| Y2K's
Intricate Challenge
By Clint Swift
U.S. banks have largely addressed
their internal challenges with Y2K. Now they must focus
on external issues that will be harder to control.
The U.S. financial industry will
spend an estimated $9 billion to prepare for computer
issues related to the year 2000, and its diligence--partly
federally inspired--places it among the best-prepared
businesses on the globe. But as internal technological
issues begin to recede, managers must redouble their efforts
to prepare for a host of market-related challenges.
Y2K involves the inability of some electronically-controlled
devices to distinguish between 1900 and 2000. When the
new millennium dawns, these systems could halt unexpectedly
or generate errors. It's an insidious problem for the
financial industry, whose production centers on electronic
calculations and recordkeeping. Undetected errors may
cause even more damage than program crashes.
The nation's financial institutions
have dealt effectively with internal systems and other
issues largely under their control, and that's saying
a lot. Federal examiners scrutinized Y2K progress during
two extensive sweeps through the nation's banks, thrifts
and credit unions and gave 97% of the institutions their
highest rating.
On June 30, financial institutions passed
the last major milestone in complying with federal guidance.
This involved testing of mission-critical systems, reintroduction
of those systems into production, and planning for resumption
of business after an interruption.
From now until the New Year, institutions
increasingly must focus on issues largely beyond their
control. Arguably, this exercise is just as important
as the tedious internal chores already completed--if not
more so. Even as institutions work with regulators to
assuage the concerns of an excitable public, they must
hone contingency plans for dealing with multi-dimensional
system disruptions. The potential for mass withdrawals
and unusual business borrowing will require comprehensive
plans to supply cash and other forms of liquidity as necessary.
Banks with international operations
will need to pay particular attention to overseas transactions
and foreign counter-parties, since many countries lag
the U.S. in Y2K readiness. From a legal standpoint, Y2K-related
representations and efforts must be positioned in a way
that minimizes the potential for litigation. The preparedness
of customers, suppliers and domestic counter-parties must
be assessed. Fraud detection and prevention is a rising
priority, and plans to handle potential customer service
overloads--for example, from a flood of telephone inquiries--must
be devised.
Though undeniably arduous, all of these
Y2K-related activities could yield dividends for financial
institutions. The enormity of the challenge, coupled with
an unalterable deadline, has sparked an invigorating wave
of collaboration--both within and among institutions--that
could provide a common foundation for future exploration
in fruitful areas such as electronic commerce.
Calming
the Masses
The most critical Y2K challenge is
preserving consumer confidence. With six months to go,
the public and the news media are asking more questions
about the preparedness of the financial services sector.
The Comptroller of the Currency, John D. Hawke Jr., recently
told Congress that "all of us--regulators, trade
associations, bankers and other members of the financial
community--should turn our attention now to public opinion."
Consumers are concerned about access
to cash and the accuracy of account information, research
shows. Sensational news treatments and disturbing reports
circulating on the Internet magnify the disquietude. This
is an important matter, since consumers could react by
dramatically changing the way they employ cash, checks,
debit and credit cards, automated teller machines and
branches.
A major concern is that consumers might
withdraw large sums of cash just before the rollover.
Financial institutions should be actively assessing customer
intentions and susceptibilities through teller conversations,
polls, focus groups and other means for the remainder
of this year.
For all types of financial institutions,
consumer-related Y2K issues extend well beyond January
1, 2000. Perceptions that electronic financial systems
are fragile could affect adoption and growth rates of
alternative delivery channels and payment methods, in
which financial institutions and other players are investing
heavily.
Speaking at a recent Bank Administration
Institute forum, for example, a senior systems executive
at the Social Security Administration said demoting 33
million direct-deposit recipients to paper checks is not
a palatable option after years spent building acceptance
of electronic delivery.
Financial institutions need to respond
with frank and persistent communications efforts, emphasizing
that they offer the safest harbor for money. They should
point out that their systems have passed test after test
using dates advanced into the next century and are reliable.
The public should be reminded that the books of financial
institutions are reconciled daily, and that multiple back-up
copies of records are made.
Financial institutions are among the
first businesses to reopen after a natural disaster, it
should be noted, and are masters of contingency planning.
Recovery scenarios for loss of telecommunications, power,
water and other essentials have been updated and tested
for every identifiable year 2000 risk. Furthermore, highly-regulated
depository institutions are under constant scrutiny by
state and federal examiners. They have been sharing Y2K
best practices during the past two to four years through
forums, conference calls and Internet discussion groups
established by active trade associations.
Individual institutions have a variety
of avenues in which to broadcast Y2K assurances. Venues
include time-and-temperature signs, ATM and teller receipts,
newsletters, disclosure statements, direct mail, Web pages,
telephone hotlines, on-hold messages, seminars, statement
stuffers, meetings with editorial boards, addresses to
civic groups and more.
However, this outreach cannot be left
solely to the discretion of individual institutions. The
U.S. financial industry needs a comprehensive, coordinated
response, almost on a wartime footing. Extremists aren't
the only ones predicting Y2K disaster. Gloomy prognostications
also emanate from churches and other respected opinion
leaders. Particularly problematic is the Internet, where
fact and fiction too often look alike.
If a single, coast-to-coast bank media
effort is too difficult to organize or too expensive to
mount, then banks should combine regionally to blanket
their markets with a single message--the safest place
for your money is in the bank--that the doomsayers cannot
obscure.
Regulators also have a role to play,
and federal officials pledge to take their story public
for the remainder of the year. FDIC Chairman Donna Tanoue
has made Y2K her top priority, and she addresses some
aspect of it in nearly every public speech. The Federal
Reserve System's governors and bank presidents, normally
barely visible, are making themselves available to newspapers,
radio and TV.
Their common story should emphasize
that every bank, thrift and credit union has been examined
multiple times. The FDIC insures deposits up to $100,000
in case of bank failure, it should be reiterated, including
failure for Y2K reasons. Also, the public should be reminded
that the Federal Reserve has accelerated printing of nearly
$50 billion in extra currency and is working to achieve
same-day delivery of cash to financial institutions.
Recent poll numbers indicate that public
sentiment is trending slowly in the right direction, which
is to say towards greater confidence. But media and academic
surveys still show that between a third and a half of
respondents plan to withdraw large sums--all their financial
assets in some cases. Obviously, even greater communication
efforts will be required.
Contingencies
and Cash
Although consumer confidence issues
could fully occupy bank Y2K project managers the rest
of the way home, there's a long list of additional issues
to consider.
Contingency planning is a high priority.
Despite years of careful planning, glitches are certain
to occur. Unfortunately, no one can say authoritatively
where the problems will surface or what their scope will
be. That makes contingency planning an integral part of
preparing for the year 2000. Y2K promises to be a systemic
event whose effects may be felt nearly everywhere at once.
Bank contingency planners must devise--and also figure
out how to test--plans for dealing with multiple simultaneous
failures.
Creativity will be required in dealing
with the unique risks posed by Y2K. For example, cloning
critical hardware and software combinations at off-site
recovery centers is an exceedingly thorough form of backup,
but the technique cannot be viewed as a total solution.
Why? Y2K-related bugs that manifest themselves in the
core system will be perfectly--perhaps devastatingly--replicated
in the backup system.
Throughout the rest of this year, financial
institutions must update contingency plans as developments
among suppliers, service providers, utilities, telecommunications
companies and other key infrastructure elements dictate--or
just in response to the hunches of experienced project
managers.
For example, BellSouth Corp. and AT&T
Corp. announced that Y2K testing of their networks had
been completely successful. But when the project leaders
of banks in BAI's Y2K forum were polled recently about
the top 10 risks they perceived, failure of voice and
data communications led the list. Discussion revealed
additional layers of managerial concerns, about routers
and other on-site equipment, small carriers, and other
external network issues.
Concerns about cash and liquidity also
loom large in the minds of bankers and regulators. Financial
institutions take seriously the threat that customers
might withdraw large sums before the end of the year.
They need to share techniques for gauging cash reserve
requirements.
Many financial institutions already
have started to shore up reserves on an individual basis,
but they also need to maintain an ongoing dialogue with
the Fed as it works to support the entire payments system
and all of the institutions within it. Tight coordination
with the central bank is necessary to ensure that adequate
currency is available for all institutions during December
and January.
Armored couriers do not have the capacity
to meet exaggerated demands for cash at the last minute.
To reduce the risk that transport bottlenecks could trigger
cash shortages, the Fed plans to add about 100 cash inventory
locations that could quickly deliver $5 billion to financial
institutions.
Banks are also worried about sudden
liquidity crunches, particularly massive drawdowns on
established lines of credit. One scenario involves thousands
of small businesses whose cash flow might be interrupted,
for example by equipment failures, a steep temporary decline
in sales, or even customer defaults. The fear is that
many affected businesses might simultaneously tap their
credit lines.
Y2K liquidity issues are particularly
difficult because they are systemic. That is, institutions
may not be able to shift short-term, marketable assets
to cash readily if almost all participants in the market
are trying to move to cash at the same moment. Similarly,
a financial institution may have its own credit lines
in place but discover that correspondents do not have
the cash to lend.
In a systemic crunch, borrowing at the
Federal Reserve's discount window may be the best alternative.
Banks should be handling paperwork and collateral issues
with the discount window this summer, so they can execute
transactions there without delays this winter.
One possible reversal of the above scenario
rests with money center banks. The Fed is actually warning
them about the possibility of excess liquidity if institutions
with large investments abroad bring that money home just
before year's end.
International
Risk
The potential international repercussions
of Y2K are particularly elusive. The President's Council
on Year 2000 Conversion notes that most countries lag
well behind the United States in Y2K readiness. It appears
that a number of countries will experience Y2K failures
in power, telecommunications, transportation and other
areas. The risk of infrastructure failure is generally
greater in developing countries, most of which started
to address the problem much later than developed nations.
Fortunately, the least prepared countries
likely represent the least potential impact on the United
States. America's most important trading partners, Canada
and Mexico, have relatively well-developed year 2000 efforts
under way. The U.S. financial industry seeks to spur international
efforts on a government level through the Joint Year 2000
Council and on the private sector level though the Global
2000 Coordinating Group.
On another front, attorneys own the
grim task of keeping staff aware that Y2K aftershocks
could be felt five to seven years after the rollover.
The banking industry favored legislation that would limit
Y2K litigation--especially disruption liability, punitive
damages and class action suits--and it advocated alternative
forms of dispute resolution. Trial lawyers, consumer groups
and the Justice Department resisted, however, saying such
restrictions could be unfair to people with legitimate
Y2K grievances.
Anticipating the possibility of litigation,
legal counsel should play a key role in ensuring that
the bank documents each phase of its Y2K project adequately,
avoids implied warranties in public communications, and
stays clearly within peer practices in a bona fide effort
to ensure that its systems and business lines operate
in 2000 as effectively as they do today.
Customer and counter-party risk also
must be addressed. After the first round of Y2K examinations,
the OCC cited incomplete assessments of customer risk
as a common deficiency among institutions rated less than
satisfactory. Federal examiners are now finishing a second
round of inspections that pay special attention to how
well institutions are assessing customer risk. The intent
is to determine whether the millennium bug will make it
significantly more difficult for customers--domestic or
international--to repay loans.
Obviously, banks do not make money on
deals they turn down. But to limit exposure, they will
have to consider requiring additional collateral, rewriting
loan terms to require evidence of Y2K preparedness, and
declining extensions of credit lines in the absence of
progress toward Y2K compliance.
Financial institutions also need to
accelerate inquiries into the Y2K preparations of the
hundreds of vendors and service providers that make up
the supply chain of even a small organization. In too
many financial institutions, despite the Year 2000 Information
and Readiness Disclosure Act, too little actionable data
has been received, and vendor management has become contingency
planning.
Institutions also face a Herculean task
in evaluating physical facilities--including those they
lease to others--for the potential impact of millions
of non-compliant micro-controllers embedded in elevators,
air conditioning, vaults and security and other systems.
Scam
Artists
The media are full of stories about
scam artists who stampede people into handing over their
money for "safe-keeping," using exaggerated
tales about the susceptibility of financial institutions
to Y2K problems.
Financial institutions know that the
principal deterrent to fraud is detection, and they should
immediately integrate their fraud awareness and detection
planning with event management and contingency planning.
They also need to respond with public awareness programs.
Internal awareness must be built as
well. Background checks are needed on the legions of new
programmers who are learning banks' systems and will know
them after they leave. Institutions should keep an especially
watchful eye on date-specific functions in derivatives
and other instruments, where a change five decimal places
to the right could make a visible difference in market
value.
Banks need to redouble efforts to ensure
that during a disruption, routine verifications and callbacks
on funds transfers or other transactions do not slip too
far down the list of priorities. Counter-parties could
be out of proof for a period, creating the conditions
for fraud.
The customer service area also should
develop contingency plans. Most financial institutions
already use all available after-hours processing cycles
to produce reports for managers and customers. Recent
research by Vanderbilt business professor Fred Talbott
shows that customers want extra evidence that the bank
agrees with their records about how much money they have
and where it is.
Operations professionals need to be
looking for innovative ways to counter the threat that
customers will bombard the bank with requests for additional
statements, clog the telephone lines to call centers,
and overload ATM databases with balance inquiries. Operations
could grind to a halt.
Is there a silver lining to the Y2K
cloud? Certainly, and payoffs beyond upgraded equipment
and augmented staffs are already surfacing. Many big banks
carefully scripted the 1998 year-end close as a trial
run and benchmark for this year's close. As a result,
Wachovia Corp., Fleet Financial Group and a host of others
reported the smoothest close in memory.
The assessment phase of each Y2K project
provided a valuable detailed inventory of hardware, software
and every key interface with an external data source.
The conversion and testing phases also required analysts
to complete vital documentation that production schedules
had never left time for.
Stringent federal requirements and tight
deadlines compelled institutions to share best practices,
creating communities of interest that bridged even vigorous
cross-town rivalries. That sharing was just as effective
within the institution. One East Coast bank with a global
footprint reports that the domestic and international
staffs have gotten to know each other for the first time
through months of discussing event plans, infrastructure
issues and even contract management.
When the common threat of Y2K recedes,
many competing U.S. financial institutions will have worked
together for three years or more. If that provides a foundation
for future common exploration of best practices in areas
such as electronic commerce, it might be the most significant
return on the Y2K investment during the new millennium.
Mr. Swift is director
of banking technology at Bank Administration Institute.
Copyright © 2003 by Banking
Strategies, published by BAI.
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