nep-rmg New Economics Papers
on Risk Management
Issue of 2017‒03‒26
nineteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Fire sales, indirect contagion and systemic stress testing By Rama Cont; Eric Schaanning
  3. Impact of multimodality of distributions on VaR and ES calculations By Dominique Guegan; Bertrand Hassani; Kehan Li
  4. Automatic Portmanteau Tests with Applications to Market Risk Management By Zaichao Du; Juan Carlos Escanciano; Guangwei Zhu
  5. An overview of the UK banking sector since the Basel Accord: insights from a new regulatory database By de Ramon, Sebastian; Francis, William; Milonas, Kristoffer
  6. Identifying early warning indicators for real estate-related banking crises By Stijn Ferrari; Mara Pirovano; Wanda Cornacchia
  7. Scope of Re-hypothecation Regulation (Report of Workshops (3)) By Kazutoshi Sugimura; Masaru Itatani; Masaki Bessho
  8. The role of cointegration for optimal hedging with heteroscedastic error term By Lukasz Gatarek; Søren Johansen
  9. Foreign Investment, Regulatory Arbitrage, and the Risk of U.S. Banking Organizations By Frame, W. Scott; Mihov, Atanas; Sanz, Leandro
  10. Credit Ratings and Predictability of Stock Returns and Volatility of the BRICS and the PIIGS: Evidence from a Nonparametric Causality-in-Quantiles Approach By Mehmet Balcilar; Deven Bathia; Riza Demirer; Rangan Gupta
  11. Compounded Generalized Weibull Distributions - A Unified Approach By Shovan Chowdhury
  12. The struggle to perform the political economy of creditworthiness: European Union governance of credit ratings through risk By Bartholomew Paudyn
  13. Type I Censored Acceptance Sampling Plan for the Generalized Weibull Model By Shovan Chowdhury
  14. Compounded Inverse Weibull Distributions: Properties, Inference and Applications By Jimut Bahan Chakrabarty; Shovan Chowdhury
  15. Corporate Disaster Risk Financing in Japan: Status quo and challenges (Japanese) By SAWADA Yasuyuki; MASAKI Tatsujiro; NAKATA Hiroyuki; SEKIGUCHI Kunio
  16. Interquantile Expectation Regression By Sander Barendse
  17. Carving out legacy assets: a successful tool for bank restructuring? By Alexander Lehmann
  18. Effects of Insurance Incentives on Road Safety: Evidence from a Natural Experiment in China By Dionne, Georges; Liu, Ying
  19. Lebanon; Selected Issues By International Monetary Fund.

  1. By: Rama Cont (Imperial College London); Eric Schaanning (Norges Bank (Central Bank of Norway))
    Abstract: We present a framework for quantifying the impact of re sales in a network of financial institutions with common asset holdings, subject to leverage or capital constraints. Asset losses triggered by macro-shocks may interact with one-sided portfolio constraints, such as leverage or capital constraints, resulting in liquidation of assets, which in turn affects market prices, leading to contagion of losses and possibly new rounds of fire sales when portfolios are marked to market. Price-mediated contagion occurs through common asset holdings, which we quantify through liquidity-weighted overlaps across portfolios. Exposure to price-mediated contagion leads to the concept of indirect exposure to an asset class, as a consequence of which the risk of a portfolio depends on the matrix of asset holdings of other large and leveraged portfolios with similar assets. Our model provides an operational stress testing method for quantifying the systemic risk arising from these effects. Using data from the European Banking Authority, we examine the exposure of the EU banking system to price-mediated contagion. Our results indicate that, even with optimistic estimates of market depth, moderately large macro-shocks may trigger fire sales which may then lead to substantial losses across bank portfolios, modifying the outcome of bank stress tests. Price-mediated contagion leads to a heterogeneous cross-sectional loss distribution across banks, which cannot be replicated simply by applying a macro-shock to bank portfolios in absence of fire sales. Unlike models based on `leverage targeting', which assume symmetric reactions to gains or losses, our approach is based on the asymmetric interaction of portfolio losses with one-sided constraints, distinguishes between insolvency and illiquidity and leads to substantially different loss estimates in stress scenarios.
    Date: 2017–03–17
  2. By: Pankaj Baag (Indian Institute of Management Kozhikode)
    Abstract: We use the asymptotic single risk factor model, which is a portfolio invariant model and preferred by BCBS with the factor based structural CreditMetrics portfolio default model to empirically estimate the Probability of default with asset correlation of a loan portfolio based on primary data from Public Sector Banks and compared the results with the estimated Probability of default without any asset correlation. We have used actual bank loan rating transition data for the period 2000-2010. Our study evidences that probability of default improves with asset correlation. We also find that asset correlation is an increasing function of probability of default. High rating firms have low correlation than low rating firms. These are opposite of BCBS assumptions for the developed nations. This implies that large corporate loans have the same systematic risk in times of economy distress. Our analyses suggest that it is imprudent to assume a decreasing relationship between average asset correlation and default probability in measuring portfolio credit risk. In light of this empirical evidence, we encourage the Basel Committee to revisit the use of this relationship in bank capital requirement.
  3. By: Dominique Guegan (Centre d'Economie de la Sorbonne and LabEx ReFi); Bertrand Hassani (Grupo Santander and Centre d'Economie de la Sorbonne and LabEx ReFi); Kehan Li (Centre d'Economie de la Sorbonne and LabEx ReFi)
    Abstract: Unimodal probability distribution has been widely used for Value-at-Risk (VaR) computation by investors, risk managers and regulators. However, financial data may be characterized by distributions having more than one modes. Using a unimodal distribution may lead to bias for risk measure computation. In this paper, we discuss the influence of using multimodal distributions on VaR and Expected Shortfall (ES) calculation. Two multimodal distribution families are considered: Cobb's family and distortion family. We provide two ways to compute the VaR and the ES for them: an adapted rejection sampling technique for Cobb's family and an inversion approach for distortion family. For empirical study, two data sets are considered: a daily data set concerning operational risk and a three month scenario of market portfolio return built five minutes intraday data. With a complete spectrum of confidence levels from 0001 to 0.999, we analyze the VaR and the ES to see the interest of using multimodal distribution instead of unimodal distribution
    Keywords: Risks; Multimodal distributions; Value-at-Risk; Expected Shortfall; Moments method; Adapted rejection sampling; Regulation
    JEL: C13 C15 G28 G32
    Date: 2017–03
  4. By: Zaichao Du (Southwestern University of Finance and Economics, China); Juan Carlos Escanciano (Indiana University); Guangwei Zhu (Southwestern University of Finance and Economics, China)
    Abstract: : This article reviews some recent advances in testing for serial correlation, provides Stata code for implementation and illustrates its application to market risk forecast evaluation. The classical and widely used Portamenteau tests and their data-driven versions are the focus of this article. These tests are simple to implement for two reasons: First, the researcher does not need to specify the order of the autocorrelation tested, since the test automatically chooses this number; second, its asymptotic null distribution is chi-square with one degree of freedom, so there is no need of using a bootstrap procedure to estimate the critical values. We illustrate the wide applicability of the methodology with applications to forecast evaluation for market risk measures, such as Value-at-Risk and Expected Shortfall.
    Keywords: Autocorrelation, consistency, power, Akaike's AIC, Schwarz's BIC, Market Risk
    Date: 2017–03
  5. By: de Ramon, Sebastian (Bank of England); Francis, William (Bank of England); Milonas, Kristoffer (Bank of England)
    Abstract: This paper provides an overview of the dramatic changes in the UK banking sector over the 1989–2013 period, seen through the lens of a newly assembled database built from banks’ regulatory reports. This database, which we refer to as the Historical Banking Regulatory Database (HBRD), covers financial statement and confidential regulatory information for all authorized UK banks and building societies at the consolidated (group) and standalone (bank) level. As a result, it permits both a more comprehensive picture of the UK banking sector as well as a more refined view of subsectors, such as small banks, than possible with other existing data sets (eg from external vendors or aggregate statistics). The overview focuses on developments in banks’ CAMEL characteristics (Capital adequacy, Asset quality, Management skills, Earnings performance and Liquidity), and relates these developments to concurrent regulatory changes, such as the Basel Market Risk Amendment. We also suggest ways in which the database can be used for evidence-based research and policy analysis.
    Keywords: Bank regulation; regulatory data; database; CAMEL; capital; capital requirements; asset quality; management; earnings performance; liquidity; funding
    JEL: G01 G21 G28 N20
    Date: 2017–03–20
  6. By: Stijn Ferrari; Mara Pirovano; Wanda Cornacchia
    Abstract: This Occasional Paper presents a formal statistical evaluation of potential early warning indicators for real estate-related banking crises. Relying on data on real estate-related banking crises for 25 EU countries, a signalling approach is applied in both a non-parametric and a parametric (discrete choice) setting. Such an analysis evaluates the predictive power of potential early warning indicators on the basis of the trade-off between correctly predicting upcoming crisis events and issuing false alarms. The results in this paper provide an analytical underpinning for decision-making based on guided discretion with regard to the activation of macro-prudential instruments targeted to the real estate sector. After the publication of the ESRB Handbook and the Occasional Paper on the countercyclical capital buffer, it represents a next step in the ESRB’s work on the operationalisation of macroprudential policy in the banking sector. This Occasional Paper highlights the important role of both real estate price variables and credit developments in predicting real estate-related banking crises. The results indicate that, in addition to cyclical developments in these variables, it is crucial to monitor the structural dimension of real estate prices and credit. In multivariate settings macroeconomic and market variables such as the inflation rate and short-term interest rates may add to the early warning performance of these variables. Overall, the findings indicate that combining multiple variables improves early warning signalling performance compared with assessing each indicator separately, both in the non-parametric and the parametric approach. Combinations of the abovementioned indicators lead to lower probabilities of missing crises while at the same time not issuing too many false alarms. In addition to EU level, they also perform relatively well at individual country level. Even though the best performing indicators have relatively good signalling abilities at the individual country level, national authorities are encouraged to perform their own complementary analyses in abroader framework of systemic risk detection, which augments potential early warning indicators and methods with other relevant inputs and expert judgement. JEL Classification: G21, G18, E58
    Keywords: early warning indicators, real estate, banking crises
    Date: 2015–08
  7. By: Kazutoshi Sugimura (Bank of Japan); Masaru Itatani (Bank of Japan); Masaki Bessho (Bank of Japan)
    Abstract: The margin requirements for non-cleared over-the-counter ("OTC") derivatives transactions are introduced in 2016 (pursuant to an international agreement by the G20 to reduce systemic risk from OTC derivatives) and restrict the re-hypothecation of initial margin collateral. While this restriction is introduced in order to protect client assets, there has been a concern that such restriction may have a negative impact on market liquidity. The Report of the Workshops on "Contemporary Financial Transactions and Their Regulatory Treatment" (2016) (the "Report") analyzes the appropriate scope of regulation in relation to the re-hypothecation of initial margin collateral. Japan implements this regulation in a manner compatible with the international agreement, and introduces a new trust scheme concept, which allows for the segregated management of collateral assets. The Report also analyzes the potential for the trust scheme, which could provide room for the re-hypothecation of securities and hence, mitigate the unintended negative impact on market liquidity, while ensuring harmonization with the international agreement.
    Keywords: Re-hypothecation; Regulation
    JEL: G19 G28 G33 K19 K22 K23
    Date: 2017–03–15
  8. By: Lukasz Gatarek (Institute of Econometrics and Statistics, University of Lódz); Søren Johansen (Department of Economics, University of Copenhagen)
    Abstract: The role of cointegration is analysed for optimal hedging of an h-period portfolio.Prices are assumed to be generated by a cointegrated vector autoregressive model allowing for stationary martingale errors, satisfying a mixing condition and hence some heteroscedasticity. The risk of a portfolio is measured by the conditional variance of the h-period return given information at time t. If the price of an asset is nonstationary, the risk of keeping the asset for h periods diverges for large h. The h-period minimum variance hedging portfolio is derived, and it is shown that it approaches a cointegrating vector for large h, thereby giving a bounded risk. Taking the expected return into account, the portfolio that maximizes the Sharpe ratio is found, and it is shown that it also approaches a cointegration portfolio. For constant conditional volatility, the conditional variance can be estimated, using regression methods or the reduced rank regression method of cointegration. In case of conditional heteroscedasticity, however, only the expected conditional variance can be estimated without modelling the heteroscedasticity. The fi?ndings are illustrated with a data set of prices of two year forward contracts for electricity, which are hedged by forward contracts for fuel prices. The main conclusion of the paper is that for optimal hedging, one should exploit the cointegrating properties for long horizons, but for short horizons more weight should be put on the remaining dynamics.
    Keywords: hedging, cointegration, minimum variance portfolio, maximum Sharpe ratio portfolio
    JEL: C22 C58 G11
    Date: 2017–03–14
  9. By: Frame, W. Scott (Federal Reserve Bank of Atlanta); Mihov, Atanas (Federal Reserve Bank of Richmond); Sanz, Leandro (Federal Reserve Bank of Richmond)
    Abstract: This study investigates the implications of cross-country differences in banking regulation and supervision for the international subsidiary locations and risk of U.S. bank holding companies (BHCs). We find that U.S. BHCs are more likely to operate subsidiaries in countries with weaker regulation and supervision and that such location decisions are associated with elevated BHC risk and higher contribution to systemic risk. The quality of BHCs’ internal controls and risk management play an important role in these location choices and risk outcomes. Overall, our study suggests that U.S. banking organizations engage in cross-country regulatory arbitrage with potentially adverse consequences.
    Keywords: regulation; supervision; bank holding companies; cross-border operations; subsidiary locations; risk; systemic risk
    JEL: G15 G21 G28
    Date: 2017–03–01
  10. By: Mehmet Balcilar (Department of Economics, Eastern Mediterranean University, Northern Cyprus, Turkey); Deven Bathia (Queen Mary University of London, School of Business and Management, London, United Kingdom); Riza Demirer (Department of Economics & Finance, Southern Illinois University Edwardsville, Edwardsville, USA); Rangan Gupta (Department of Economics, University of Pretoria, Pretoria, South Africa)
    Abstract: This paper provides a novel perspective to the predictive ability of credit rating announcements over stock market returns and volatility using a novel methodology that formally distinguishes between different market states that can be characterized as bull, bear and normal market conditions. Using data on the credit rating announcements published by the three well-established credit rating agencies and data on BRICS and PIIGS stock markets, we show that the stock markets react heterogeneously, and in quantile-specific patterns, to ratings announcements with more persistent and widespread effects observed for PIIGS stock markets. The effect of rating announcements is generally stronger and more widespread in the case of volatility of returns, implying significant risk effects of these announcements. Finally, we show that the results of the aggregate ratings are driven mostly by rating upgrades rather than downgrades, implying asymmetry in the predictive ability of ratings announcements during good and bad times. Overall, our findings show that predictive models can be greatly enhanced by disaggregating the overall rating announcements and taking into account nonlinearity in the relationship between ratings announcements and stock return dynamics.
    Keywords: Stock Markets Returns and Volatility, Credit Ratings, Nonparametric Quantile Causality, BRICS, PIIGS
    JEL: C22 G15
    Date: 2017–03
  11. By: Shovan Chowdhury (Indian Institute of Management Kozhikode)
    Abstract: A unified approach is proposed in this paper to study a family of lifetime distributions of a system consisting of random number of components in series and in parallel. While the lifetimes of the components are assumed to follow generalized (exponentiated) Weibull distribution, a zero-truncated Poisson is assigned to model the random number of components in the system. The resulting family of compounded distributions describes several well-known distributions as well as some new models with some of their statistical and reliability properties. Various ageing classes of life distributions including increasing, decreasing, bath-tub, upside-down-bathtub and roller coaster shaped failure rates are covered by the family of compounded distributions. The simplest algorithm for maximum likelihood method of estimation of the model parameters is discussed. Some numerical results are obtained via Monte-Carlo Simulation. The asymptotic variance-covariance matrices of the estimators are also obtained. Five different real data sets are used to validate the distributions and the results demonstrate that the family of distributions can be considered as a suitable model under several real situations.
    Keywords: Unified approach, Compounding, Generalized Weibull Distribution; Hazard Function; ML Estimation; Zero-Truncated Poisson Distribution.
  12. By: Bartholomew Paudyn
    Abstract: Analysing the European Union's regulatory response in the wake of the credit and sovereign debt crises, this paper argues how its adoption of risk management as the core strategy for governing the credit ratings space may undermine European efforts to rebalance the growing asymmetry between private expertise and public democracy. While centralised oversight, enhanced transparency and restorative, technical intervention seem like sound regulatory initiatives, I problematise the methodologies, models and assumptions of sovereign ratings to show how the new ratings framework may actually impede the ability of the technocratic European Securities and Markets Authority (ESMA) to redress the most egregious deficiencies of ratings. Drawing on the performativity of market relations, the paper argues how ESMA's supervisory conflicts undermine the EU's capacity to perform an alternative political economy of limits. Neither is it democratically sanctioned to interfere in the analytical substance of ratings nor should it distort the social facticity of creditworthiness by relying primarily on quantitative risk analysis, ESMA will be forced to either repoliticise the ratings process or promote the status quo, which diminishes fiscal sovereignty.
    JEL: J1
    Date: 2015–09–04
  13. By: Shovan Chowdhury (Indian Institute of Management Kozhikode)
    Abstract: In this paper, we develop acceptance sampling plan when the lifetime experiment is truncated at a pre-assigned time. The minimum sample size required to ensure a specified median life of the experimental unit is provided when the lifetimes of the units follow generalized Weibull distribution which exhibits both monotone and non-monotone failure rates. The operating characteristic values of the sampling plans as well as the producer’s risk are also presented. One data analysis is provided for illustrative purpose.
    Keywords: Acceptance sampling, Failure rates, Generalized Weibull distribution, Life test, Type I censoring, Minimum sample size, Producer’s risk.
    Date: 2016–10
  14. By: Jimut Bahan Chakrabarty (Indian Institute of Management Kozhikode); Shovan Chowdhury (Indian Institute of Management Kozhikode)
    Abstract: In this paper two probability distributions are introduced compounding inverse Weibull distribution with Poisson and geometric distributions. The distributions can be used to model lifetime of series system where the lifetimes follow inverse Weibull distribution and the subgroup size being random follows either geometric or Poisson distribution. Some of the important statistical and reliability properties of each of the distributions are derived. The distributions are found to exhibit both monotone and non-monotone failure rates. The parameters of the distributions are estimated using the maximum likelihood method and the expectation-maximization algorithm. The potentials of the distributions are explored through three real life data sets and are compared with similar compounded distributions, viz. Weibull-geometric, Weibull-Poisson, exponential-geometric and exponential-Poisson distributions.
    Keywords: Inverse Weibull distribution, Poisson distribution, Geometric distribution, Hazard function, Maximum likelihood estimation, EM algorithm.
    Date: 2016–12
  15. By: SAWADA Yasuyuki; MASAKI Tatsujiro; NAKATA Hiroyuki; SEKIGUCHI Kunio
    Abstract: In this paper, we investigate the factors behind the low disaster insurance subscription rate in the Japanese corporate sector using unique firm level datasets on the corporate awareness of disasters, insurance subscriptions, and the determinants of risk financing methods. From the survey, we find that disaster insurance participation rates are 59.5% and 47.0% for large companies and small and small-sized enterprises, respectively. The data outline how Japanese companies specify highly probable natural disasters, formulate business continuity planning/business continuity management (BCP/BCM), subscribe to disaster insurance, and select a risk financing method. Descriptive statistics indicate that the majority of companies identify disasters that would cause the worst damages, but fewer companies have an estimation of the scale of asset damages caused by such disasters. Furthermore, it shows that only about half of the respondent companies observe management's commitment toward disaster risk management and establish specific BCP/BCM, and that disaster insurance in the corporate sector is characterized disproportionately by property insurance for coverage, while the subscription rate for disaster insurance is subject to various restrictions. Regarding the risk finance behavior, irrespective of the firm size, the combinations of either equity capital (self-financing) and bank loans or disaster insurance and equity capital are the most popular financial instruments to cope with damages caused by a natural disaster and the resulting shortage of cash flow. This suggests a problem of "over-reliance" on self-financing against potential disaster damages. On the other hand, lack of knowledge and high insurance premiums are the two major reasons for not subscribing to disaster insurance. Since high exposure to natural disasters is likely to undermine corporate activities and the overall economy, expansion of formal insurance mechanisms will be indispensable. This paper also analyzes companies in the area damaged by the Kumamoto earthquake in 2016. The above mentioned results clearly shows the importance of policy interventions to improve corporate management's awareness of and commitment to disaster risk management and disaster insurance.
    Date: 2017–02
  16. By: Sander Barendse (Erasmus University Rotterdam, The Netherlands)
    Abstract: We propose a semiparametric estimator to determine the effects of explanatory variables on the conditional interquantile expectation (IQE) of the random variable of interest, without specifying the conditional distribution of the underlying random variables. IQE is the expected value of the random variable of interest given that its realization lies in an interval between two quantiles, or in an interval that covers the range of the distribution to the left or right of a quantile. Our so-called interquantile expectation regression (IQER) estimator is based on the GMM framework. We derive consistency and the asymptotic distribution of the estimator, and provide a consistent estimator of the asymptotic covariance matrix. Our results apply to stationary and ergodic time series. In a simulation study we show that our asymptotic theory provides an accurate approximation in small samples. We provide an empirical illustration in finance, in which we use the IQER estimator to estimate one-step-ahead daily expected shortfall conditional on previously observed daily, weekly, and monthly aggregated realized measures.
    Keywords: quantile; interquantile expectation; regression; generalized method of moments; risk management; expected shortfall
    JEL: C13 C14 C32 C58 G32
    Date: 2017–03–20
  17. By: Alexander Lehmann
    Abstract: This paper was originally produced as a testimony for the European Parliament. The separation of so-called legacy assets from the remaining healthy business of a bank has become a central concern in risk management and supervision. In the European Union, non-performing loans amount to over €1 trillion and an additional stock of non-core assets that is at least as large is also being offered in the secondary market. Banks have employed various organisational models to separate these assets from their core business. At one extreme, banks have tasked specialist staff to focus on workout or selective sales, while the bulk of these assets remain on the same balance sheets. To do this, appropriate incentives have to be set for bank staff, and a number of failures that are inherent to the market for loan sales have to be addressed. At the other extreme, in situations of serious distress, countries set up external asset management companies (AMCs), either specific to an individual bank, or working across the industry for specific types of loans. As the transfer to another entity crystallises the value loss of legacy assets, this option requires a capital injection and restructuring of the bank’s balance sheet. Past EU experience has demonstrated the effectiveness of AMCs, in particular when they work with a large part of the banking sector and are focused on specific loan types. Asset separation in conjunction with an asset management company can also be an effective tool for bank resolution, but the difficulties inherent in setting up an AMC and achieving a track record in restructuring should not be underestimated. Countries are well advised to prepare the legal basis for such entities.
    Date: 2017–03
  18. By: Dionne, Georges (HEC Montreal, Canada Research Chair in Risk Management); Liu, Ying (Shandong University)
    Abstract: We investigate the incentive effects of insurance experience rating on road safety by evaluating the claim frequency following a regulatory reform introduced in a pilot city of China. Our contribution to the growing literature on moral hazard is to offer a neat identification of a causal effect of experience rating on road safety by employing the differences-in-differences methodology in the framework of a natural experiment. The pre-treatment placebo test corroborates the assumption that the pilot city and the control city share the same pre-reform time trends in claims. We find that basing insurance pricing on traffic violations reduces claim frequency significantly. These results are robust to the inclusion of vehicle controls, alternative definitions of claim frequency, two placebo experiment tests, and several robustness checks. The effects of basing pricing on past claims are not significant.
    Keywords: Insurance incentives; experience rating; road safety; natural experiment; China; traffic violation; past claim; moral hazard.
    JEL: C33 C35 D81 D82 G22 R41
    Date: 2017–03–15
  19. By: International Monetary Fund.
    Abstract: This Selected Issues paper analyzes the impact of the Syrian crisis on Lebanon’s economy. Output growth in Lebanon has fallen sharply since the onset of the Syrian crisis and is too low to accommodate new job seekers, or to address the needs of Lebanon’s more vulnerable population. Moreover, low growth is taking a toll on public debt dynamics, raising the prospect of higher borrowing costs and constrained social and investment spending—both are much needed to improve the quality of public spending and direct it toward more useful and productive uses. The authorities have presented an ambitious proposal to the international community, which centers on a multiyear effort to stimulate growth and employment through a targeted series of investment initiatives.
    Keywords: Financial system stability assessment;Financial sector;Banks;Bank supervision;Basel Core Principles;Risk management;Stress testing;Financial safety nets;Capital markets;Insurance;Reports on the Observance of Standards and Codes;Lebanon;
    Date: 2017–01–24

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