EXCERPTS: OFFICIALS ASSESS Y2K IMPACT ON FINANCIAL SECTOR (Digital video conference with Sydney, Australia) (3660)

Washington -- U.S. Federal Reserve officials say they do not expect the Year 2000 (Y2K) problem to cause broad-scale financial gridlock.

The officials discussed the impact of Y2K on world financial markets during a U.S. Information Agency digital video conference February 16 with journalists and financial sector representatives in Sydney, Australia.

Oliver Ireland, associate general counsel in charge of Monetary and Reserve Bank Affairs for the Board of Governors of the Federal Reserve System, said that the Federal Reserve is encouraging everybody to fix and test their systems so that things like financial gridlock won't occur.

"If you posited a 5 percent failure of the most time-critical transactions, you might very well be concerned," he said. "I don't know anybody here that is expecting that to occur at this point in time..."

Stephen Malphrus, director of the Division of Information Resources Management, Board of Governors of the Federal Reserve System, said it is important to note that in many countries the computing that's used in financial markets and banking is based on IBM mainframes.

"You won't find the diversity of computing platforms that you find in this country...in larger banks, in the securities industry," he said. "So the problem itself...is simpler in some ways."

Malphrus added that it's also important to realize that IBM got out in front in solving the Y2K problem very early. "In fact, they set the standard in the information technology industry for working with their customers in disclosing information, remediating systems and that sort of thing," he said.

Following are excerpts from the digital video conference:

(Begin excerpts)

MR. MALPHRUS: ... I'm going to start first and talk a little bit about the President's Council and the international aspects of the Joint Year 2000 Council and then Ollie will talk more specifically about the Federal Reserve.

By way of background, as you may know, the United States has a national coordinator, John Koskinen, who is advisor to the President and Chairman of the President's Council on Year 2000 Conversion. John has identified some five critical sectors. Finances is certainly one, as well as power and telecommunications.

In addition to representing the Fed on the Council I chair the Council's Financial Sector Group. That sector group consists of some twenty-two federal agencies that are involved in the debt to equity to credit and the exchange trade derivatives markets. We also have a representative from the National Association of State Insurance Commissioners. As you probably know, in the U.S. insurance is regulated at the state level.

The focus of the council this year is shifting from government readiness and private-public sector partnership to contingency planning, event management and that sort of thing. The council is making the results of its work available. The first public report was published recently. You can access that on the council's web page: www.Y2K.gov. That gives a sector-by-sector analysis of the readiness and the issues that we're faced with.

John Koskinen has worked with the UN and Ambassador Kamal, who heads the Informatics Committee, to recently establish something called the "International Y2K Cooperation Center." That will be operating in Washington, D.C. The goal of that center is to coordinate with the national coordinators in some 180 countries. This comes out of a meeting that was held at the UN last Fall.

On the financial front the "Joint Year 2000 Council," which is chaired by Governor Roger Ferguson, a member of the Board of Governors, consists of financial market regulators and is focusing at the international level on financial markets.

There are four sponsoring committees that created the Joint Year 2000 Council last year: the Basle Committee on the Banking Supervision, the Basle Committee on Payment and Settlement Systems, the International Association of Insurance Supervisors, and the International Organization of Securities Commissions.

The Joint Council has issued a number of papers. Information can be obtained by going to www.bis.org, that's Bank for International Settlements. The council also publishes a monthly bulletin and the council itself will begin to focus on contingency planning, event management and that sort of thing.

The council's papers on contingency planning will be released within the next couple of weeks. This is just a series -- one of a series of papers in advising financial market regulators around the world.

With that let me turn it over to Ollie.

MR. IRELAND: Well, let me turn a little bit to what we at the Federal Reserve have been focusing on in this area. The first thing is really our own operation. And that is in the areas of where we have the heaviest data processing, which is probably monetary policy. That is, the Central Bank carries out monetary policy functions in the United States and wants their systems to work and in the area of the provision of payment services, which we provide through twelve regional reserve banks.

We have been going through a process for some time of remediating those systems and testing them to make sure that our own house is going to be operative and will not be impaired by our own problems with our own computer systems, even though there might be problems generated outside of those systems.

Our second big area of concern from the outset was in our role as bank supervisors. We have endeavored through that role to encourage banking institutions that we supervise both to remediate and test their own systems, a process that we have encouraged through both supervisory guidance and through on-site examinations and review of their remediation and test programs.

We obviously can't do the testing for them and can't be sure that they will function properly, but we can look to see whether they're making the appropriate kinds of efforts and devoting the appropriate level of resources to fixing their own mission-critical systems.

The other thing we've tried to do is to make sure that they are ready to deal with problems that may happen elsewhere in the economy due to the Year 2000 conversion problems. For example, we expect them to look at their borrowers and assess their borrowers efforts to remediate Year 2000 problems as a part of assessing whether or not their borrowers are, in fact, credit worthy and, therefore, protecting the credit quality of their asset portfolios over this period.

At the same time we have expected them to make contingency liquidity plans in the event of market disruptions or unusual demands for withdrawals by their customers. We have hoped that they would have in place adequate sources of liquidity so that they can manage the liability side of their balance sheets in the event of disruption -- a function that has sort of bridged the provision of payment services and the supervisory function.

We have encouraged banking institutions that use our payment services to test their own operations, payment operations, with us, and provided opportunities and time in which they can dial into our systems or link up to our systems and test their own systems to make sure that they're going to work in the conversion environment.

The third and perhaps broader area of concern that we've had, again, is in our role as a central bank. It is for the overall health and efficiency of the economy in the year 2000 conversion process. In this regard we're not terribly concerned about major changes in economic conditions but we are concerned about particular disruption that might occur that we might be able to address.

In that regard we think of two areas in particular. One is the provision of currency. As the Central Bank of the United States we are the issuer of Federal Reserve notes, the prevailing currency in the United States and a store of value in many other countries as well.

We are trying to make sure that we are able to deliver adequate supplies of currency to all who think they need it during this period. One of the phenomena that we have seen already is that many people who think that there will be serious disruptions in the conversion process believe that they should hold extra supplies of currency in order to be able to engage in transactions.

If, for example, the credit card systems don't work or other retail computer-based payment systems don't work, they still want to be able to buy goods and services. And many of them are anticipating that they will hold a somewhat larger supply of currency over that New Year's weekend than they would otherwise hold. When you multiply that by millions of households in the United States, the numbers quickly become rather large and the distribution of additional supplies of currency is a logistical concern.

Related to that is the more general issue of liquidity and whether computer disruptions, either in individual institutions or in financial market utilities, might effect the liquidity of markets and general liquidity within the economy. We are looking at fall-back or contingency plans that we might put in place to address any problems that could arise in that area.

I should point out that the currency phenomenon or liquidity phenomenon, of course, are linked. In order for a banking institution to supply currency to its customers it has to be able to hold currency as an asset. It may have to liquidate other investments in order to hold that currency. That comes at some cost. Perhaps the provision of liquidity through the Central Bank can address that cost at some point.

Since we do not yet know the level of currency demands, we don't know what those costs are, and we're not at all sure what our planning might be. But we are trying to make sure that we're ready for a variety of eventualities.

In this regard it's sort of interesting to note that the sort of contingency planning that I'm now describing is beginning to address second order effects of potential year 2000 conversion issues, i.e., not the direct effects of computer system failures because of the year 2000 conversion but rather the effects of people's own contingency planning to avoid the consequences of those perceived problems or feared problems. So we are finding ourselves in the process of contingency planning not only to address direct problems that arise but also indirect problems that arise from other people's contingency plans....

Where you might see other problems is as you get down into the individual banking institutions. We think the United States is going to be in pretty good shape. We're not so sure about some individual other countries.

So at the retail level you might see some disruption of transactions because while the basic utilities, infrastructure utilities were working, an individual institution might have problems. I would fully expect that there would be some problems at that level.

We have no reason now to think that they are going to be so severe as to fundamentally disrupt international capital flows.

MR. MALPHRUS: ... There's been an awful lot of coordination across various clearing payment and settlement systems and, indeed, testing, very active testing. Regarding Swift, Swift has a very active program. The Belgium Banking Authority now has -- just recently -- the authority to examine Swift. We are participating in that. They have an extensive Y2K program.

The Swift itself, of course, is concerned about readiness in the public infrastructure. If Swift runs but there's a failure in major telecommunications facilities in a country or disruptions, that of course can impact Swift as it can impact any participants in financial markets....

MR. IRELAND: I think one comment might be useful here. It seems to me that to assume on a country-by-country basis the level of success of tests and remediation is uniform within the country is almost undoubtedly a mistake.

The strongest incentive for people to fix their systems and to be able to function normally during this conversion process is the market discipline from their counterparts. The people who are dealing with individual account authorities -- we have certainly been encouraging them to talk to their counterparties and assure themselves of their counterparties' efforts to their own satisfaction, and if they can't get that assurance, to take appropriate safeguards.

I think that people dealing with counterparties in other countries as well as people dealing with counterparties in the United States, for example, have to follow basically the same procedure.

MR. MALPHRUS: Let me offer one other perspective. Now this is a generalization and, therefore, it's got to be taken as that.

I think it's important to realize that in many countries the computing that's used in financial markets and banking and the securities industry is based on -- fundamentally is based on IBM mainframes.

You won't find the diversity of computing platforms that you find in this country, and certainly in banking today in this country in larger banks, in the securities industry. Most large Japanese banks run IBM mainframes. Virtually all of the critical applications; demand deposit accounting, commercial lending, general ledger, run in that environment. So the problem itself, the problem set, is simpler in some ways.

I think it's also important to realize that IBM got out in front of this very early. In fact, they set the standard in the information technology industry for working with their customers in disclosing information, remediating systems and that sort of thing.

I simply throw that out as a generalization but I think it is important. You can't just talk in general ways. You've got to understand a little bit about what kind of computing is used in countries to get a better perspective on what the problem might be....

MR. IRELAND: We are not expecting a broad-scale financial gridlock, no. I mean if we were I think we would be taking additional steps to try to address it. What we're trying to do is to encourage everybody to fix and test their systems so that won't occur.

I think you also have to think about what happens as you talk about things like financial gridlock, what happens when individual types of problems arise and whether or not those transactions can be rerouted through other means or, in fact, how time-critical those transactions are. If you posited a five percent failure of the most time-critical transactions, you might very well be concerned. I don't know anybody here that is expecting that to occur at this point in time....

We today have a mix of very large branch bank networks and a large number of stand-alone branches or banks. There are blessings and problems with both of those structures.

First of all, if you have an integrated banking network that is composed of a large number of branches with centralized, or if not centralized a common automation environment, you only have to fix it once. That's the good news. The bad news is: if you haven't fixed it, you have a bigger problem.

With the stand-alone institutions you have to make sure that a larger number of institutions are remediating their own systems. That's the bad news. The good news is that, if you have a problem, it is isolated to a somewhat smaller level in terms of, for example, payment volume or deposit accounts effected.

So there are advantages and disadvantages to both structures. We have them both here and are trying to deal with them both.

MR. MALPHRUS: I would just add a footnote. In the United States many of the communities, particularly the smaller community institutions, will 'outsource' their computer workload. There are a number of companies in the United States such as Electronic Data Systems, Pfizer, Marshall & Isley, etcetera, that provide -- if you will, provide computing resources. That is they actually process the workloads, the bank workloads, in the data centers they operate. We call them -- the term of art, we call them 'servicers.'

As part of the program that Ollie described to you earlier, that is, our supervisory program including examinations, we are subjecting those servicers to examination. Where deficiencies are found or I should say the results of those examinations are being made available to the customers.

So, if you're a community bank and you're using EDS and the examiners when they go in and do the Year 2000 examination will identify problems or, indeed, if they don't find problems, issue a satisfactory rating. That information is available -- made available to the bank's customers and has been since earlier -- well, since about mid-1998 -- starting mid-last year.

Of course, if a bank is concerned about a servicer, it can essentially vote and leave that servicer -- there may be some contract buy-outs that have to be done -- and go to another servicer....

The major credit and debt rating agencies generally view Y2K as a risk that needs to be incorporated in country and institution ratings. In many cases they have started internal watch lists. They have not published those yet. My sense is that you will see them begin to put institutions, and in some cases countries, put them on watch lists, that is public watch lists....

MR. IRELAND: I would have to add that, having spent part of my career writing software contracts from the buyer's side, anybody that relies on self-report statistics one way or the other is probably not behaving as prudently as they might.

It's very nice to conduct surveys and to try to make generalizations. What relevance those generalizations have to actual performance on January 3rd, the year 2000, though, has to be open to some question....

It is also possible that if there are in fact extraordinary currency demands beyond those that people have anticipated, that the lender-of-last-resort function of the Central Bank can be used to provide liquidity in order to meet currency demands -- as it is used sometimes to provide liquidity for banks that are suffering withdrawal pressures or runs, even though they are solvent institutions....

We would expect to continue to have the same funds rate target through this period assuming constant economic conditions, i.e., there isn't some other reason for adjusting the funds rate.

If liquidity pressures push the rate one way or the other, we would try to push it -- we would try to push it back -- if we're worried about a shortage in liquidity -- by providing liquidity. Other central banks have similar abilities.

So, there are just inherent systems in the conduct of monetary policy that will tend to effect some liquidity pressures. Now that does not necessarily address the problem if banking institutions in developed countries all of a sudden decide that loans to a particular lesser developed country, for example, or just any other particular country are at greater risk because of year 2000 conversion concerns.

But, again, I think you have to ask yourself why would that necessarily be the case? Year 2000 problems are going to be computing problems but they will not necessarily effect the solvency of individual private companies experiencing those problems. In some cases they may and some cases they may not.

So it would seem to me that a wholesale shutdown of liquidity to individual sectors or individual geographic regions is not necessarily reflective of economic fundamentals. Inherent systems of maintaining liquidity within the countries ought to help to address that to some extent.

MR. MALPHRUS: Another market response, of course in terms of market expectations, is pricing. Indeed, it appears in terms of market expectations that if one looks at when contracts are coming due, a butterfly effect, if you will, is forming. There's always a slight premium in pricing at the end of the year when a lot of contracts come due.

It appears, at least the last time I looked, if one looks at contracts coming due in September and then again at the end of the year, December 1999, and then in March that, in effect, there's a butterfly. There's a peaking that's going on. The last time I looked it was about 43 basis points, it's relatively small at this point.

The point is that the market will price the risk and it appears that there is -- appears, I would underline -- a Y2K market premium that is starting to show up in contracts. I think we certainly will be taking a close look at that and following that in terms of pricing. But that certainly is another response....

MR. IRELAND: We are looking very carefully at the kinds of communications that we are making publicly and that we expect to be making publicly over this period. We don't to date see such market disruptions developing that we have the need -- see the need -- to invigorate our Chairman to go out and make specific market-calming pronouncements if, in fact, that would calm the market. We're watching those issues and expect to take appropriate steps depending on what we see develop.

I think one has to be careful of making any kind of pronouncements early on. You don't want the level of your own interest to cause the very problems that you're trying to avoid.

I have -- years ago when I worked at one of our regional reserve banks we had a problem with a very large bank. There was a rumor in the market that they were going to declare themselves to be insolvent. There was virtually no market reaction to that rumor.

Somewhat later in the day the Chief Funding Officer of the bank made an announcement to one of the wire services that the rumor was untrue and everybody picked up that announcement. They immediately started to have a funding problem. So your efforts to address problems can cause the very problem you're trying to avoid....

(end excerpts)

-- (Busy@the.top), February 22, 1999

Answers

My oh my........

They sure used a lot of words to say so very little............

"I simply throw that out as a generalization but I think it is important. You can't just talk in general ways."

I am reassured. They will give me as much cash as I need to feel comfortable. I will go get it today.

Gobbledegook in the finest beaurocratic fashion.

argh

-- Jon Williamson (jwilliamson003@sprintmail.com), February 22, 1999.

IBM is "out in front" of the y2k problems at the same time they're behind the whole thing. Righteous marketing, dude.

-- Puddintame (dit@dot.com), February 22, 1999.

Let me here you now,

If you are happy and you know it, clap you hands! If you are happy and you know it clap your hands!

I hope those who spoke in the article above are correct. However, I am still going to "needlessly stockpile" some cash, is that ok with you?

-- kay (y2kay@aol.com), February 23, 1999.

oops , typo. Here should be hear. I think ya know what i mean anyway. :-) Sorry.

-- kay (y2kay@aol.com), February 23, 1999.