EconSouth (Second Quarter 1999)

Exterminating the Y2K Bug in Banking

ow do you plan to spend Dec. 31, 1999? Not so long ago, many people believed that the eve of the Year 2000 would represent the largest party the world had ever seen. Now, however, some people are thinking about anything but partying.

Why? The answer lies with a once small bug that has grown into a very large pest. This pest, referred to as the Y2K or millennium bug, was given little, if any, thought in the early computer age in the 1950s. Today, however, large and small businesses and governments are spending what some experts have estimated to be as much as $300 billion worldwide to exterminate the bug.

Since virtually all of the world's major power, communications, transportation and banking systems are now controlled by computers, many of which are linked together, the stakes in the race to exterminate the Y2K bug are extremely high. The stakes are so high, in fact, that some people are literally heading for the hills, stockpiling food, fuel and cash.

But are these alarmists basing their Y2K perceptions on hard facts, including the large-scale preparations that are under way to address the problem, or on sensational fiction from magazine racks at the local supermarket's checkout line? To answer this question, it helps to understand the problem, its origin and, more importantly, some of the efforts going into addressing the problem, particularly those of the U.S. banking system, which is a keystone of the U.S. economy.

How did we get here?
Simply put, the Y2K problem is the risk that computers will read the two-digit date code "00" as 1900 instead of 2000. The problem stems from a computer programming convention from the punch-card era that abbreviates dates by their last two numbers.

The reason the two-digit code was created in the first place was to conserve computer memory, which was substantially more expensive back in the dark ages of computer technology. Companies ran programs on enormous, and enormously expensive, mainframe computers that they leased or bought by the byte. According to the Gartner Group, an information technology consulting firm, one megabyte of magnetic disk storage in 1965 cost approximately $750 compared with about 75 cents today.

The code is still around today because computer software has proved to be surprisingly durable. Following the maxim "If it ain't broke, don't fix it," many organizations are still relying on computers and software that have not been replaced or updated to be Y2K compliant, and this hardware and software may not function effectively, or at all, beginning Jan. 1, 2000.

With the ultimate expiration date rapidly approaching, individuals, businesses and governments are working to correct the problem. This process involves identifying where the two-digit year code is found in computer systems and then fixing the code, testing systems and software, and developing contingency plans in case a system does not work temporarily at the rollover.

But fixing the Y2K problem is far more complicated than updating stand-alone computer systems. The linkages between computer systems in today's high-tech world are quite complex, and locating, fixing and testing problems can be difficult, time-consuming and expensive.

Linkages can seem endless
Just consider the computer linkages involved in processing a direct deposit transaction from a company to one of its employees. For example, suppose ABC Co. pays Jane Smith every month by directly depositing funds into her bank account. This transaction would pass through not only ABC Co.'s computer systems but also the systems of ABC's payroll service company and its bank. The bank's computer systems, in turn, might connect with the systems of other organizations, like the Federal Reserve, that would process the payment for deposit into Jane Smith's bank account. To complicate matters, for all these organizations to connect with one another, they must rely on electrical power and telecommunications systems, which also are dependent on computers.

This simple example represents only one of the myriad possible computer system scenarios, but it gives an idea of how interconnected our technology has become and how potentially disruptive the Y2K bug can be.

What could happen?
The stakes in the race toward Y2K become significantly higher when one considers the U.S. and international financial system, in which the U.S. banking system plays a critical role. In this arena, the scenarios for Y2K-related disruptions seem endless, and some sources — not just the tabloid headline seekers — are forecasting severe circumstances.

Edward Yardeni, chief economist and global investment strategist for Deutsche Bank, believes the Y2K bug poses a serious threat to the U.S. economy. He said, "Currently, I believe there is a 70 percent chance of a worldwide recession, which could last 12 months starting in January 2000."

Federal Reserve Governor Edward W. Kelley Jr., who leads the Fed's Y2K efforts, however, takes a more pragmatic view. "A few economists are suggesting that Y2K-related disruptions will induce a deep recession. That is probably a stretch, but it is unlikely that we will escape unaffected," he said. "I anticipate that there will be isolated production problems and disruptions to commerce, and perhaps some public services, that could reduce the pace of economic activity early in 2000. But, just like the shocks to our nation's physical infrastructure that occur periodically, I would expect the Y2K impact to our information and electronic control infrastructure is likely to be short-lived."

Preparing the banking system
The performance of the banking and financial system is critical to ensuring a successful transition to the Year 2000. Banking regulators, including the Federal Deposit Insurance Corp. (FDIC), the Federal Reserve, the Office of the Comptroller of the Currency, the Office of Thrift Supervision and state banking regulators, have been working intensively with domestic and foreign financial institutions operating in the United States for the past several years to help them prepare their systems for Y2K. (See the sidebar on international Y2K issues.)

Y2K experts, including John A. Koskinen, chair of the President's Council on the Year 2000 Conversion, has named the financial industry among the best prepared for the Y2K rollover. The President's Council, formed in early 1998, is responsible for coordinating the federal government's and major industries' efforts to address the Year 2000 problem.

A few economists are suggesting that Y2K-related disruptions will induce a deep recession. That is probably a stretch, but it is unlikely that we will escape unaffected.


As of March 31 of this year, federal regulators had examined each banking organization twice for Y2K compliance. The most recent evaluations showed that, of the 10,000 FDIC-insured banks and thrifts, over 97 percent rated satisfactory, 3 percent rated needs improvement and less than one-half of 1 percent rated unsatisfactory, according to Donna Tanoue, chairman of the FDIC. Federal regulators have taken public enforcement actions against some institutions. But regulators believe that banks understand the reputational importance of the Y2K problem and thus that market pressure will be more effective than regulation in spurring compliance.

Federal banking regulators are also requiring banks to develop Y2K contingency plans just in case of a temporary disruption in banks' computer systems. Contingency plans are nothing new for banks. In fact, most already have plans in place to deal with disruptions such as power outages or natural disasters. Banking regulators are also developing their own Y2K contingency plans.


Evaluating International Y2K Efforts

There are many unknowns when it comes to determining Y2K preparedness on the international front. Fed Governor Roger Ferguson, who serves as chairman of the Joint Year 2000 Council, has worked with representatives from the international banking community to evaluate and promote Y2K readiness. The Joint Year 2000 Council is made up of central banks, insurance and securities regulators, and banking supervisors from throughout the world.

In a recent speech, Ferguson described the difficulty of getting concrete information on the preparedness of the banking community in some countries. "As you can understand, it is difficult to measure accurately the level of international Year 2000 readiness, and certainly no one can predict with confidence exactly how the century date change will unfold internationally. . . . With that said, I believe that, as with the United States, in most countries the financial sector was probably somewhat ahead of other sectors in recognizing the Year 2000 problem and is probably somewhat more advanced in testing and business continuity planning."

In the absence of concrete information, it seems reasonable to assume that some nations and institutions will not be as well prepared for Y2K as the United States is. However, it is important to note that most internationally active banks have been preparing for Y2K for quite some time.


Such plans will help to ensure that banks continue to function despite any disruptions, which Fed Governor Roger Ferguson said are likely. "Nothing this large and complex can be perfectly faultless. We should remember, however, that there have been serious disruptions to service in daily life before, from storms, temporary power outages, disruptions of telephone service, etc. In general, these prove to be annoying and inconvenient, but nothing more."

The Fed's unique role
In addition to supervising banks' compliance efforts, all of the federal banking regulators have been working for several years to prepare their own internal computer systems for the Year 2000 rollover. While fixing the Y2K problem is important to the functioning of each regulator, this effort is even more important for the Federal Reserve as it provides critical financial services to the federal government and to many depository institutions, including banks, thrifts and credit unions. In fact, the Fed processes more than 80 percent of the total dollar amount of U.S. payments — more than $2 trillion per day — including everything from the settlement of U.S. government securities to private securities, checks, electronic payments and old-fashioned cash.

The Fed recently confirmed that it has fixed the Y2K problem in its most critical systems, including those that interact with banks and with the federal government, to ensure that they will work in the Year 2000. During the remainder of 1999, the Fed will continue to test its systems. A report from the U.S. General Accounting Office recently cited the Federal Reserve as having established effective Y2K management controls for its internal systems.

The Fed has also been working with banks as they test their internal systems with their service providers' and with the Fed's to ensure compatibility. As of April, more than 8,000 depository institutions had already tested their systems with the Fed's — and some of these institutions had tested numerous times.

Cash availability around the Y2K rollover has been a major concern of banks and their customers (see the sidebar on page 6). The Fed, with responsibility for putting cash into circulation in response to public demand, has worked with the U.S. Treasury to ensure that ample supplies of currency will be available around the rollover to the new year.

Federal Reserve Chairman Alan Greenspan discussed the Fed's Y2K cash plans in recent congressional testimony. "As a precautionary measure, the Federal Reserve has acted to increase the currency in inventory by about one-third to approximately $200 billion in late 1999 and has other arrangements available if needed," he said. "While we do not expect currency demand to increase dramatically, the Federal Reserve believes it is important for the public to have confidence in the availability of cash in advance of the rollover." According to Fed officials, the Fed has taken these steps to demonstrate its commitment to protecting the U.S. financial system during Y2K.

As part of this commitment, the Fed also says that it stands ready, if called upon, to perform another of its central bank roles: lender of last resort, providing lending on a collateralized basis to banks and thrifts in need of an infusion of cash. Through its discount window, the Fed extends credit directly to banks and thrifts, which hold reserves with the Federal Reserve. Though the Fed doesn't think that such Y2K-related loans to banks will be necessary, it has encouraged banking institutions to have their documents regarding collateral in order. The FDIC has also stated that it is prepared to fulfill its deposit insurance obligation on deposits held in FDIC-insured institutions.

On a Personal Note, Leave Your Money in the Bank

Worried that they may lose their life savings in a Y2K computer systems outage, some individuals have announced their plans to take their money out of the bank and put it under their mattresses. Others may take out several weeks' cash in the event that computer systems fail and checks, credit and debit cards are of no use. All of this talk raises the question of whether your money is really safer outside versus inside the bank.

In congressional testimony in February, Fed Chairman Alan Greenspan responded strongly to questions about what people should do with their money that is in the bank. "I would say the most feasible thing is to leave it (money) where it is. That's probably the safest thing. There's almost no conceivable way in which I can envision that computers will break down and records of people's savings accounts will disappear."

To withdraw cash from the bank means that people will lose deposit insurance and would also lose interest income that money might earn. Greenspan also voiced concern about people taking their money out of the bank and then potentially losing it in a fire or a mugging.

Though the Federal Reserve is urging consumers to leave their money in the bank, it is also working to ensure that an ample supply of currency will be available both in its vaults and in circulation at the century rollover in case the public decides to hold additional cash. By year's end the Fed estimates that it will have about $200 billion in its vaults as a cushion to meet any increased demand for currency as the Year 2000 approaches.

The Federal Reserve's message is clear: Your money is safer in the bank.

Reliance on other industries
No matter how comprehensive the banking industry's Y2K preparations have been, the industry doesn't operate in a vacuum. It depends on other industries, including power, telecommunications and transportation, to keep the payments system running. Recent data suggest that these other key industries have also made substantial progress in readying themselves for Y2K.

But Koskinen recently said that key industries, such as power, banking, telecommunications and transportation, have much more work to do during the remainder of 1999 to prepare for the Y2K rollover. He said he is pleased, however, with these key industries' overall efforts, and he thinks that national Y2K failures in these industries are unlikely.

Nothing this large and complex can be perfectly faultless. We should remember, however, that there have been serious disruptions to service in daily life before, from storms, temporary power outages, disruptions of telephone service, etc. In general, these prove to be annoying and inconvenient, but nothing more.


The Year 2000 and beyond
Without question, the Y2K bug is a serious problem. As the Year 2000 approaches, increased attention will be focused on Y2K preparations, and rightfully so, since there are many governments, businesses and entire industries worldwide whose performance is critical to ensuring that business as usual remains the norm and not the exception.

The banking system, including individual banks, central banks, regulators and payments system providers, ranks among the most important in keeping the U.S. and world economies running smoothly. While glitches may occur, such as an isolated automated teller machine outage or a temporary power outage, the banking system is taking the necessary steps to ensure that transactions continue to take place and that funds continue to flow during the Y2K rollover and beyond.


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