. Vighneswara 48
  49. 49. Save Environment – Save Earth

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