Financial Sector Assessment Program United Kingdom Detailed Assessments of Standards and Codes

This technical note reviews the Financial Sector Assessment Program of the United Kingdom. It examines the United Kingdom’s public debt management practices using the IMF-World Bank Guidelines for Public Debt Management as a framework. It analyzes the government’s Code for Fiscal Stability, transparency, accountability, debt strategy, and risk management framework. It also provides a detailed assessment of the antimoney laundering and combating the financing of terrorism regime and compliance of the Basel Core Principles of the United Kingdom.

Abstract

This technical note reviews the Financial Sector Assessment Program of the United Kingdom. It examines the United Kingdom’s public debt management practices using the IMF-World Bank Guidelines for Public Debt Management as a framework. It analyzes the government’s Code for Fiscal Stability, transparency, accountability, debt strategy, and risk management framework. It also provides a detailed assessment of the antimoney laundering and combating the financing of terrorism regime and compliance of the Basel Core Principles of the United Kingdom.

I. Basel Core Principles for Effective Banking Supervision

A. General

1. This assessment of U.K. compliance with the Basel Core Principles for Effective Banking Supervision was undertaken as part of the Financial Sector Assessment Program (FSAP) that the IMF has conducted at the request of the U.K. authorities over the period February–July 2002. The assessment was conducted by John Abbott (IMF-MAE), Laurie Edlund (Office of the Comptroller of the Currency), and Jan Rein Pruntel (Netherlands Bank).

B. Information and Methodology Used for the Assessment

2. The assessment has been based on the Core Principles Methodology that was published by the Basel Committee On Banking Supervision in October 1999.

3. In view of the highly developed nature of the U.K. banking sector, this assessment takes into account both the essential and the additional criteria that have been set out in the Core Principles Methodology.

4. The assessment takes into account a comprehensive self-assessment of compliance with the Basel Core Principles that was submitted by the U.K. authorities to the IMF prior to the May mission. Major further sources used for the assessment include numerous publications available from the FSA website, the Financial Services and Markets Act 2000 (FSMA), a CD-ROM provided by the FSA containing its Handbook of rules and guidance, presentation material and internal documents provided by FSA officers, and background material from various industry sources.

5. In addition extensive interviews were held with FSA officers, representatives of major U.K. incorporated banks and U.K. branches of overseas banks, senior representatives of the British Bankers Association, the Foreign Bankers and Securities Association, the Practitioners Panel on transparency established under the FSMA, and the Institute of Chartered Accountants in England and Wales. The assessment team gratefully acknowledges the cooperation received from all concerned which has added substantially to the effectiveness of the assessment.

C. Institutional and Macroprudential Setting—Overview

6. The FSA was established by the U.K. Government in May 1997, and commenced operation in an interim or transitional way in June 1998. The relevant law, the FSMA, was passed in 2000, and took full legal effect on December 1, 2001, a date usually referred to in this context as N2. The FSA initially absorbed the activities of a nine previous regulators or government departments, and in bank supervision specifically, the previous supervisory function of the Bank of England, and has since taken on even more responsibilities.

7. The U.K. banking industry has benefited from a remarkably stable macroeconomic environment and sustained growth over nearly a decade. The favorable environment owes much to sound macroeconomic policies as well as a strong policy framework, and to sustained structural reforms. Recently, however imbalances have emerged, particularly in the expansion of credit to consumers and businesses and burgeoning house prices. Although these imbalances are, on the whole, not large and likely to be resolved gradually, they do pose risks to the financial system that require monitoring and management.

D. General Preconditions for Effective Banking Supervision

8. The United Kingdom has a well developed judicial system with a reputation for probity and professionalism. Civil commercial matters are normally heard in one of the divisions of the High Court, with appeal processes available through the Court of Appeal and, if accepted, the House of Lords. The senior EU Court is the European Court of Justice and it has similar professional standing to the English upper courts. The legal system is based on case law as modified by equity considerations and domestic legislation. As the U.K. has no written constitution, Parliament is the supreme domestic law making body, but as a general principle EU law overrides domestic law under the Treaty of Rome. EU directives agreed by the Council of Ministers do not have the status of law but must be converted into national law by member states. From a regulatory point of view the legal and judicial precondition to effective banking supervision are very well satisfied.

9. The professions important to the financial sector are also well developed in the U.K. and are subject to full liability for breach of duty. The U.K. chartered accountants are expected to continuously maintain minimum levels of professional training. They have world class qualification and accreditation requirements and are seen as best practice resources by educators and professionals in many other countries. A new system of non-statutory independent regulation of the accountancy profession’s audit activities has recently been established under the auspices of the Accountancy Federation, which will raise the standards for oversight of the accountancy profession. The convergence toward fair value accounting (IAS 39) will introduce new issues for both firms and for regulators, issues that the U.K. profession is now beginning to address. Again, this precondition for effective regulation and supervision is well satisfied.

10. The auditing profession is also well established. External auditors need to be members of recognized supervisory organizations and to remain eligible to be a member under the rules of that organization (leading to a practicing certificate). Recognized organizations have to ensure that all their members are ‘fit and proper’ and that audit processes are carried out in a professional manner and with integrity. The main coordinating body for the six U.K. accounting bodies, the Counsultative Committee of Accounting Bodies, is a recognized supervisory body. The assessment team was not able to determine the level of performance of the internal audit function within the banking sector, but there appear to be varying degrees of competence and awareness of the risk based approach.

11. The United Kingdom is among the leading countries in the world in setting standards for corporate governance, including public disclosure practices. With regard to the regulated financial sector, market discipline is reinforced by the fact that the U.K. authorities have publicly stated their view that it is neither possible nor desirable to remove all risk of financial failure.

12. The United Kingdom has no special statutory insolvency procedures for banks. As limited liability companies, banks and other FSA-supervised financial institutions are generally subject to the same insolvency laws and procedures as those that apply for non-regulated companies. FSMA gives the FSA a limited role in statutory insolvency procedures for financial institutions, including the power to petition for an institution to be placed in administration or winding-up proceedings. Under the current system, bank depositors are treated like other creditors at the beginning of administration proceedings and delays in repayment of deposits can span several weeks. In terms of pre-statutory resolution of a troubled institution, however, the FSMA provides the FSA with a broad range of powers to resolve problems in banks, ranging from public censure to withdrawal of authorization, and the financial stability Memorandum of Understanding (between HMT, the FSA and the Bank) provides a broad framework within which official intervention of various sorts could be contemplated in more systemically important cases.

13. Overall the U.K. satisfies the Basel Core Principles preconditions for effective banking supervision.

Table 1.

Detailed Assessment of Compliance of the Basel Core Principles

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Table 2.

Summary Compliance of the Basel Core Principles

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C: Compliant.

LC: Largely compliant.

MNC: Materially non-compliant.

NC: Non-compliant.

NA: Not applicable.

E. Recommended Action Plan and Authorities’ Response to the Assessment

Recommended action plan

14. Table 3 sets out the actions recommended by the mission with respect to Bank supervision. Note that the recommendations related to principles 15, 16, 18, and 19 are to improve compliance with the Core Principles, while the other recommendations are more technical ones for Principles already complied with. The mission considers the latter desirable measures for further refining bank supervision given, in particular, the role of London as a major international financial center.

Table 3.

Recommended Action Plan with Respect to the Basel Core Principles

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Authorities’ response to the assessment

15. The U.K. authorities consider that the FSAP assessment is valuable and clearly demonstrates the U.K.’s very high degree of compliance with the Basel Core Principles. They support the broad thrust of the FSAP mission’s findings and recommendations and find them helpful in taking forward some existing strands of work. In particular, they agree with the usefulness of developing a new approach to liquidity monitoring, and changes to their existing approach are in train. There are a small number of recommendations where they believe the current regime effectively fulfils the IMF’s requirements. There are also some recommendations where further consideration will be required to effectively account for the costs of implementing them relative to the benefit. Specific comments from the authorities on the recommendations in the table above, are as follows:

  • On CP 8, in line with their risk based approach to regulation, and the principle of proportionality, the FSA indicated that it currently operates a selective process to reporting asset quality, i.e., if they have concerns about an institution’s asset quality, or the possible deterioration of that asset quality, they may ask the bank to provide regular info on asset quality. Their approach to this issue is being considered under the currently ongoing data needs project, and would be considered in the same context as CP 18.

  • On CP 12, they noted that the FSAP team has rightly recognized their need to focus most of their resources, which are of course finite, on the institutions that have the largest combination of impact and risk.

  • On CP 13, the authorities agreed with the usefulness of developing a new approach to liquidity monitoring, and changes to their existing approach are in train. They have already consulted on systems and controls requirements and it is planned to introduce these in summer 2004. They will also consult on a framework of quantitative requirements for liquidity risk in summer 2003.

  • On CP 15, the authorities noted that they already monitor the reports of Money Laundering Reporting Officers and have undertaken a specific study of reports from 75 banks. This program of work will continue.

  • On CPs 16-19, in the context of a risk based approach, the authorities were of the view that, while valid, some of the recommendations about the supervisory process in relation to these Principles relating to on/off site supervision, management contact and validation of information, could be overly prescriptive and less relevant to low impact banks (which account for only 0.02 percent of deposit liabilities). They felt that, by and large their tools are adequate and it is doubtful whether the value of extra reports on asset quality would outweigh the cost. Nonetheless, they are reviewing their data needs requirements generally and exploring ways of strengthening baseline monitoring, including the quality of data they receive from firms and the timeliness of notifications. (See also comment on BCP 8). The recommendations will be considered in this context.

    With respect to D firms [all low impact and low risk/medium low impact firms], in the authorities’ view, their new systems and processes deliver a robust, and appropriate supervisory regime for these firms, which have a low RTO and they do not wish to overburden this sector with unnecessary or disproportionate regulatory obligations.

    Regarding CP 17, they noted that block one of the FSA handbook sets out senior management responsibilities and the Principles for Businesses. These have the status of rules and apply to all firms. One of these Principles requires firms to disclose appropriately anything that the FSA could reasonably expect to be notified of. The authorities felt that providing detailed criteria and triggers for when firms should contact or notify the FSA is unlikely to make firms more open. They already have a list of basic events that must be notified and moving beyond this minimum could perversely restrict the issues on which a firm feels it has to consider communicating, and also weaken senior management’s responsibility to make considered judgments.

    On CP 19, the authorities noted that the FSA checks the plausibility of comparisons and trend analysis on financial returns from banks. Where there are concerns supervisors can request further information or appoint a skilled person (under S 166 of FSMA) to verify the accuracy of information. Auditors have a statutory duty to report to the FSA. Again, they are reviewing the recommended CP 19 requirement under the data needs project.

II. IAIS Insurance Core Principles

A. General

16. This is an assessment of the observance of the core principles of the International Association of Insurance Supervisors (IAIS) in the United Kingdom (U.K.). Insurance is supervised in the United Kingdom by the Financial Services Authority, an independent nongovernmental incorporated body limited by guarantee and operating under powers granted by the Financial Services and Markets Act 2000. The assessment was conducted by Carl Hiralal, Senior Director, Office of the Superintendent of Financial Institutions Canada, Conglomerates Group, and Rodney Lester, Lead Specialist and head of the Insurance and Contractual Savings practice in the Financial Sector Development Department of the World Bank. Frank Engels, U.K. desk officer for the IMF provided early commentary on the assessment and participated in the feedback sessions.

B. Information and Methodology Used for Assessment

17. This assessment has been based on the Insurance Core Principles Methodology (ICP) of the IAIS dated October 2000, as modified by the joint IMF/World Bank assessment template.

18. Given the highly developed nature of the U.K. insurance market, the current lack of stability in certain segments of the market and the large exposure to international financial activities, this assessment has been carried out on the basis of both the essential and supplementary criteria underpinning each Core Principle. In addition the assessors relied on the override provisions in the Methodology,1 and applied standards appropriate to a leading industrial country.2 The United Kingdom is the first insurance market of global significance to be assessed and provided special challenges. In particular it would have been possible to provide observed ratings on most of the CPs if just the law and FSA model (especially once rolled out) had been considered. The assessors view has been that this would not have added value given the current transition stage in the evolution in FSA, particularly with regard to supervision,3 and would not have done justice to the importance of the U.K. insurance sector, both domestically and internationally. Thus the assessment is based on the FSA as it was at the date of the assessment when supervisory practices were still being developed and resourced. In addition it needs to be explicitly stated that demanding benchmarks were applied and this will need to be acknowledged in any comparison with other industrial countries.

19. Major sources of information used for the assessment included the answers to the questionnaire submitted by the IMF prior to the mission, a comprehensive self assessment carried out by the Insurance Firms Division, information available from the FSA web site including numerous consultation papers, comprehensive CD-ROM databases provided by FSA, presentation material provided by FSA officers, statistical information provided by the Association of British Insurers (ABI) and S&P Thesys, and background information available from various professional firms and international industry intelligence services. In addition extensive interviews were conducted with numerous officers in FSA and the various governmental and regulatory bodies concerned with private pensions, senior management of ABI and the National Association of Pension Funds (NAPF), members of relevant boards of the Institute of Actuaries, senior chartered accountants and rating agency personnel, and a wide range of senior management from the insurance sector, including Lloyds. All concerned gave willingly of their time and were cooperative, and this added significantly to the effectiveness of the insurance assessment team.

C. Institutional and Macroprudential Setting—Overview

20. The British insurance industry is venerable and large. With net premium income in 2000 of £174 billion or approximately 10 percent of the world market, it is the third largest after the U.S. and Japan (although considerably smaller than either). See following table for premiums data. It includes the most important cross-border non-life insurance markets in Lloyds and the London Market, which together account for 65 percent of approximately US$20 billion of annual global cross border general insurance premium flows (Source-Sigma No. 6, 2001), and is a significant source of life insurance products for people resident in other EU countries. Insurance penetration4 at 15.8 percent is the highest in the world, South Africa excepted. This penetration is driven largely by a strong imperative to save for retirement in the U.K. given a relatively low (and declining) social security replacement ratio.

21. The insurance industry also makes a significant contribution to the economy. It employs in excess of 220,000 people directly and another 115,000 indirectly, accounting for 1.5 percent of total U.K. employment. It is an important contributor to the balance of payments, with overseas earnings in 2000 approaching £7 billion (£8.7 billion in 1999), of which the major element is insurance ‘exports’ (off shore insurance accepted or intermediated by a U.K.-based insurer or broker). U.K. insurers are also active in foreign markets; however this represents a relatively minor and reducing component of foreign earnings. Net assets of overseas operations have fallen for three years in a row with the main declines occurring in the U.S. and Europe, and only the few leading players continue to have global ambitions.

Table 4.

Gross Direct U.K. Sourced Premium Revenues

(in £ billions)

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Source: ABI.

22. The U.K.-based insurers are, with self-administered pension funds, the most important repositories of individual financial sector wealth. Of total FY 2000 financial assets of households and related non-profits of £3 trillion, more than 50 percent is represented by insurance policyholder related liabilities (Source National Statistics, Financial Statistics, Table 12.1N). Total investment assets under management at the end of 1999 amounted to slightly over £1 trillion and the life and pensions sectors were easily the major providers of finance to government and private borrowers. When examined over time the long term insurance sector has also been the most consistent source of new investment funds in the economy, although given the stresses the industry is now experiencing (see below), this is not guaranteed to be the case in the future. While a figure for ‘other’ company securities on issue is not readily available, life insurers appear to account for a major part of the Sterling commercial paper on issue.

23. U.K. insurance companies and pension funds are under considerable stress given that their income has been eroded by market risk. While balance sheet concerns remain, the insurance sector is not likely to pose a systemic threat to the financial system. Owing to their investment profile, U.K. insurers, most notably life insurers and pension funds, have been specifically affected by the fall in stock prices and exceptionally low bond yields. Coupled with long-term non-life claims, substantial losses related to September 11, and in some cases mounting liabilities based on guaranteed annuities or defined-benefit schemes, the sector constitutes a potential source of market risk, as insurers hold around a fifth of total U.K.-quoted equities and could resort to asset sales to safeguard profitability and regulatory capital. Growing balance sheet concerns in the insurance industry have been reflected in increased supervisory activity, including suspensions and modifications to the FSA’s resilience tests and enhanced monitoring of the financial modeling of insurers.

Table 5.

Insurance Sector Asset Allocation, end-1999

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Source: ABI 1/

ABI is one good source of summary information on insurance industry developments but this is oriented to turnover and assets rather than detailed financial analysis. S&P Thesys is one good source of financial analysis. The U.K. regulatory returns tend to be liability oriented and insurers have traditionally been given considerable leeway in terms of submission time, although this has recently been tightened. Although most regulatory returns are still filed in paper form, firms now have the option to file electronically. Returns for individual companies are publicly available from Companies House.

Table 6.

Holdings of U.K. Securities 1998

(% of outstanding value)

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Source: ONS

D. General Preconditions for Effective Insurance Supervision

24. The United Kingdom has a well developed judicial system with a reputation for probity and professionalism. Civil commercial matters are normally heard in one of the divisions of the High Court, with appeal processes available through the Court of Appeal and, if accepted, the House of Lords. The senior EU Court is the European Court of Justice and it has similar professional standing to the English upper courts. The legal system is based on case law and domestic and EU legislation. As the United Kingdom has no written constitution, Parliament is the supreme domestic law making body, however as a general principle EU law overrides domestic law under the Treaty of Rome. EU directives agreed by the Council of Ministers and the European Parliament must usually be implemented into national law by member states. International Insurance Law can in many ways be said to be based on U.K. case law given the jurisdiction’s long history of insurance actions and settlements. Many insurance contracts around the world continue to be subject to English law and from a regulatory point of view the legal and judicial precondition could hardly be better satisfied.

25. The professions important to the financial sector are also well developed in the U.K. and are subject to full liability for breach of duty. There are in excess of 65,000 practicing chartered accountants in the U.K. many of which are insurance specialists. In addition there are approximately 3,000 actuaries active in the United Kingdom, all of which are expected to maintain minimum levels of continuing professional training. Both professions have world class qualification and accreditation requirements and are seen as best practice resources by educators and professionals in many other countries. Again it is hard to imagine a better level of satisfaction of a precondition for effective regulation and supervision.

26. One idiosyncratic feature of the U.K. environment is that there is no insurance accounting standard. Instead there is a Statement of Reporting Principles (SORP), largely worked out by the insurance sector on a modified regulatory reporting basis, but informed by general company reporting requirements, and with no objection from the Accounting Standards Board (which in the U.K. has the right to issue standards on its own authority, although under the guidance of the Financial Reporting Council). As a general rule the ASB has taken a limited interest in the financial sector allegedly because of the major scope for disagreement over reporting principles: the assessors were advised that the imposition of IAS in the EU in 2005 will to a large extent supplant the ASB role and that the U.K. will then be in a position to enforce an appropriate modern approach, which is still evolving. The IASB is still engaged in resolving the contentious issue of the valuation of liabilities arising from insurance contracts. In the interim there is ongoing scope for there to be up to three different sets of accounts struck within the United Kingdom for a long-term insurer (regulatory, modified regulatory, and assessed value).

27. The auditing profession is also well established. External auditors need to be members of recognized supervisory organizations and remain eligible to be a member under the rules of that organization (leading to a practicing certificate). Recognized organizations have to ensure that all their members are ‘fit and proper’ and that audit processes are carried out in a professional manner and with integrity. The role of the external auditor is increasingly taking on a prevention and detection role and the FSA’s regulatory model seeks to build on this. The main coordinating body for the six U.K. accounting bodies, the CCAB, is a recognized supervisory body. The assessment team was not able to determine the level of performance of the internal audit function within the insurance sector; however, anecdotal evidence pointed to considerable variation in levels of competence and awareness of the risk based approach. A number of large insurers now employ distinct full time compliance teams with high level reporting lines.

28. A relatively unique aspect of the FSA model is its rejection of the twin peaks model where market conduct and prudential supervision fall under different regulators and/or supervisors. Thus many officers in FSA have a joint responsibility to consider the financial strength of an institution at the same time as they are ensuring that its customers are being treated fairly. This integrated role can potentially place substantial demands on FSA supervisors if other parts of government also make decisions which affect this trade off.

29. The regulatory environment is in a process of rapid transition with the consolidation of at least nine former regulators into an independent FSA. While the reasons for this are well known and well founded there is a need to ensure that the circumstances which have made the U.K., and London in particular, the insurance center of the world, are not fundamentally altered. Prior to the formation of FSA the key formal insurance regulators was DTI and subsequently HMT, in both cases advised by the Government Actuary’s Department (GAD). These were seen to have a light regulatory touch (although the informal rules were well understood by the market) and in practice the role of rating agencies formed a third, market based form of regulation, providing an additional effective influence on governance in the general insurance segment.5 This has been supplemented by the central role of the appointed actuary in the long term sector. Overriding all of this has been the growing governance roles of directors and managers, supported by the internal and external audit functions.

30. The U.K. authorities are in the process of strengthening their approach to insurance regulation along the lines of their risk-based approach to supervision. The creation of the FSA as a single regulator revealed significant differences between the supervision of insurance and other financial sectors regarding similar types of risk. The so-called Tiner project has been initiated to implement and take forward a risked-based approach to insurance supervision where regulatory attention focuses on firms and activities likely to pose the greatest risk to the achievement of the regulator’s statutory objectives. This has already been reflected in the inclusion of major life and non-life offices in the Major Financial Groups Division (MFGD) of the FSA which conducts integrated regulation and supervision of the most important market participants. The Tiner project also aims at improving the prudential and conduct of business regimes for insurers, notably an increased focus on the firms’ strategies, quality of management and systems and controls; an improved disclosure and financial reporting regime; and a more proactive prudential regime with less reliance on desk-based analysis of financial returns.

31. The U.K. easily satisfies the preconditions for a full assessment.

E. Principle-by-Principle Assessment

32. As to the main findings of the mission regarding insurance supervision, the key issue is that FSA’s interim regime presently lacks a sufficient degree of experienced on site examination capacity. In addition greater precision in defining what is required of management and boards is desirable as many smaller institutions in particular will not be familiar with modern risk management concepts. Thus, while the assessors agree that the FSA’s objective of placing more governance and internal control responsibilities on insurance firms’ boards and management is highly desirable, they strongly feel that more independent assessment of the effectiveness of firms’ systems and controls is warranted.

33. At present there is no guarantee that a sufficiently comprehensive review of the appropriateness of firms’ risk management systems, asset allocation limits, internal controls, capital and reserves, and reinsurance programs will take place in light of the nature and amount of business underwritten: this is particularly the case where bank based large groups containing significant insurers are involved, or bank supervisors have been given very large insurance based groups to supervise and assimilate. This skills requirement will become even more evident when the envisaged risk-based approach to supervision (together with fair value accounting) is introduced, as this will inevitably require the ability to review complex simulations using model offices. As a consequence, the FSA should take steps to ensure that the risk review team, on which the large group supervisors draw, formally contains (either as establishment or through a solid line matrix) specialist insurance expertise in areas such as reinsurance, actuarial modeling and long-tail non-life claims, in addition to generalist insurance people. Some of these skills are scarce (for example non life actuarial skills) and long term consulting or staff exchange programs may be appropriate.

34. In terms of the current interim supervisory model, the present desk-based analysis of returns does not appear to adequately capture the risks of underlying exposures, again largely because of the availability and disposition of the requisite skills. Consequently, the assessors are of the view that the IAIS CPs 5, 6, 7, and 12 are broadly rather than fully observed. The mission also confirms the authorities’ self-assessment that CP 13, as formulated, is materially non-observed, given the limited reliance on onsite inspections under the current practice, while the core principles call for detailed onsite reviews of books, records, accounts and other documents. By contrast the assessors feel that the standards achieved in the U.K. under the governance and market conduct CPs constitute very good examples of international best practice.

35. It is the assessors’ understanding that the FSA is currently in the process of rolling out new risked-based modalities for prudential supervision (and related market conduct supervision in the case of with profits contracts) of insurance markets and building the available insurance skills base. These actions are based on the findings of the Tiner report and will operate within the overarching risk based philosophy and methodology which has been developed in the last three years. This program is expected to remedy most of the noted shortcomings on the prudential side. As a consequence, the recommendations which appear below are intended to work within this new framework, while emphasizing the unique (and in many cases highly indeterminate) nature of many insurance balance sheet risks.

Table 7.

Detailed Assessment of Observance of the IAIS Insurance Core Principles

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