Financial services industry technology: is the Y2K challenge a harbinger to things to come?

Business Economics, Oct, 1998 by Albert E. DePrince, William F. Ford

During the past quarter century, financial service industries in the United States have survived a number of crises in which thousands of banks, thrifts, credit unions, investment firms and insurance companies failed. Those failures, combined with a persistent and mounting wave of mergers, have reduced the ranks of U.S. depository, insurance and investment institutions to less than half the number that existed in the early 1970s. Nevertheless, all major segments of the U.S. financial industry are currently enjoying record profits, and the market values of most stockholder-owned companies are at or near their all-time highs.

At the same time, on the technology front, U.S. financial industries face an uncertain future. For example, in spite of enormous investments in payments system modernization, consumers have stubbornly resisted efforts to substitute electronic payments for their traditional reliance on cash and paper checks, both of which are still growing in usage.

Now, as the millennium approaches, the so-called Y2K problem has forced the financial industries to divert much of their attention and resources, on the technology front, away from improving their labor productivity and customer services. The scope of this technology resource diversion, in just the U.S. banking and thrift industries, has been estimated by the Federal Reserve as costing about $50 billion (Kelley), which roughly equals the U.S. banking industry's current annual profits. And the global cost of addressing Y2K problems in all industries, world wide, has been estimated to run in the range of $1 to 1.3 trillion (Bylinsky; PC Week). That amounts to upwards of 3 percent of Gross World Product (GWP). Were this phenomenon viewed as an ecological event, its impact would be equivalent to, say, fifty or sixty Hurricane Andrews, which inflicted upwards of $20 billion in damages on the southeastern United States in 1992. That is the bad news. The good news is that, unlike hurricanes and earthquakes, the Y2K event is both predictable and manageable, in spite of its high cost. This paper examines the nature of the Y2K problem, the regulatory agencies' responses and the compliance efforts of financial institutions. It ends with an assessment of the Y2K outlook for the financial sector of our economy.

THE NATURE AND SCOPE OF THE Y2K PROBLEM

Financial institutions are vulnerable to Y2K problems on a number of fronts. It is now generally understood that the common sources of all potential Y2K problems lie in time- and date-driven computer programs and devices that use two-digit (i.e., 98) rather that four-digit (i.e., 1998) date codes. As a result, whenever year 2000 date entries register in such programs and computer driven devices, they may malfunction and/or fail to perform their prescribed tasks properly. Such events may affect financial institutions in many ways.

Because of the media hype concerning the so-called "millennium bug," some cynics have sought to minimize the seriousness of the problem, arguing that it is nothing more than a technical problem with wellknown solutions. Nonetheless, laggard institutions at best run the risk of regulatory wrath and at worst could put their directors at personal risk.(1) Moreover, there is an emerging sense that the best of efforts to deal with this "technical problem" may be inadequate, and Congress is considering various legislative initiatives to provide protection to institutions that make incorrect (but good-faith) disclosures regarding Y2K readiness. Other legislative proposals would limit the liability of vendors provided certain conditions are met. At this point, such laws, when enacted, do not pass the constitutional litmus test (see Baranick). Nonetheless, they do recognize that even the best of Y2K compliance efforts may prove inadequate.

Internally, Y2K malfunctions may cause any or all of the institutions' data applications to stop working and/or to produce inaccurate outputs. This could generate serious problems in handling any kind of payable, receivable or payment system transactions conducted by financial institutions. Customer loan and deposit, accounting, investments, currency, payroll and other normal financial service transactions are all vulnerable. In addition, any of an institution's P.C. software, timelocks and security systems, elevators, HVAC, lighting, fire control and other support systems may be impacted.

Externally, financial institutions may also be impacted through a variety of channels. It is possible, for example, that public utility services (power, gas, water, telephone lines, etc.) may be subject to Y2K-driven malfunctions. Malfunctions impacting suppliers of transportation and emergency support services may also affect the institution through its external dependencies.

Y2K-driven malfunctions affecting an institution's clients and trading partners, or the complex communications networks that connect them, may also cause serious problems. A loss of confidence by bank depositors, occasioned by Y2K failure scares for example, could generate a run on banks or thrift institutions, especially if responsible national leaders like Senator Robert Bennett (R-Utah) publicly make frightening statements about potential Y2K problems, e.g., "There will be some blackouts across the country, some individual banks may become bankrupt, some credit unions may disappear..." (USA Today). On the loan side, Y2K-driven business failures could cause otherwise creditworthy bank and thrift borrowers to become insolvent. Institutions involved in international financial, currency trading, futures, options and other cross-border transactions may also experience Y2K problems through contagion effects spilling over from such off-shore sources.