Chapter 2: Literature Review
Introduction
The chapter consists of all the relevant information that can be collected from past studies and are combined to present a clear view. It is the initial for determining the factors that can be used to synthesize the overall study through findings and discussion. The positivist approach is used to collect and summarize the information from the previous studies and determine the model that can be used to conduct a viable study. The positivist approach emphasizes all the relevant information regarding the topic that is to compare Islamic and Traditional banks using data envelopment analysis. The theoretical framework is presented to provide a brief statement of keywords used in this chapter. The material or data is collected from past studies to determine their relevancy for the project. A conceptual framework is included in the chapter to elaborate concepts that are extracted from past studies. Also, the conceptual framework has clarified some important facts that are discussed in the researches and has relevancy with the topic. A brief summary is presented at the end of the chapter to present a clear understanding of the work done in this chapter. All the areas are covered in this chapter by dividing them into subsections and headings that can present a concise and precise view of the reader. These areas are covered with the important things that are considered crucial and beneficial for the study.
Theoretical Framework
The key terms are used in this chapter that is discussed briefly in this section. These definitions are taken on account of their relevancy with the study. The definitions and concept are selected as they contain sufficient information that should be easily understood by the reader.
Data Envelopment Analysis
Data envelopment analysis is a method to assess the performance of production frontiers. It is used to measure the productive efficiency of an organization. The analysis is helpful in identifying strengths and weaknesses in a production process of an organization. Analysts use this tool to identify that the business unit is providing expected outcomes or there is a need to bring a change in the overall process (Mousa, 2015).
Islamic Banking
It is the system that consists of Islamic principles and laws also known as Shariah. It also includes sharing of profits and loss as well as the prohibition of receiving or paying interest. Islamic countries are now adopting this banking system to reduce the interest factors from the economy that is prohibited in Islam. It was formed to facilitate the Islamic users who are willing to do transaction free from any interest (Srairi, 2013).
Traditional Banking
It refers to the ordinary banking institution that accepts deposits, offers loans, makes investments, and provides certificates of deposits and other basic investment products (Youssef & Samir, 2015).
Investment Risk
Investment risk is also known as the probability of losses that may occur in future and is associated with the return on investments. There may be external risks that may result in the obstacle of growth in that particular investment (Abd. Majid, Musnad, & Purab, 2014).
Financial Crisis
Financial crisis is a broader term of the critical circumstances in which the nominal values of some financial assets suddenly diminish to a great extent. It put an adverse effect on the financial market, and the financial institution suffered a huge loss even move towards bankruptcy. The huge financial crisis was noticed in 2008 when big financial institutions were damaged.
Past Studies
Adoption of Online Banking is Islamic Banking System
Dalhatu (2014) states that Islamic banking has entered into innovation that is providing online services to its worldwide customers. They are also adopting online services to gain competitive advantage and provide efficient and reliable services to their customers. High customer satisfaction is the priority of any banking system working in a competitive environment (Dalhatu, 2014). Abedifar, Molyneux, & Tarazi state that according to the norms of Islamic ethics, only the wealth, the source of which is own work and entrepreneurial efforts of its owner, as well as an inheritance or gift, is righteous. Also, the profit is the reward for a reasonable risk associated with any business venture . Lodh & Nandy (2008) also states that growth is expected in the banking industry of developing and emerging countries due to the adoption of e-banking system. The system is being implemented by Gulf countries to obtain their short-term and long-term objectives. These countries now intend to strengthen their financial institutions and ensure growth in the capital and financial market (Lodh & Nandy, 2008).
Abd. Majid, Musnadi, & Putrab states that significant difference is in more passive operations of Islamic banks with securities. Modern banks become active participants in the financial market, which is often detrimental to the real economy. Regarding project financing, Sukuk is one of the most popular products. It is also sometimes referred to as Islamic bonds, although the correct comparison would be with the certificates of participation. This is essentially the securitization of investment projects. In the world of Islamic finance, the amount of Sukuk accounts to 11.3%. Sukuk is interesting to small companies engaged in capital-intensive industries. So it makes sense to issuers to consider this type of investment as the market diversification of raising capital .Srairi (2013) explains that Islamic banking emerged in Egypt in the early 60-ies of the previous century. In fact, it was the peasants’ mutual aid, organized with the participation of the economist Ahmad Al-Najjar, who later established the Mit Ghamr Bank. Ahmad Al-Najjar had experience in West Germany, and the German model of mutual funds Sparkasse also influenced him. Almost simultaneously savings fund for the accumulation of funds for the pilgrimage to Mecca appeared in Malaysia. In the United Arab Emirates, the first Islamic Bank Dubai Islamic Bank was established in 1975. Muslims do not accept the Western banking also because often the bank does not control the use of capital, the borrower can use it in any way, for example, engaged in the production of alcohol, which is strictly prohibited by Islam . Almumani concluded that based on the analysis of transactions of Islamic banks and conventional banks in the West, these types of financial intermediaries have both similarities and differences. Both types of banks are engaged in a more efficient reallocation of capital in the economy. However, this role they perform in various ways .
The Use of Data Envelopment Analysis
Mousa (2015) states that data envelopment analysis is used to measure the productive efficiency of business for decision making. It does not involve figures or calculation, but it considers the areas of production frontier to determine the efficiency level of an organization. Also, it is used to determine the efficiency of financial institutions divided into two groups named Islamic banking and traditional banking (Mousa, 2015). AlKhathlan also states that it is the best approach to determine the efficiency of Islamic banking as compared to conventional or traditional banking. The efficiency of Saudi Banks is determined by using it (AlKhathlan, 2010). Almumani (2013) explains that it is the only approach that resulted in identifying the relative efficiency of Saudi banks as compared to others located in different states or cities. The result determined that the efficiency of Islamic banking is relatively high than the traditional banks (Almumani, 2013). Srairi explains that data envelopment analysis is useful in identifying the efficiency of Islamic banks as compared with traditional banks in MENA countries. It is the best tool or method that does not concerned with statistical figures and facts but it focuses on the performance of financial institution with refer to their management and control .
Efficiency of Banks
Sillah & Harrathi (2015) state that on a constant scale, there is no indication that Islamic banks are inefficient as compared to conventional banks. The data was collected from 28 conventional and 20 Islamic banks from six countries. The results showed that there is no difference in the outcome of the two types of banks except they are measured on the assumption of a variable return to scale. Islamic banks still have three sources of income, as well as Western banks. The first source of income for the Islamic banks is in such operations as “Musharakah”. Musharakah is the Islamic way of cooperation in the financial sphere, when the two sides pool their capital for financing a project, with the profit they share in a predetermined order, but losses depending on the equity. The second source of profits of the Western commercial banks (transactions in the financial market) exists for Islamic banks, but in a more limited way. For example, if a bank acquires shares for the preservation of its assets, that is, using the shares to invest in them their money, then there’s nothing forbidden from Islam here. In this regard, Islamic banks are mainly engaged in long-term investments. As for the third source of profits of Western banks (commissions), its share of the revenues of an Islamic bank is especially great. There are many transactions that Islamic banks operate at a profit in the form of commission (Sillah & Harrathi, 2015). Mousa (2015) argues that it is not essential that all the Islamic banks provide similar results about efficiency as it varies by financial management of banks. It is mandatory to analyze the efficiency level while considering all factors rather than to focus on financial ratios. There is a big difference hugeween the two types of banks, and no evidence is found that Islamic banks are more or less efficient in providing potential returns to the stakeholders. Comparing Islamic banks with commercial banks in Western countries, the issue of bank interest should be resolved at first. Economists interpret loan interest in different ways. However, almost all of them agree on the definition, according to which the interest is a payment received by the creditor for the use of money given the loan. But Islamic banks also consider the opportunity to collect payment for the funds. However, it is possible that in certain country or region, Islamic banks are performing more efficiently than traditional banks depending on the type of people living in it (Mousa, 2015). AlKhathlan (2010) also states that Saudi banks are efficient in managing their financial resources on a relative scale. The study conducted to analyze the performance of Saudi bank in comparison with others revealed that they are efficient in satisfying the maximum requirements of their major stakeholders. Western economists give some arguments for interest. For example, in their opinion, the loan interest is an incentive for the implementation of savings and investments. It helps to assess investment decisions more accurately, and finally, the state uses the interest rate as one of the flexible mechanisms of regulation of monetary circulation and the whole economic system. (AlKhathlan, 2010).
Youssef & Samir (2015) states that there is no difference in variables between traditional banks and Islamic banks. Also, the efficiency of the two banks is not different from each other while having an absence of interest rate in Islamic banks. The empirical study proved that the outcomes and financial position of the two banks are not affected by the changes in the operation functions of business (Youssef & Samir, 2015). Panah, Ahmadanuar, & Norhan (2014) state that labors and deposits are best input while loan and investments are best output in Islamic banking. It represents that the input and output of Islamic banking are more efficient than traditional banking due to the effective management of financial resources and investments. (Panah, Ahmadanuar, & Norhan, 2014). It also explains that there is no difference in stability and reliability of business between the two banks. The long-term profitability and stability of the business are unaffected due to the effective management of assets. Srairi (2013) states that the ownership structure and risk taking the behavior of Islamic banking is better than traditional banks according to the study of MENA countries. The main thing is the risks management of Islamic banking that had proved to be effective at the time of recession when its efficiency was not disturbed by the financial crisis worldwide (Srairi, 2013).
Asset Management
Abd. Majid, Musnadi, & Putrab (2014) state that asset management is essential in maintaining stability and reliability in financial institutions. Islamic banking is different from traditional banking, so there is an excessive requirement to maintain best asset management and ensure potential outcomes. However, the asset management of Islamic banking is better than the traditional banking due to the investments in less risky projects (Abd. Majid, Musnadi, & Putrab, 2014). Dalhatu also provides a clear evidence of asset management and adoption of technology in Islamic banking. It clarifies that Islamic banking invest in new techniques to generate potential revenues rather than focusing on huge investments (Dalhatu, 2014). Abd. Majid, Musnadi, & Putrab (2014) provide evidence that the asset management of Islamic banking is effective that it cannot be affected by any crisis. The investments in less risky projects and control on the utilization and purchase of securities are the main reason for the strong financial structure of Islamic banking (Abd. Majid, Musnadi, & Putrab, 2014). The asset management of the financial institutions are effective but due to the development of Islamic banking, it is noticed that the performances of Islamic banks are better than traditional banks. Panah, Ahmadanuar, & Norhan (2014) also states that input and output in the Islamic banks ensure that they have potential to grow in future by controlling and managing their short-term and long-term assets (Panah, Ahmadanuar, & Norhan, 2014).
Financial Crisis
Derbali (2015) states that financial crisis of 2007 was a great recession that resulted in the bankruptcy of different banks located in various parts of the world. However, it did not affect the profitability and growth of Islamic banks (Derbali, 2015). Farooq & Zaheer (2015) also state that Islamic banking is unaffected by the financial crisis as evident from the great recession in 2007-2008. In fact, Islamic banks were providing more loans to the customers to improve their financial position. It was an unusual situation in which Islamic banks were on a winning side, and there was no evidence of shutting down of any Islamic bank (Farooq & Zaheer, 2015). Panah, Ahmadanuar, & Norhan state that a general deterioration of financial conditions in the world during the financial crisis has led to the fact that Saudi banks (as well as banks in many other countries) experienced a reduction of liquidity and narrowing the interbank lending market. The peak of the liquidity problems occurred in October 2008, when the volume of the interbank market, compared with the beginning of the year fell by half, and liquidity ratio fell to less than 1%. Even taking into account the seasonality of certain trades in the interbank and bank liquidity, these indicators may be called critical . Beck, Demirgüç-Kunt, & Merrouche state that during the global financial crisis, the banking sector of the national economy of the Muslim countries has shown surprising resilience because of the restrictions imposed on them according to the norms of Islam; therefore, Islamic banks may become a source of investment in the world economy. An attractive element is that the high stability of the entire banking system is provided because the goods or services that are used as cash flow corroborate all debt agreements. Also, Islamic banks’ conservative approach to business, restraint in stimulating growth, focus on the business, which is the basis for the efficient functioning of the banking sector, domestic market-oriented, are considered as a naturally created shield screen protecting against potential losses .
Low Risk
Almumani (2013) states that Islamic banks usually invest in the low-risk project and ensure that potential outcomes are expected in future. The investment strategy of Islamic banks is different from others due to the absence of interest and markup. Overall, Saudi banks have tried to minimize the risks associated with a lack of liquidity, bringing the structure of assets and liabilities in a better balance. In particular, the share of bank assets for over one year decreased from 43 percent to 33 percent while the share of assets for three months to one year increased from 15 percent to 26 percent. These banks provided loans at low return due to the less risk involved in those investments (Almumani, 2013) Abedifar, Molyneux, & Tarazi (2013) also state that Islamic banks offer sharia-compliant financial products to its customers, and they charge low rents from their customers. The main reason for reducing the liquidity of the banking system was the gradual increase in the mandatory reserve requirements for funds on current. This measure was aimed at fighting inflation, which began to grow in the conditions of extreme flow of petrodollars caused by rising energy prices. The sharp decline in the liquidity of the system, as well as the actual suspension of long-term loans under the presence of large-scale investment programs in the Kingdom, have forced financial agency of Saudi Arabia to lower interest rates on REPO and reserve requirements. It is also observed that the loan quality of Islamic bank is less responsive to domestic interest rates in contrast to conventional or traditional banks (Abedifar, Molyneux, & Tarazi, 2013). Srairi (2013) also explains that the risk-taking the behavior of Islamic banks is well managed and developed by their management, and there is, and this is the main reason for the strong financial structure of Islamic banks. It is evident from the financial crisis of 2007 when only Islamic banks were unaffected by the external factors, and the main reason was the investment in relatively low-risk projects that is ignored by the traditional banks. This led to the normalization of the situation with bank liquidity. However, the authorities failed to maintain the growth rate of domestic enterprises lending and restore the share of long-term loans in the total amount of outstanding loans, like banks for obvious reasons have become more careful in conducting credit policies (Srairi, 2013).
Youssef & Samir elaborates that Islamic banking has spread in the modern economy, since, first, it is more conservative and more reliable compared to conventional, there is much less risk of losing savings, which is convenient and important for the average consumer. Secondly, for the consumer (including investors) the importance of the organization’s financial affairs in a manner ethical increase . Dalhatu states that the rise of Islamic banking due to the preferences of investors wishes to invest properly in an ethical sense and regarding risk management. It is not related to issues of religion: the investors and customers of Islamic banks in the majority or a significant part are non-Muslims. Ethical banking is quite a phenomenon. There are financial institutions acting on biblical principles, although they are less well known .
Interest Factor
Youssef & Samir (2015) explains that although there is an elimination or low-interest rate in Islamic banks, it does not affect their profitability and stability. The efficiency of banks remains stable due to the effective management techniques and tools to invest in less risky projects and satisfy the demands of customers. Abedifar, Molyneux, & Tarazi states that considered banks have written off against the allowance for possible losses on loans to more than 1.3 billion dollars of bad debt, which corresponds to 50 percent of the volume of bad debts at the end of 2011. Also, the experience of other countries indicates the probability of lending practices. Nevertheless, in the short term, the banking system in Saudi Arabia seems stable and the risk of systemic problems in the course of the next years is assessed as low, compared with other Arab countries . AlKhathlan states that Western economists give some arguments for interest. For example, in their opinion, the loan interest is an incentive for the implementation of savings and investments. It helps to assess investment decisions more accurately, and finally, the state uses the interest rate as one of the flexible mechanisms of regulation of monetary circulation and the whole economic system. The growth of these banks is attributed to the efficient response to the external factors and risks that may put a direct impact on the operational activities .
Abd. Majid, Musnadi, & Putrab (2014) explains that the return is relatively low from the investments in Islamic banking as compared to traditional banks. Islamic banks generate profits from rents and other operational activities and maintain their financial stability to gain competitive advantage. All transactions of Western commercial banks can be divided into two major groups: loan and commission transactions. Loan transactions include passive and active banking operations. The essence of passive operations is to attract funds, mainly in the form of deposits of households and legal entities, as well as through loans from other financial institutions. Active operations of commercial banks mean the use of accumulated funds to issue loans or buy securities. The second group includes such operations, which the bank carries out on behalf of clients for a commission (money transfers, documentary credit transactions, foreign exchange, etc.). Profit from Western banks has, therefore, three main sources. Firstly, the bank receives income from the difference between the interest rate, at which it attracts loans and interest, at which it grants loans. Secondly, the bank makes a profit from operations in the financial market in securities and currencies. Finally, part of the banking income is generated by commission payments from customers. The comparison of Islamic banking and traditional banking shows that the efficiency level of Islamic banking is higher as compared to traditional banking due to less involvement of risk factor and potential return on investments (Abd. Majid, Musnadi, & Putrab, 2014). Abdul-Majid, Saal, & Battisti also claim that the bank’s profitability does not solely depend on the interest rate as there is evidence from the Egyptians bank that had made huge profits while following Islamic banking system. The activity of Islamic banks is characterized by the prohibition of interest (riba), which is a major difference between Islamic and traditional banking activities. Islam prohibits riba because the interest is a form of exploitation, incompatible with the notion of justice. This means that the pre-establishment of a positive rate on the loan as a consideration for the use of borrowed funds is not allowed. (Abdul-Majid, Saal, & Battisti, 2010).
Mousa states that the fixed interest rate has some drawbacks. Primarily, these deficiencies are manifested regarding unexpected inflation. At the conclusion of the agreement between the Islamic bank and its client (borrower), the first is not important to try to guess the future rate of inflation, to lay the inflation rate in the size of the nominal interest rate (taking into account the effect of Fischer). After all, Islamic bank profits are not as the interest rate on the amount borrowed, but as part of the profit from the project, which it sponsored. Youssef & Samir explains that it should be noted that the percentage of defaults of loans in Islamic banks tend to zero. It is due both to the nature of the relationship between the bank and the customer, as well as moral and ethical component, which is the desire of the borrower to repay the debt as soon as possible .Abd. Majid, Musnadi, & Putrab claim that the fixed interest rate has some drawbacks. Primarily, these deficiencies are manifested regarding unexpected inflation. At the conclusion of the agreement between the Islamic bank and its client (borrower), the first is not important to try to guess the future rate of inflation, to lay the inflation rate in the size of the nominal interest rate (taking into account the effect of Fischer). After all, Islamic bank profits are not as the interest rate on the amount borrowed, but as part of the profit from the project, which it sponsored .
Growth in Islamic Banking
Mousa states that Islamic banks have entered the European market. So, in 1978 in Luxembourg the first Islamic bank in the Western world – Islamic Finance House – was opened. Then, Islamic financial institutions have appeared in the UK, France, Germany, Belgium, Holland, the USA and Canada . Panah, Ahmadanuar, & Norhan state that in the United Kingdom and the United States amendments to the existing legislation were adopted, authorizing Islamic banks to carry out transactions using special tools. It was quite difficult to do since the banking legislation of these countries was one of the most sophisticated and complex in the world, and there were fears that the amendment relating to Islamic finance would destroy the integrity of the existing legislative framework . However, this did not happen – laws, defining the principles of Islamic financial institutions on the territory of these states, quickly found their place in the legislative field of English law and continue to function normally .
Dalhatu (2014) states that the Middle East and Malaysia are the world’s largest centers of Islamic banking. Almost 400 Islamic financial institutions can be found in 58 countries. The undisputed leaders in the dynamics of development of Islamic banking are the countries of the Gulf Cooperation Council (GCC), namely Saudi Arabia, Kuwait and Bahrain with approximately 49%, 45% and 28% market share correspondingly . Srairi states that other countries are in the process of drafting legislation and Islamic financial institutions operate within the existing legal framework. In three Muslim countries, namely Sudan, Pakistan and Iran, only Islamic financial institutions currently operate. After Saudi Arabia showed one more year of encouraging outcomes, its banking sector is arranging itself to benefit from the state’s expansionist fiscal strategy and the huge amount of projects it has formed. Meanwhile, prospects in other fields of the lending background are being discovered, most remarkably among the country’s smaller companies. Traditional industries, such as the percentage of banking, insurance and transactions in the financial markets in these countries are prohibited . Lodh & Nandy state that Modern Islamic Bank is an independent financial institution, satisfying customer needs and ensuring the growth of shareholder returns. Of course, the economy is in its essence cannot be Islamic, Christian or Buddhist. But confessional basis largely determines the systems and mechanisms of doing business, performing a kind of “code of honor” of the businessman. The main feature of Islamic banks is that they do not attract deposits and do not disburse loans at interest .
Conceptual Framework
Islamic banking is different from conventional or traditional banking as there are many differences in operations of the two types of banks (Youssef & Samir, 2015). A big difference is that there is no interest in Islamic banking. Islamic banking was introduced to bring changes in the financial sector and align it with the principles and laws of Islam. As the questions arise whether Islamic banks can perform better than traditional or conventional banks or they are less efficient (AlKhathlan, 2010). The data envelopment analysis is useful to determine the efficiency of the operations of Islamic bank in comparison with others. There is a lot of evidence for the increasing efficiency of Islamic bank in UAE and especially Saudi Arabia. It should be noted that from a formal point of view, the banking sector in Saudi Arabia has not yet been faced with deteriorating loan portfolio quality (the proportion of bad debts in the sample was 1.3% for the loan portfolio). At the same time, some indicators suggest that the actual quality of the loan portfolio significantly worse. The growth is seen in the financial sector of the region irrespective of the fact that they do not charge interest (Srairi, 2013). However, Saudi banks have a better financial management structure that is effective in managing and controlling all the functions and helpful in deriving potential profits (Sillah & Harrathi, 2015).
A continuing procedure of governing reform and strong rivalry continue to explore challenges to the Saudi Arabia’s banks. However, fundamental stability relates to that they can be undertaken from a position of power. The Kingdom’s vigorous economy is the major aspect empowering the flexibility of the banking industry. An additional source of power is its exciting development, which has comprised stages of a noteworthy challenge from which the industry has come back with improved robustness.It can be observed that interest rate does not put a direct impact on the profitability and reliability of banks. The main thing is to maintain stability and strengthen operational activities by investing is less risky securities (Abedifar, Molyneux, & Tarazi, 2013). It can be noticed that Islamic banking performs better than others during a recession, and they issue more loans to the customers during a financial crisis. Due to the digitalization of the world, banks should invest in online banking and digital channels’ development to attract more customers and increase profits. The last, but not the least is that Islamic banking faces the lack of skilled staff, so it is necessary to provide with the indicators of Islamic banking growth within the world and the assessment of Islamic banks’ difficulties in foreign states .
Summary
The chapter reveals that there is a big difference between traditional banks and Islamic banks. It can be seen that Saudi banks are more efficient than conventional banks due to the potential control over its financial resources that can be utilized to generate high profits. The interest rate is considered in traditional banks while Islamic banks consider rent of the assets that is acquired by the individuals or organization. However, there are few banks that are not showing adequate efficiency due to their ineffective management, external environment, or lack of financial resources.
Overall UAE banks are efficient that shows this sector has potential to grow and provide high returns in the long run. The data envelopment analysis reveals that Islamic banks are performing better than traditional or conventional banks on account of their potential asset management. Also, there is no effect of a financial crisis on Islamic banks as they invest in the less risky projects, and there is no interest. It could be observed that the growth is expected in Islamic banks due to low investment risks and high returns. The current segment progressed from the simple banking sector, which occurred in the first half of the XX century, included a network of native money exchangers and a minority of international banks that provided with a reasonably small trade community. The prompt increase of oil manufacture in the years after the World War II established the procedure the economic change, which has recognized the country as the local economic center that Saudi Arabia’s banking sector is nowadays. Moreover, Islamic banks are also performing well in other countries like Egypt and Oman. They are moving towards improvement in this sector so that potential returns can be ensured and stability can be brought to the overall operations of banks.
It was vital to study the principles of functioning of Islamic and conventional banks, understand their main features and find similarities and differences if available. Through the analysis of secondary data within books, peer-reviewed journals, financial magazines and state websites many important things were found. The main finding was that one of the advantages of Islamic banking sector of the economy as a new product on the market of banking services is the system to participate in the profit and loss statement, taking the place of traditional percentage. This approach promotes the inclusion of large sections of the Muslim population in the country’s financial system, increase in savings rates and enhancing entrepreneurship in Islamic countries. Islamic banks have succeeded in integrating population into a development of the country, having accumulated significant contributions to the capital. Islamic banks are focused mainly on small and medium businesses. They operate in industries, where the state cannot provide with financial support. The success of Islamic banks requires developing its method of accounting, as the modern Western technique is not quite precisely reflects the results of the functioning under the Islamic canons. Often the implementation of operations by the principles of Islam can be very inefficient if the Western method of accounting is used. A more serious and profound problem is in overcoming the stereotypes existing in the social psychology of many countries, in the form of work of client with his/her bank. These stereotypes were formed under the influence of Western banking traditions, certainly prevalent in the world.
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