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P.K .

Gen er al Ma na ger
Punjab Nati onal Ban k
He ad Office, N ew Del hi
Outline of the Presentation

 Introduction to Risk Management and Overview

of Basel II
 Approaches to measure Credit Risk
 Credit Risk Management in Punjab National
 Benefits of moving to advanced approaches

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Need for Risk Management

 Globalization of Indian Economy

 Integration of global markets

 Competition from Foreign and Private Sector Banks

 Need to shift from demand driven to supply driven limits

 Bank should determine appetite for borrower based on his

risk assessment
 Risk Based Lending

 Improve and monitor portfolio quality

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Basel Committee on Banking Supervision-

 A committee of central bankers/ bank supervisors from

major industrialized countries like Belgium, Canada,
France, Germany, Italy, Japan, Luxembourg, the
Netherlands, Spain, Sweden, Switzerland, United
Kingdom and United States.
 BCBS has no formal supranational authority nor legal
 However IMF , World Bank, International Rating
Agencies, International Financial Institutions, etc use it as
a benchmark for assessment of the banks/ banking system

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Basel Accord – I (1988)
 Portfolio Approach – It focused primarily on credit risk and assets of
the banks were categorized into risk buckets with risk weights ranging
from 0% to 150%.
Particulars Risk We ight
Cash in hand, Balance with banks, Investment in
government securities etc
Money at call and short notices, Investment under
government guaranteed securities, Advances to 20%
staff members etc
Claim guaranteed by DICGC/ECGE 50%
Advance to public against Housing Finance 75%
Advances to corporates, claim on PSUs, SME
and Retail exposure etc.
Advances under consumer credit 125%
Advances covered under Commercial real estate 150%

 Minimum Capital Requirement – 8% of risk weighted assets only for

credit risk (9% by RBI)
 Based on 1988 accord, RBI initiated various actions for the banks like
classification of assets, provision norms, classification of asset class
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Need for a new frame-work
 Financial innovations viz derivatives and securitisation
etc. and growing complexity of transactions
 Requirement of more flexible approaches as opposed
to “one size fits all” Approach
 Requirement of Risk sensitivity as opposed to a
“broad- brush Approach”
 In last 8-10 years banking sector worldwide has seen
catastrophic losses which led to failure of some
established banks like Bearing bank and Continental

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Banking Risks
 Credit Risk
 Market Risk
 Liquidity

 Interest rate

 Foreign exchange

 Commodities and Equity

 Operational Risk

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Credit Risk
 Credit risk is defined as the possibility of losses
associated with diminution in the credit quality of
borrowers or counter-parties. In a bank’s portfolio,
losses stem from outright default due to inability or
unwillingness of a customer or counter-party to meet
commitments in relation to lending, trading, settlement
and other financial transactions.
 Alternatively, losses result from reduction in portfolio
value arising from actual or perceived deterioration in
credit quality.

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Market risk

 Market Risk is the risk to the bank’s earnings and

capital due to changes in the market level of interest
rates or prices of securities, foreign exchange and
equities, as well as the volatilities of those changes.
 The Bank for International Settlements (BIS) defines
market risk as “ the risk that the value of ‘on’ or ‘off’
balance sheet positions will be adversely affected by
movements in equity market and interest rate market,
currency exchange rates and commodity prices”.

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Market risk
 Liqu idit y risk : Liquidity risk occurs when Bank is not in a
position to pay amounts due to its customers/counterparties
or these are met by borrowing from the market at high cost.
 In ter es t Rat e Ri sk : The risk that changes in interest rates
will adversely impact the revenues and balance sheet.
 Fo rex ri sk -Risk that a bank may suffer losses as a result of
adverse exchange rate movements during a period in which it
has an open position.
 Equ ity /Commo dit y ri sk – Risk that a bank may suffer
losses as a result of adverse movements in equity/commodity
prices during a period in which it has an open position.

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Operational Risk
Basel Committee on Banking Supervision defines the operational risk
“Risk of direct or indirect loss resulting from inadequate
or failed internal control processes, people, systems or
from external events”

 Such breakdowns can lead to financial losses through

 Error

 Fraud

 Failure to perform in a timely manner

 Cause the interest of the bank to be compromised like

exceeding authority, conducting business in an unethical

or risky manner
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Examples of Operational Risk

Cause Definition
Internal Losses from failed transactions, client accounts,
Processes settlements and every day business processes.
People Losses caused by an employee or involving employees
(intentional or unintentional), or losses caused through
the relationship or contact that a firm has with its clients,
shareholders, third parties, or regulators.
Systems Losses arising from disruption of business or system
failure due to unavailability of infrastructure or IT.
External Losses from the actions of 3rd parties including external
Events fraud, or damage to property or assets, or from change in
regulations that would alter the firm’s ability to continue
doing business.

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Approaches to measure different risk
under new accord
 Approaches to measure Credit risk
 Standardized approach

 Internal ratings based (IRB) approach

 Foundation

 Advanced

 Approaches to measure Operational risk

 Basic Indicator Approach

 The Standardised Approach

 Advanced Measurement Approach

 Approaches to measure Market risk

 Standardised method

 Internal Model

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Approaches to Credit Risk
Management under Basel II
ADVANCED Banks use internal
estimations of PD,
INTERNAL RATING loss given default
BASED (LGD) and exposure at

APPROACH default (EAD) to

calculate risk weights
for exposure classes
FO UND ATION Banks use internal estimations
INT ERN AL RA TING of probability of default (PD) to
calculate risk weights for
BA SED AP PRO AC H exposure classes. Other risk
components are standardized.
Risk weights are assigned in slabs
STAN DAR DISED according to the asset class or are based
on assessment by external credit
APPR OACH assessment institutions


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Credit Risk: Standardised Approach

 Risk weights are assigned in slabs of 0%, 20%, 50%,

100% & 150% on the basis of rating assigned by
ECAIs. For example -- Claims on Sovereigns (or
Central Bank) – 0% to 150% risk weight on the basis
of country risk scores and at national discretion, a
lower risk weight may be applied.
 Claims on Corporates – will be risk weighted in the
range of 20-150% and unrated Corporates will be
assigned 100% risk weight.

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Credit Risk: Standardised Approach
RW for RW for banks
Foreign RW for
Ratings foreign Rupee
Currency Corporates
Sovereign Claim Claim
AAA to 0% Scheduled 20% 20% AAA
AA Banks 50% AA
A 20% 50% 100%
BBB 50% 20% 50% 150%
BB to B 100% 100% 150%
Below B 150% Others 150% 150%
Unrated 100% 50% 100%
RW as per RBI document.
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Off Balance sheet items under
Standardised approach
 The credit risk exposure attached to off-Balance Sheet items has to be first
calculated by multiplying the face value of each of the off-Balance Sheet items
by ‘credit conversion factor’ (CCF). This will then have to be again multiplied by
the risk weights attributable to the relevant counter-party as specified in previous
Sr. Instruments Credit
No. Conversion
Factor (% )
1 Direct credit substitutes e.g. general guarantees of 100
indebtedness (including standby L/Cs serving as
financial guarantees for loans and securities) and
acceptances (including endorsements with the
character of acceptance).
2 Certain transaction-related contingent items (e.g. 50
performance bonds, bid bonds, warranties and
standby L/Cs related to particular transactions).
3 Short-term self-liquidating trade-related contingencies 20
(such as documentary credits collateralised by the
underlying shipments) for both issuing bank and
confirming bank.
*** Above list is not exhaustive.

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Credit Risk Mitigants under
Standardised Approach
Eligible collaterals
 Cash or deposit with bank, Gold
 Securities issued by Central and State Governments
 Indira Vikas Patra, Kisan Vikas Patra and National Savings
 Life insurance policies ( up to surrender value)
 Debt securities rated by a recognised Credit Rating Agency having at least “BB”
rating when issued by public sector entities and at least “A” rating when issued
by other entities.
 Debt securities not rated by a recognised Credit Rating Agency where these are
issued by a bank, listed on a recognised exchange and classified as senior debt
 Equities included in main index.
 Mutual funds having publicly quoted daily prices.
 Irrevocable, unconditional guarantees issued by entities with a lower risk weight
than the counterparty.

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Four Key Risk Elements in IRB Approach
Probability of Default Lo ss Give n De fault
(PD) (LGD)
It mea su re s t he It m easu res t he prop ortio n
lik eliho od th at th e of t he expo sure that wil l
bor ro we r w ill def au lt be lo st if a defau lt occurs.
ov er a giv en tim e-
hor izon.
Exp osu re at Defaul t Maturi ty
(EAD) (M)
It me asu res the amou nt of It me asure s the re main in g
the faci li ty t hat is like ly to eco no mic maturity of the
be dra wn i f a defa ult occur s exposu re .

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Probability of Default (PD)

 Probability of default measures the likelihood that the

borrower will default over a given time-horizon i.e.
What is the likelihood that the counterparty will
default on its obligation either over the life of the
obligation or over some specified horizon, such as an
 For estimation of PD, PNB already has Risk Rating
System in place for the last 5 years and the history of
default rates is being tracked since then.

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Loss Given Default (LGD)

Loss Given Default is the credit loss incurred if an obligor of

the bank defaults.
 LGD = 1 – Recovery Rate

where, Recovery = Present Value of { Cash flows received

from borrower after the date of default - Costs incurred by
the bank on recovery }

Recovery rate = Recovery (as calculated above)/ Exposure on

the date of default

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Exposure at Default (EAD)


65 60

Sanctioned limits Loan outstanding Utilisation of unavailed Exposure at time of

limit in event of default default (EAD)
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Maturity (M)
 It measures the remaining economic maturity of the exposure.
 Determines framework for comparing different exposures.
Principal & outstanding balance 10000
Opening Date of Loan 01/01/2003
Contractual date of Maturity of Loan 31/12/2006
Contractual and Discount Rate of Interest 9.00%
Freq. of int. payment per annum 1
Tenor/Maturity (Years) 3
Time Period Cash Present Value of
in years flow Cash Flow (A) x (c)
(A) (B) (c)
1 900 825.69 825.69
2 900 757.51 1515.02
3 10900 8416.80 25250.40
Total ------------------------> 10000.00 27591.11
Economic Maturity = = 2.76
Internal Rating Based Approach
 Under the IRB approach, a bank estimates each borrower’s
creditworthiness and the results are translated into estimates of a
potential future loss amount, which forms the basis of minimum
capital requirement.

 Under this approach, the treatment of each exposure class (i.e.

corporate, bank, sovereign, retail & equity exposure) is based on
three main elements namely: -
 Risk components

 Risk weight functions

 Minimum requirements

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Internal Rating Based Approach
 The underlying concepts and approaches prescribed in IRB have
been developed based on credit risk measurement techniques
being used by sophisticated banks for ascertaining their capital
 The Capital required is derived from an estimate of potential
losses for a credit portfolio over one year time horizon with
99.9% confidence level.
 99.9% confidence level implies that there is only one chance in
1000 that the losses will be larger than the regulatory capital.
 The credit risk on an asset, reflected in UL & EL, increases as PD,
LGD, EAD or M increases.

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Foundation IRB Vs Advanced IRB
Foundation IRB Approach Advanced IRB Approach

Values for Loss given default (LGD) and Values for Loss given default (LGD)
exposure at default (EAD) are provided by and exposure at default (EAD) are
the regulatory authority. determined by each bank through
internal modeling with a data of 5-7

Assessment of values of credit mitigants is Banks may assess the value of its credit
done by the regulatory authority. mitigants.

For retail exposure, there is no foundation Advanced IRB is applicable to retail

IRB (only advanced IRB where besides exposure also.
PD, the bank concerned will have to
estimate LGD & EAD.)

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Expected Loss (EL)

 Expected Loss is the bank’s cost of doing business. Expected

loss has to be provided for.
 The Expected Loss (in currency amounts)
If expressed as a percentage figure of the EAD
EL = PD * LGD.
 The bank should also proactively incorporate an expected loss
rate in the estimation of the total spread to be charged on
the loan.
 Expected loss is not a measure of risk as it is anticipated.

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Unexpected Loss (UL)

 Regardless of how prudent a bank is in managing its

day-to-day business activities, there are market
conditions that can cause uncertainty in the amount
of loss in portfolio value.
 This uncertainty, or more appropriately the volatility
of loss, is the unexpected loss. Unexpected losses are
triggered by the occurrence of higher default rates as
a result of unexpected credit migrations.

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Expected V/s Unexpected Losses

6.00% Unexpected loss
Loan losses

4.00% 3.93%
3.52% 3.32%
2.21% 2.30%
2.00% 1.96%
1.21% 1.41%
1.00% Expected loss 0.56%
0.44% 0.27% 0.42%
1 2 3 4 5 6 7 8 9 10 11 12 13 14

Time (Year)
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Capital Requirement under IRB
Borrower Transaction
Internal Rating Collateral Maturity

Probability of Loss Given Maturity

Default (PD) Default (LGD) (M)

Capital = Exposure at Risk

X X 9%
Requirement Default Weight

[LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 * G

- PD * LGD] * (1 - 1.5 x b(PD))^ -1 × (1 + (M - 2.5) *
b (PD)
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Risk Weight function
Standard normal Inverse of the Inverse of the
distribution (N) standard normal
applied to
standard normal
threshold and distribution (G) distribution (G)
conservative value applied to PD to applied to
of systematic derive default confidence level i.e.
factor threshold 99.9% to derive
conservative value
of systematic factor

= [LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 *

G (0.999)]
- PD * LGD] * (1 - 1.5 x b(PD))^ -1 × (1 + (M - 2.5)
* b (PD)
Expected Asset Maturity Smoothened
Loss (E.L.) Correlation (regression)

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Minimum Criteria for IRB Adv Approach

To be eligible for IRB Approach a bank must demonstrate to its

supervisor that it meets certain minimum requirements at the
outset and on an on going basis. These include:
• A robust rating system comprising all of the methods,
processes, controls and data collection and IT systems that
support the assessment of credit risk, the assignment of
internal risk ratings, and the quantification of default and loss
• Risk rating system operations which includes Coverage of
ratings, Integrity of rating process, overrides based on expert
judgement, Data maintenance and use of stress tests in
assessment of capital adequacy.

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Minimum Criteria for IRB Adv Approach

• Corporate Governance and overseeing of risk management by

Board of Directors/Top Management
• Use of Internal ratings and default and loss estimates in credit
approval, risk management processes, corporate governance
functions etc apart from using them in capital calculations
• Risk quantification covering definition of default,
requirements specific to estimations of PD, LGD and EAD
• Robust internal control systems for risk management and
validation of the models used, internal estimates of risk inputs
viz. PD, LGD and EAD etc.

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Set Up for Management of Credit Risk

Developing Migration Implementation Periodical Conducting

SYSTEM and Analysis of Preventive portfolio various
& implementing and Default Monitoring review analysis
MODELS credit risk Rate System
models Analysis. (PMS)

INDUSTRY Preparation of Liaison with external Monitoring industry

scenarios of various agencies for wise profile of the
industries updating the industry bank
GROUP profiles.

INDUSTRY Approval of rating of borrowers falling under

DESK HO powers

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Implementing Standardised Approach
 RBI has advised banks to start parallel run of
“Standardized Approach of Credit Risk” w.e.f.
 This require system for categorisation of assets as per
Basel II and for collating data of credit risk mitigation
techniques i.e. details of primary/collateral securities.
 System should also be able to consolidate Risk
Weighted Assets and arrive at the required capital
charge for credit risk..
 Bank has implemented the system and parallel run as
per RBI guidelines has since been started.

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Implementing Foundation IRB approach

 All eligible credit exposures beyond a threshold limit

of above Rs 20 lacs are risk rated through internal credit
risk rating models.
 Default Rates for last five years generated. The default
rates are satisfactory and comparable with international
 Migration of ratings analysed since last four years.
 In addition to Default rating, Facility-rating is being

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Implementing Advanced IRB approach

 Data requirements as well as features of application

tools for Risk Management finalized.
 A data warehouse is being established which will have
application tools also.
 The gaps in the existing systems for adoption of Basel
II are being identified.
 Goal is to adopt IRB advanced approach by March
2010, subject to RBI approval.

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Annual Average Default rates as at 31.03.2006
Rating Large Mid Combined*** Small Loan A/Cs
Corporate (5 Corporate Three year Two Yr. Average
years average (3 year Average DR(%) DR(%) for 2005-
DR) % average DR) for 2004-06 06
AAA 0.00 0.00 0.00 0.00
AA 0.00 0.00 0.00 0.00
A 0.18 0.78 0.40 0.59
BB 0.64 0.88 0.77 0.90
B 0.91 4.03 2.35 1.96
C 6.44 8.16 6.40 3.60
D 14.96 12.82 13.21 11.93
Total 1.91 2.06 1.72 1.25
***Large & Mid Corporate
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Validation of rating models
GINI Coefficient
X Actual
Ideal Y
B rating
90 C rating
BB rating

70 A rating

50 D rating
AA rating
20 Random
GINI Coeff ici ent
0 =
10 20 30 40 50 60 70 80 90 100

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Probability of default of PNB Vs Crisil
CRISIL Exponential
Probability of Default

4.00% PNB
Actual 0.03% 0.09% 0.40% 0.77% 2.35% 6.40% 13.21%
Exponential 0.04% 0.10% 0.28% 0.77% 2.14% 5.94% 16.47%
CRISIL 0.00% 0.00% 1.01% 3.47% 15.85% 30.30% 28.57%

Rating Grades

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Comparative average annual default rate
(Up to 31.03.06)
AAA 0.00 AAA 0.00 Aaa 0.00 AAA 0.00
AA 0.00 AA 0.00 Aa 0.02 AA 0.00
A 0.40 A 0.06 A 0.00 A 1.01
BB 0.77 BBB 0.18 Baa 0.15 BBB 3.47
B 2.35 BB 1.06 Ba 1.29 BB 15.85
C 6.40 B 5.20 B 6.81 B 30.30
D 13.21 C 19.79 C 24.06 C 28.57
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Impact of Basel II on Capital Requirement
Existing Standardised
Approach -
Particulars Basel II
Total Capital (A) 12831.85 12831.85
Min. Capital Requirement (@ 9%) (@ 9%)
Credit Risk 8001.22 7813.69
Market Risk 1075.90 1075.90
Operational Risk 0.00 855.90
Total Capital Required (B) 9077.12 9745.49
CRAR = [(A)/(B)]*0.09 12.72 11.85
Risk Weighted Assets
Credit Risk 88902.46 86818.76
Market Risk 11954.44 11954.44
Operational 0.00 9510.03
Total Risk Weighted Assets 100856.90 108283.23
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Road Map for Basel II Implementation
Approach RBI’s Indication Bank’s Preparedness
Credit Risk
Standardized 31.03.08 Parallel run started w.e.f 1.4.06
IRB Foundation Not Indicated March 2009 (Subject to RBI approval)
IRB Advanced Not Indicated March 2010 (Subject to RBI approval)
Market Risk
Standardized 31.03.06 Already implemented
Internal Risk
Model Method Not Indicated March 2008 (Subject to RBI approval)
Operational Risk
Simple approach can be implemented
Basic Indicator 31.03.08 immediately (Subject to RBI approval)
Standardized Not Indicated March 2009 (Subject to RBI approval)
Advanced Not Indicated March 2010 (Subject to RBI approval)

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Benefits of moving to Advanced approaches

 Relief in Capital Charge

 Risk based Pricing – focus on identified business
areas. Competitive pricing in niche areas.
 Image/Prestige
 International recognition/benefits in dealing with
Foreign banks
 Risk Control

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Areas requiring attention of Auditors
 Banks must correctly classify the assets into Sovereign, Banks,
Corporate, Retail and Equity asset classes.
 Banks must have used data of at least 5 to 7 years in various
models for estimation of various risk components (viz., PD, LGD,
EAD and M).
 Banks must have robust systems in place to evaluate the accuracy
and consistency with regard to the system, processing and the
estimation of PDs.
 Banks must use proper credit risk mitigants in capital calculation.
 Banks must have a credible track record in the use of internal
ratings at least for the last 3 years. Banks must disclose in greater
detail the rating process, risk factors, validation etc. of the rating
system. Internal and External audit must review annually, the
banks’ rating system including the quantification of internal
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Areas requiring attention of Auditors
 Banks must use appropriate risk weights against the asset classes.
 Banks must update the credit risk rating at least on annual basis.
 Banks must have adequately qualified and trained staff for rating
 Banks must compute the default rates on regular basis and these
should be validate at regular intervals.
 Banks must have in place sound stress testing process for the
assessment of capital adequacy.
 Internal rating must be explicitly linked with the banks’ internal
assessment of capital adequacy in line with requirements of Pillar

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Thank you and Happy New Year

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