Abstract
The Year 2000 problem is one of the major concerns facing industries in every part of the world as the new millennium approaches. This paper concerns itself with an analysis of the possible effects, both technical and social, of the millennium bug, as well as the pre-emptive steps that have been taken. It will examine the possibility that companies will be unable in the near future to obtain loans owing to the high risk posed by the problem. It also discusses the likelihood and possible manifestations of panic within the next few years. A look at the various opportunities for profit in the sector is included. We conclude with an update on the progress that financial institutions have made in their efforts to combat this pervasive problem.
Contents
A vast amount of literature is currently available on the Year 2000 Problem. It is a phenomenon whose effect will to all appearances be felt far into the next century. Already it has captured much of the popular imagination, giving rise to varying degrees of concern, pessimism, and despair. It will not be straying off the mark to claim that perhaps the most central aspect of the functioning of modern-day society in the United States and elsewhere, is the economic system and its concrete manifestations, the financial institutions. These, preparedness aside, are under extremely high risk from the millennium bug because all its aspects have more to do with record-keeping (via computers) than with anything else in this day and age.
In section two, we detail the effects of Y2K turmoil and risk on borrowers. Section three discusses the possible effects of consumer fears concerning Y2K. Section four discusses a few current events in finance related to the Year 2000 Problem, with the intention of showing how unpredictable the workings of the millennium situation can be. Our fifth section reveals worldwide financial policies and progress to date. We conclude with a summary of the issues facing the financial community and the likely outcomes of the apple falling at midnight of December 31, 1999.
The financial industry began working on the Y2K problem in the early 1990's, long before other industries had even heard of the problem. Yet for an industry that is by far ahead of the rest, the message may not have reached overseas soon enough to avert disruption.
The finance industry was one of the earliest industries to attack the problem because it ran into the problem at a very early stage. Banks in the 1970's had to input 30-year mortgages into computers with end dates after the turn of the century. In order to accomplish this task, banks had to build in Y2K compliance. Intense regulation of financial intermediaries is believed to be another reason why firms were so quick to start repairing their systems: realizing regulators would force the changes sooner or later, they figured repairing systems at the present would reduce risk and costs. A third factor is the inherent risk mitigating nature of banks. They are constantly assessing the risk level of loans, thus they were aware that Y2K posed a threat to the heart of their business [JAG98].
While most major U.S. banks got an early start on the problem, a recent survey suggests that many weren't able to meet a recent deadline imposed by financial regulatory agencies. Of the 73 domestic banks that responded to a 1998 regulatory survey, 32 indicated they would not be able to meet the December 31, 1998 deadline to complete renovations. United States government banking regulators (the Office of the Comptroller of the Currency, the Federal Financial Institutions Examination Council, and the Federal Reserve Bank) set that date as a deadline for programming changes in mission critical applications. The regulatory agencies indicated that companies that have not started their testing by the end of 1998 will "probably be too late to fully convert their systems in time for the millennium" [YAR98B].
America's largest banks appear to be safe, however. Wells Fargo/Norwest completed their renovation and testing of mission critical systems in 1998 [WEL99]. BankAmerica/Nationsbank has completed remediation and is in the testing process [BOA99]. Citigroup, which expects to spend $650 million, is currently renovating and testing and plans on implementing their compliant system in June 1999 [CIT99]. Chase has renovated all non-desktop systems and is currently in a desktop remediation and testing phase [CHA99].
As part of the remediation efforts, member-firms of the Securities Industry Association (SIA), a trade association of nearly 800 securities firms, have been sharing Y2K knowledge with the permission of the Antitrust Division of the Department of Justice, which saw no anti-competitive outcomes resulting from information sharing among the member firms [BIS98].
Banks have also taken preemptive measures to educate clients about the Y2K problem and their efforts to reduce their exposure to it. With the possibility of investor panic very real (See the section on Panic), banks have posted messages on their web sites about their Y2K readiness. Stock exchanges have also taken to this practice, providing information on their compliance procedures. Nasdaq posted a detailed summary of their progress to date [NAS99], while NYSE has posted news on the progress of their testing as well as the text of a speech by their chairman [NYS99]. The Pacific Stock exchange has posted quarterly updates on the status of their testing[PSX99]. Britain's Midland Bank took it a step further by sponsoring a Y2K conference keynoted by British Prime Minister Tony Blair, discussing the nature of the problem and creating investor confidence in their efforts [JAG98].
Believing that they have adequately addressed the problem, 40 of the top U.S. banks compiled a "Top 10 Awareness" list in October 1998. The list was designed to help consumers understand the problem, make them aware of the actions banks have taken to avert disruption, and instill depositor faith in the bank. Those 40 banks hold 70% of the banking assets stored in the United States [CNN98L].
The SIA has been coordinating the remediation effort for communication between intermediaries. In mid-July 1998, the SIA simulated four days of trading to represent the last three days of December 1999, and the first trading day of 2000, January 3. The three trading days before the New Year are being simulated to allow for the full cycle of a transaction to be completed, which typically takes 3 days. The tests simulated 10,000 trades a day, or approximately 500 trades for each of the 28 participating firms. Trading was simulated in equities, municipal bonds, corporate bonds, unit investment trusts, mutual funds, options, government-backed and mortgage-backed securities. The simulation included every aspect of a transaction, from its initiation at a securities firm, through an exchange, a clearance and settlement organization, and a depository. The tests also accounted for trade cancellations and corrections [SIA99]. Results from these simulations indicated 90% of the transactions were completed successfully.
A series of follow-on tests began on Saturday, March 6. Like the 1998 tests, these tests simulate securities trading right before and after the beginning of the next millennium. In contrast to previous tests, this series has about 400 securities firms participating, including many smaller ones. Weekend tests later this month will continue to simulate trading through the first day of January [WSJ99A].
Reports from the first day of testing indicate that transactions were completed with few glitches. This result is not the least bit surprising, since it is simulating trading in 1999. The simulation of January 3, 2000, to occur on the last Saturday of March, will reveal the true status of remediation progress. Two Saturdays in April will provide testing for the mutual-fund industry as well as simulate the first day for expiration of options in 2000 [WSJ99B].
The NYSE is requiring all exchange members and member organizations with electronic links to participate in the March tests. In late October 1998, the Federal Reserve announced that more than 3000 United States depository institutions had conducted more than 9000 tests their Federal Reserve financial services applications. The Fed has been urging institutions to at least test all mission critical systems by June 30, 1999 [FED98].
Though the domestic finance industry has gotten a head start and appears to be well on their way to being as ready as they can, their simulated tests are not surefire indicators that trading on exchanges will happen on January 3, 2000. In fact, the only way the SIA could integrate so many firms into the current round of tests was with the assurance that lagging firms would not be exposed. Another problem is that not all the inputs that make for successful trade executions are being tested. Power companies and telephone operators were not included in these tests. Although these industries are doing their own independent testing, there are no guarantees of seamless trading in 2000.
The domestic financial system seems to be on solid ground, however no financial marketplace operates in a vacuum. Overseas markets and institutions have lagged behind their American counterparts in their efforts. An April 1998 report by the Basle Committee on Bank Supervision indicated that only 9 of 40 countries had started preparing for the problem by the end of 1996. Basic preparations that many institutions hadn't even started included the establishment of target dates for completing programming and testing [JAG98].
Southeast Asia seems to face the highest risk. A survey by the Bank of Japan (BOJ) indicated that only 48.3% of Japan's financial institutions had repaired their key accounts systems by the end of June 1998 [BOJ99]. A report by the bank indicated that about 80% of Japan's financial institutions would be ready by the end of 1998, and 92% by March 1999, but in all likelihood some institutions will fail to meet the January 1, 2000 deadline [YAR98A].
The Japanese banking industry is laden with late starters. Japan's largest bank, the Bank of Tokyo-Mitsubishi (third-largest in the world), indicated that it started its Y2K project in April 1997, while the tenth largest bank in the world, Sumitomo started in March 1997, 19th ranked Industrial Bank of Japan began in April 1997 and number 34, Tokai Bank, started in September 1997.
Much like the United States, communication systems between banks appear to be on track to make the millennium deadline despite intrabank problems. On February 18, 1999, the BOJ completed its second industry-wide test of major financial network systems. The tests indicated that payment and settlement systems are "adequately addressing" the Y2K problem [BOJ99]. The cabinet of Taiwan has taken a hard line on non-compliant banks, threatening to shut them down if they don't pass an official Y2K inspection in mid-1999. The finance ministry stated that this procedure will prevent non-compliant banks from corrupting those that are compliant. In Thailand, the Bank of Thailand is racing against the clock to meet a mid-1999 deadline to repair their systems sufficiently to avoid blacklisting by the Bank for International Settlements, a central organization of international banks [CNN98M].
Fearing that the millennium bug could cripple trading on several Asian markets, the Australian Stock Exchange has made arrangements to accommodate temporary listings of Asian companies. The exchange has already spoken with at least one "significant" Indonesian company that wishes to avoid Y2K turmoil on the Djakarta exchange [YAR98C].
Latin America has fewer computers, less wealth, and fewer interdependencies than Southeast Asia, yet it too has problems. Over 50 percent of South American companies are expecting Y2K problems [HCO99]. Questions about the readiness of Brazil's telecommunications services put its entire financial infrastructure at risk. At last report, the Mexican Stock Exchange had advanced to 65-70% compliance by late August 1998 [YAR98D].
In Europe, the smooth transition to the Euro bodes well for the Year 2000 problem. Italy may face the greatest challenges of any country: the government set up a Y2K committee only on January 14, 1999. Although 1998 was a difficult year for Russian banks, they are making strides to address the problem. Despite the government first becoming aware of the Y2K problem at a G8 summit in May 1998, as of October 1998, almost all of the commercial institutions in Russia that were aware of the problem were financial institutions. The Russian central bank has been at the center of the progress, initiating a Y2K preparation program and beginning to test equipment [YAR98E]. Although this is good news for many bank operations, dependencies on firms in other industries could cripple banks unless other sectors attack their compliance issues. A recent CIA report to Congress indicated that power failures, food shortages and civil unrest are becoming increasingly likely results of the Y2K problem in Russia. All three of these outcomes put the financial infrastructure at risk.
For banks that will be unable to meet the millennium deadline, the Basle Committee advised finding a compliant buyer as "an approach to contingency planning." Contrary to this advice, the Committee also warned compliant banks about merging or acquiring a non-compliant bank [YAR98G].
There have been no widely publicized bank mergers consummated for the sole intention of avoiding Y2K problems. To the contrary, swarms of bank mergers have occurred over the past two years with hardly a mention of their Y2K ramifications [CNN98K, CNN98N, CNN99C].
Although only nine of the 40 respondents to the Basle survey had prepared for Y2K before 1997, all 40 of the respondents reported that they had contacted banks, and 65% had already issued written instructions to banks [YAR98G].
The situation might not appear so bad in some countries, but then one must consider that many officials are looking at their national situation through rose-colored glasses. No country wants to admit that it is drastically behind. Take the case of Russia, where officials did not become aware of the Y2K problem until May 1998. At a conference in Washington, D.C., Dr. Sergey Rogov, a member of the Advisory Board of the Russian Security Council and the Advisory Board of the Foreign Ministry and the Advisor to the Foreign Affairs Committee of the Duma of the Russian Federation tried to stress that they are "to some extent" in a better situation than the United States or Japan. This may be true in some cases, but the bottom line is that the government isn't seriously addressing the problem, and even if it were, it wouldn't have the money to fix the few mission critical systems that exist. The Russian Committee on Communications and Information requested $500 million to evaluate the Y2K problem: equivalent to the entire revenue of the Russian federal government. However, by stating that Russia was in some way ahead of western nations generates national pride and confidence, even if it is false. Y2K observers must tread cautiously when evaluating statements from countries which in the past have put positive spins on situations that were realistically grim.
Aside from the legal action that may ensue from withholding the truth, no banks have an incentive to be forthright in announcing Y2K status. If they preannounce Y2K problems, banking regulators will shut the bank down. This situation would undoubtedly result in a bank run. Banks who are at risk, and all companies in such a situation, would much rather keep news in-house and hope for the best on January 1, 2000. If they can't operate on that fateful day, then the resultant chain of events would be very similar to the results of preannouncing their problems. This time, however, it would be accompanied by legal action against the board of directors of the bank. With the bank in an illiquid state, litigation would likely be at the bottom of a director's list of priorities.
Evidence of this behavior exists in forecasted expenditures for Y2K repairs. BankAmerica, the eighth largest bank in the world is projected to spend $380 million fixing their problems, while Tokyo-Mitsubishi (the third largest bank in the world) expects to spend only $66 million. Japanese banks have insisted that their costs are reduced because they have more mainframe systems than their American counterparts, however an 80% difference in remediation costs seems extreme.
Despite incentives to misrepresent the truth, we believe major United States banks are well positioned to make a seamless transition into the new millennium. The same cannot be said about many of the smaller domestic banks or banks of any size overseas.
"The only thing we have to fear is fear itself."
--- Franklin Delano Roosevelt, President of the United States, Inaugural Day Address, 1933
"He didn't ask if he should take his money out of the bank. He asked when…"
--- David Eddy, Software specialist and online computer columnist.[BBJ98]
Certainly, not all the threats associated with the Year 2000 computer problem lie with computers. It is widely recognized that the actions of various bank customers, investors and insurance policy holders, reacting to fears about Y2K, could cause more trouble than any COBOL-based mainframe computer. Possibilities range from widespread panic, which has not been seen since the Great Depression in 1929, to a series of irregularities in the financial activities of individuals, extending over a period of years. We consider some of these in this section.
If there were to be a panic of some sort, how would it happen? From experience, it would require a huge trigger of some sort - like the great drop in the Dow Jones Industrial Average in 1929. It could be bad news from any aspect of the United States' operations that is considered important by the general public. Concerning financial institutions, we can think of a few possibilities.
One is a large number of computer errors at commercial banks reported in a short space of time, perhaps less than a week. Our section on Compliance Policies discusses some possibilities. There have already been a few incidents reported, though not with particularly great emphasis, in the Press. An example is an incident in which Bank One Texas sent out 2,013 false account overdraft statements generated by a Y2K bug test [HC98A]. When real errors occur as the Year 2000 approaches, it could be dangerous to have hundreds of thousands of false overdrafts going out in even one particular area, because fear might spread. A list of important dates, including those on which to expect trouble, can be found at [TIC99].
As is noted elsewhere in this paper (section on Credit Crunch) there is also a high likelihood that banks may suddenly stop issuing loans owing to the high risk posed by the Year 2000 problem. This would lead to unemployment, and then possibly to panic or depression.
Another threat is the possibility of a false alert gone awry. That the public can easily be misled concerning Year 2000 issues is evidenced by incidents such as a bogus telemarketing scheme that occurred in the Milwaukee area in January 1999. Individuals claiming to be telemarketers offered to send "replacements for the magnetic strips on the backs of their credit cards to protect [users] from Y2K complications" [MJS99]. It is possible, although not probable, that an insufficiently checked, greatly distorted, or widely misunderstood news item could build, as this scheme did, on popular fears and ignorance, to devastating effect. One remembers the Orson Welles radio broadcast in 1938 that sparked off a panic in some cities, when listeners to a science-fiction radio play thought they were hearing news of a Martian invasion. As then, the issues at stake are so large here that a slight distortion will propagate rapidly, as it did in that case, by word of mouth.
The above scenario seems at once more and less likely in view of the fact that today, there are many more sources of information available to the public. The most notable of these is the Internet, where the public first heard of, for example, the Monica Lewinsky incident, despite the refusal of major periodicals like Newsweek to run the story. While there are more avenues for news to spring from to incite a panic, it may also be true that the proliferation of news sources also gives the public more opportunities to verify information. But since there has been so much concern over the Y2K issue already, the public may find bad news more credulous than good. The tendency might be to "make sure" by withdrawing cash from the bank. This is a significant possibility since there is likely to be some concrete (but minor) manifestation of Y2K in the environment to add credibility to a scare.
One aspect of the situation that may give us less to worry about is that whatever will happen will be to a great degree anticipated. Although expectations vary widely, even the most optimistic believe that there will be many computer errors at the turn of the century. So, we feel that more likely than instantaneous and jarring panic is the possibility of changes in economic activity over a period of years, owing to widespread fears.
The stock market is the prime suspect in this scenario. Dr. Edward Yardeni, expects "a global recession" starting in the second half of 1999, if the stock market drops as much as he expects in anticipation of the Year 2000 problem [YAR98F]. Yardeni is not used to making pessimistic forecasts: he has previously predicted accurately high numbers for the Dow Jones Industrial Average for 1995 and the present day. In fact, he adds that "stock prices should start to recover in 2001 and soar to a new Dow Jones record high of 15000 by 2005." Concerning his predictions of changes in trading pattern, the Securities and Exchange Commission might agree: an associate director of the SEC's division of market regulation, Sheila Slevin, said firms must prepare for events such as heightened customer service demands and a decrease in trading. However, a Federal Reserve Governor, Roger Ferguson, believes that the chances of catastrophic-level disruptions to the world's financial community are slim [CNN99A]. In January, he described the disruptions that will occur as "mild and short lived."
Public fears have affected very many financial aspects of the Year 2000 problem and its treatment because so much of our modern economy is based on the sentiments of individuals. Global 2000 is an organization consisting of 250 of the world's biggest banks, insurance companies, and securities companies. It had initially planned to issue public ratings of each country's readiness for the millennium bomb, but did not because the danger of publishing ratings was that it could have a counter-productive effect. Apparently, some central banks had warned the group that a negative public rating could add to the financial instability of some emerging markets, notably in Latin America, which were already in difficulty because investors were withdrawing capital [FTL99A].
From the commercial banking sector, we find more examples of this trend. Banks criticized the telecommunications giant GTE for advising, in a newsletter, its 2 million customers in Florida, Texas and California to "withdraw a few weeks' worth of extra cash before December 31, 1999, just in case your ATM is temporarily out of order or your credit cards won't work" [TT99]. The Tampa Tribune also reports that GTE countered accusations of contributing to a consumer panic by stating that the advice was drawn from a "summary of news media accounts about Y2K." Criticism was given to GTE for giving advice in finance, supposedly beyond their field of specialization.
We see efforts made on the part of regulatory bodies in giving advice to companies on how to assuage consumer fears. The Federal Financial Institutions Examination Council (FFIEC) says that banks, savings & loan companies and credit unions need to make clear to customers what they are doing to ensure that people have access to their money and continue to receive accurate information on their accounts. The council also suggested that financial institutions point out to customers that the year 2000 date change will not affect their $100,000 federal deposit insurance coverage on each account (Journal of Commerce, February 19, 1999).
Finally, we look at the various perceptions of the Y2K problem at the present time, as a possible indicator of the future. On the Internet, even the simplest searches for "Y2K"- related material yields links to many web pages by organizations with suspicions or predictions of disaster. "The Y2K Family Survival Center" claims in its introduction to the Year 2000 problem [VV98] that since suspicions of non- compliance will cause computers at banks to stop trading data, "even if the problem is fixed ... the system still goes down." It goes on to say that news on Y2K has not caused a panic only because it is disseminated in "neatly packaged news stories that aren't really intended to alarm" viewers and readers.
On this subject, we find in the press that 70 percent of those surveyed in a January 1999 poll sponsored by the Media Studies Center believe that removing cash from the bank and similar related behavior is "overreacting" to the problem [WRD99]. At least two things are noteworthy. The first is that one hundred minus seventy is thirty, and the Internet article cited above (as well as others based on it) did not report the number of those who thought otherwise. The second is that a further research at the home page of the Freedom Forum, which the Media Studies Center is part of [FF99], reveals that 25 percent of those surveyed felt that "that some of these actions may be appropriate." That there was less emphasis on the latter, a somewhat more unsettling statistic, indicates that perhaps some effort is being made by the media to reduce the likelihood of panic. The survivalists would appear to have a point.
More specifically, the poll indicates that 13 percent of respondents are "Very Seriously" considering withdrawing money from banks and other investments. 33 percent are just as serious about "collecting paper records of all investments, bank accounts, insurance policies, etc." The survey also indicates that the public feel that there is much to be desired in Year 2000 Problem coverage: too much focus on lurid tales of survivalists relocating with food supplies, too little on what steps individuals should take in the New Year. This approach on the part of the press probably doubles as a means of boosting sales through sensationalism, as well as a means to distract the attention of the public. After all, having 13 percent of the public seriously considering withdrawals does not seem so small when one recalls that only 10 percent of the $4.5 trillion in US bank accounts is available in cash at any given moment.
From the preceding information, one thing, at least, is clear: most customers are, or will be, worried about the Year 2000 Problem. How much of an economic problem consumer fears will pose is uncertain, but it seems likely that despite the efforts of institutions, regulators and the media to assure the public, the overall effect will be damaging.
The ability for companies to get financing for new projects and Y2K repairs is contingent on stability in the financial markets and the willingness of commercial banks to make loans. As stated previously, it is likely that the domestic financial infrastructure will be able to weather the Y2K storm, but volatility in the capital markets and the high risk nature of business loans may make borrowing a difficult task.
For financially constrained companies wishing to pursue new projects or make Y2K repairs, retail banks and financial market intermediaries are two of the easiest sources of capital. However, in the months leading up to the new millennium capital markets are likely to dry up, hurting both the firms that need capital and those that are in the business of providing it.
The Federal Reserve Board has encouraged lenders to pay special attention to Y2K compliance of potential borrowers. Although they urge banks to be careful in their lending practices, it's anticipated that the Fed will try to keep interest rates low to enable companies to get the funds necessary to complete their Y2K preparations [CNN98A]. If a borrower presents too much risk (from normal business operations or Y2K), however, then banks will either not make the loan or only provide credit at a higher interest rate with restrictive loan covenants. This shuts out borrowers from the easiest and fastest source of capital and could cause companies to fail before the turn of the century. This is a tenuous position for the Fed, which wants to keep capital flowing to companies to fix their Y2K related issues, but doesn't want banks to expose banks to any risk of insolvency because of too many loans gone bad.
In Japan, the supply of capital from banks is dry enough without any worries about Y2K. Throughout most of 1998 and lasting until the time of this writing, banks have been reluctant to lend to because of problems in their own financial markets [FTL99B]. Dr. Ed Yardeni, chief economist for Deutsche Bank Securities, characterized Asia's problem as the a Year 1998 problem, since many financial institutions attempted to stave off bankruptcy resulting from bad loans in 1998 [YAR98A].
For those companies wishing to sell equity to the public to raise cash, the market volatility likely to ensue in the fourth quarter of 1999 and early 2000 will deter even the most promising of IPO candidates (See Consumer Sentiment). This volatility is likely to result from questions of the effect of Y2K on corporate profits. Yardeni predicts a 30% decline in stock prices resulting from shortcomings in corporate profits. These doubts could lead to investor panic and rapid market withdrawals. Market volatility in the summer of 1998 all but killed the market for new issues [CNN98B, CNN98C]. Industry leaders such as Goldman, Sachs & Co. had to scrap IPO plans, while unproven Internet stocks such as Theglobe.com shelved plans as well [CNN98F]. Companies looking to use the capital markets to fund their Y2K renovations before the new millennium risk informing the market of just how pervasive the problem is, possibly prematurely triggering a market selloff.
Even high-yield debt, which is often the best source for large amounts of financing for high-risk companies, has been prone to dry up in times of market volatility. Created in the last 1970's as a source of capital for risky acquisitions, high-yield debt pays a higher interest rate to lenders than "commercial-grade" debt, which is issued by companies with a top-notch credit rating. Today's industry leaders such as Hewlett-Packard and Xerox issued high-yield debt, or "junk" bonds, in their infancy when other forms of capital weren't available to them.
Uncertain profits and credibility widen the spread between investment grade (corporate) debt and high-yield, making it more costly for risky firms to raise capital. This past fall, the junk market was virtually non-existent as a large spread kept many potential borrowers on the sidelines [CNN98D, CNN98E]. It is especially difficult for the markets to assess the risk that individual companies face. Although the company may have renovated, tested, and implemented compliant software and hardware, all companies face the risk of problems in their supply chain or an overall market recession.
For companies that cannot raise the requisite cash to continue operations because of their own Y2K problems or market conditions, the only alternative may be to cease operations. This situation could also be a reality for companies that already have debt on their books, but can no longer meet their interest payments because of problems repairing their own Y2K problems or those of their suppliers and clients.
Companies that are prepared for Y2K and only need small cash infusions may be the only market participants able to finance future growth with debt from third party investors.
The resulting lack of companies able to get financing would damage the bottom lines of both commercial and investment banks, who earn money by providing the financing.
With the Fed dropping interest rates and commercial banks carefully monitoring the Y2K risk of their borrowers, the return on investment of banks' loan portfolios would decrease. This return would further decrease when factoring in the biggest risk faced by companies: a recession (See Consumer Sentiment). Economic downturn would lead to increasing defaults by borrowers, thereby yielding a lower return on loan portfolios. In order to maintain profitability, banks would lower interest rates paid to depositors. The difference between the rate at which money is loaned at and the rate depositors are paid, known as the spread, would shrink as rates decline
The situation for banks could be even more complex if investor panic creates a liquidity crisis for banks, forcing them to raise interest rates in order to maintain deposit levels and liquidity [CNN99B]. This situation could eventually lead to insolvency, since banks would be locked in to a lower interest rate from long-term borrowers while paying out a higher interest rate to short-term depositors.
For investment banks who specialize in tapping the capital markets to raise debt and offer equity, business would vanish as market volatility deters investors from buying risky debt and corporations from selling equity. In the case of Paine Webber, a firm with retail brokerage, sales and trading, and investment banking operations, investment banking contributed almost seven percent of 1997 total revenues [PW98]. For Morgan Stanley Dean Witter, which has an even larger Investment Banking operation (in addition to sales and trading and retail brokerage operations), banking contributed almost ten percent of 1997 total revenues [MSD98].
As profits from investment banking activities plummeted, Wall Street firms would rush to cut costs to maintain profitability. Such was the case this past summer and fall, when the troubles in Russia and lingering effects of Asia caused profits to diminish and jobs to be cut [CNN98G, CNN98H, CNN98I, CNN98J].
On the retail brokerage side of an investment firm, market volatility would lead to customers wanting to move their money out of risky stocks and into safer assets such as debt and cash. These transactions would generate fees that would boost the bottom line of investment firms.
Market volatility would not affect revenues generated through mergers and acquisitions activity (M&A), though we would see a change in the type of activity . Companies would begin to put free cash to work by buying companies for cash at low market prices. These cash purchases would take the place of stock-for-stock transactions that are popular in the current bull market.
Corporate stock buybacks would also increase as companies capitalize on a diminished stock price by concentrating ownership. A buyback also acts as a signal to the market that management believes the stock is undervalued and is willing to put money on it. After a major drop in stock prices last fall, IBM and Advanta capitalized on their depressed stock prices to initiate buyback programs [CNN97].
Although the effects of market volatility move investment bank profits in opposite directions, the factor with the greatest weighting on profits, the issuance of debt and equity, is likely to result in a strong decline in total revenue and in the end, net profits.
The risk that both small and large companies face at the turn of the millennium will result in tight capital markets and restricted lending policies by banks. These actions will undoubtedly hurt companies, many of which will be forced out of business by the lack of available capital. With business for intermediaries diminished, the intermediaries themselves will likely be forced to layoff employees and take a hit in their profits. These changes will significantly impact the financial landscape as we move into the 21st century.
There have been widespread attempts within the financial services industry to profit from the possible outcomes of the Y2K problem. Approaches, relying on predictions with varying degrees of uncertainty, have been examined and put in practice. For some of these, there has already been considerable feedback.
Several years ago, it appeared that there might be a good market for an insurance policy to cover Year 2000 problems, but sales have been disappointing, according to an article in the Journal Of Commerce, December 21, 1998. Insurance firms in the United Kingdom and the United States such as American International Group and Lloyd's of London. An executive of Aon Insurance Services, which markets such a policy, says that sales have not matched the significant interest among the potential customers, which are Fortune 500 companies. Apparently, these are "just about the only ones that can afford the high cost of even seeing if they qualify for coverage." But the policies are not selling well, says another executive, because the underwriting information is so burdensome and costly "so our potential Y2K customers decide not to purchase the coverage and just hope they never run into a problem."
The special nature of the Year 2000 problem is the cause of the strange approach by companies and banks to insurance. The Year 2000 problem is so widespread and the likelihood of at least some measure of error so inevitable that it could almost qualify as a disaster of sorts. This is especially the case considering the virus-like aspect of information corruption over networks and in companies' internal computers. It is likely that unless communications are restricted and slowed down considerably, it will be nearly impossible to detect the source of an error in transaction records. However, if the Year 2000 problem is an unavoidable disaster, then there is really no point in insuring it, since the insurance firm is bound to lose. Hence the reality is that policies are being sold, but insurance companies "have to demonstrate that they've taken major steps" to demonstrate compliance. Businesses "likely must show that the insurer that they can generate forms, bills, checks, invoices and any other documents with post-2000 year dates" [JOC99]. The goal is to ensure that the company "probably won't be forced to shut down operations because of Year 2000 computer bugs." The article ends with a quote suggesting that although sales are slow at present, demand could change in the coming months.
There have been similar disappointments on Wall Street [FTL98]. Many Y2K-related stocks, seen two or three years before as a "golden investment opportunity," have become less attractive after executives announced disappointing results, one by one. The software tools company Micro Focus, after having its share price triple in 1997, "came down to earth with a bump" in November 1998, settling at the price it had sold for eighteen months before. "Lower than anticipated demand" was the reason management gave.
In 1996, the investment bank J. P. Morgan had predicted that the Year 2000 Problem would be a windfall, that it "could account for all the forecasted worldwide systems integration services revenue through 2000." It divided its favored Y2K stocks into four broad categories: "contract programming companies such as Micro Focus and Viasoft, specialist Y2K tools suppliers such as Micro Focus and Viasoft, traditional large systems integrators such as EDS or Computer Sciences, and a fourth set of companies destined to benefit in other ways, such as recruitment agencies" [FTL99A]. Viasoft, despite having half its revenues come from Y2K work, announced a quarterly loss in October 1998 and plans to lay off 10 per cent of its workforce. "Weaker demand and increased competition worldwide for Viasoft's Y2K software tools had a negative impact on first quarter results," said Steven Whiteman, Viasoft chairman and chief executive. Although Viasoft stock had reached $65 in mid-1997, it had collapsed to $4 by November 1998.
However, some Y2K stocks are doing well, such as Data Dimensions, a company similar to ViaSoft, as well as software house Compuware. The reason for the disparity between the performance of these stocks is that different companies have used different strategies for dealing with Y2K. Although some organizations are making use of IT outsourcing partners, others are using existing IT staff, hence "the Y2K issue has not produced the expected boom for outsourcers." Vendors of software tools are expected to fare better, but even they must cope with increasing competition [FTL99A].
Recently (March 1999), more consultants are shifting away from Y2K-related work. Also, a recent survey by BT Alex. Brown analyst Edward S. Caso found that more companies are shifting their Y2K spending this year to in-house technicians, depriving service firms of their revenue. Caso believes that revenue forecasts from the leading year-2000 service providers are overly sanguine. [WSJ99C].
Apparently, the gateway to the new millennium is not paved with gold. Or is it?
Many investors have shifted their portfolios towards commodities such as gold, as a hedge against the possible effects of the Year 2000 Problem. Some say that precious metals could serve as a stop-gap currency if networks fail and people can't draw on their bank accounts with checks or ATM cards. Gold is apparently more attractive to some investors because it is at a historic low, say industry experts. Some companies, such as Blanchard & Co., the country's biggest seller of investment-grade gold coins, recommend that clients put 10% of total assets in gold, rare gold coins and other hard assets.
As a result of this trend, the U.S. mint, which makes bullion coins from gold, silver and platinum, had a record year in 1998, selling more than 1.8 million ounces of gold American Eagle coins, the most since its launch in 1986. However, the price of gold has fallen in the past two years alone by more than $120 an ounce to $287.50 per ounce in January 1999. Also, some analysts, aware of year-2000-related gold buying, say that Y2K investors could spark further bear markets for precious metals when the problem is averted and investors turn around and sell.[WSJ99D]
A Cable News Network Financial News article from February 18, 1999 reports that Chicago futures traders are buying and selling futures contracts on short-term interest rates, in the hopes that Year 2000 fears will cause members of the public to withdraw money from the bank (see section on Panic). This, according to the article, would send short-term interest rates soaring, perhaps only for a few days, but with possibly profound impact [CNN99B]. Paul Kasriel, economist at Northern Trust, a trading firm, also predicts in the article that corporations will increase the size of their inventories towards the New Year, to in case they face a shortage in January 2000. He claims that since this will require borrowing on their part, buyers of futures on short-term interest rates are likely to benefit.
In view of the other "Y2K opportunities" described above (under Insurance and Wall Street) and their actual performance, we would not advise traders to be overconfident about their predictions.
We have examined in depth many of what we consider to be the important aspects facing the financial infrastructure in the next year.
Special thanks to James McKim for pointing us in the right direction. Thank you to Duncan Simmons for his debt market expertise.
|
Chris Mahoney. Officials Try To Avert Y2K Bank Runs. Boston Business Journal, 3 November 1998. [page number unavailable]. | |
|
Bank of America. Year 2000 Initiatives at Bank of America. Visited 11 March 1999. | |
|
Lynnley Browning. States Warn Small Banks On Y2K bug. The Boston Globe, 13 January 1999. | |
|
Rolin P. Bissell. Securities Industry to Exchange Year 2000 Information Lessons for Other Industries. 31 December 1998. | |
|
Bank of Japan. Results of the Second Industry-wide Test for the Year 2000 Problem. 17 February 1999. | |
|
Chase Manhattan Bank. Year 2000 Readiness Disclosure. Visited 11 March 1999. | |
|
Citicorp. Qualitative Self Asssesment - Citicorp/Citibank. Visited 11 March 1999. | |
|
Cable News Network. IBM in on buyback trend. 28 October 1997. | |
|
Cable News Network. Y2K Problem May Help Decrease Interest Rates. 2 November 1998. | |
|
Cable News Network. Where are all the IPOs? 7 September 1998. | |
|
Cable News Network. IPOs roar back to life. 1 December 1998. | |
|
Cable News Network. Corporate bonds need a lift. 30 September 1998. | |
|
Cable News Network. Earnings problems ahead. 12 October 1998. | |
|
Cable News Network. Theglobe.com Shatters One-Day IPO Record 13 November 1998. | |
|
Cable News Network. J.P. Morgan to cut staff. 24 February 1998. | |
|
Cable News Network. Deutsche Bank cuts staff. 26 February 1998. | |
|
Cable News Network. Wall Street mulls layoffs. 22 September 1998. | |
|
Cable News Network. Merrill Lynch slashes staff. 13 October 1998. | |
|
Cable News Network. Travelers, Citicorp to Unite. 6 April 1998. | |
|
Cable News Network. US Banks Develop Top 10 List For Year 2000 Issues. 1 October 1998. | |
|
Cable News Network. Thailand - Year 2000 Could Prove Expensive For Govt. 26 May 1998. | |
|
Cable News Network. Blockbuster Bank Deals Set. 13 April 1998. | |
|
Cable News Network. Global Y2K Crisis Unlikely. 21 January 1999. | |
|
Cable News Network. Betting on Y2K. 18 February 1999. | |
|
Cable News Network. BNP in Big Paris Match. 9 March 1999. | |
|
Federal Reserve Financial Services. Federal Reserve and Depository Institutions conduct Year 2000 Tests of Major Payments Applications. 28 October 1998. | |
|
The Freedom Forum. Survey: The public weighs in on media coverage of Y2K. Visited 11 March 1999. | |
|
High-flyers come down to earth with a bump. Financial Times, 8 December 1998. | |
|
Financial Times (London), 1 February 1999. | |
|
Gillian Tett. BoJ 'ready to pump liquidity into markets'. Financial Times (London) Page AP-06, 18 February 1999. | |
|
Houston Chronicle, 1 January 1998. | |
|
John MacDonald. Y2K Spells Trouble for Russia, Other Countries, Study Says. Hartford Courant Page A14, 6 March 1999. | |
|
Peter de Jager. Financial Community leads the Y2K Race. 24 September 1998. | |
|
Journal of Commerce, 19 February 1999. | |
|
Milwaukee Journal Sentinel, 25 January 1999. | |
|
Morgan Stanley Dean Witter. Annual Report. Visited 21 February 1999. | |
|
National Association of Securities Dealers. Year 2000 Preparedness. Visited 21 February 1999. | |
|
New York Stock Exchange. Year 2000 Information. Visited 11 March 1999. | |
|
Pacific Coast Stock Exchange. Year 2000. Visited 21 February 1999. | |
|
Paine Webber. Annual Report. Visited 21 February 1999. | |
|
Securities Industry Association. SIA 2000 Beta Test Update. Visited 11 March 1999. | |
|
Techology Integration Center. Key Y2K Dates. Visited 11 March 1999. | |
|
Ted Jackovics. Tampa Tribune, 6 February 1999. | |
|
M. J. Zuckermann. Y2K: Minor Glitch or Major Disaster? USA TODAY, 31 December 1998. | |
|
Smaller financial institutions preparing for Y2K as well as large banks. USA TODAY, 13 January 1999. | |
|
Gary North. It May Be Too Late For Society, But Your Family Has Time! Visited 11 March 1999. | |
|
Wells Fargo. The Wells Fargo Year 2000 Strategy. Visited 11 March 1999. | |
|
Declan McCullah. Y2K: Americans Want To Know. Wired News, 29 January 1999. | |
|
Rebecca Buckman. Year-2000 Test Is in the Works on Wall Street. Wall Street Journal Page C26, 2 March 1999. | |
|
Lynn Cowan. Wall Street Opens a Nationwide Test for Y2K and Encounters Few Problems. Wall Street Journal, Page C18, 8 March 1999. | |
|
John G. Auerbach. Millennial Computer Menders See Work Orders Start To Fall. Wall Street Journal 11 March 1999 [page number unavailable]. | |
|
Tezrah Ewing. Year 2000 Prompts A Shift To Gold By Some Investors. Wall Street Journal, 20 January 1999 [page number unavailable]. | |
|
Dr. Ed Yardeni. Japan: A Different Schedule. Visited 11 March 1999. | |
|
Dr. Ed Yardeni. Bankers Read Riot Act. Visited 11 March 1999. | |
|
Dr. Ed Yardeni. Asia: Sweet & Sour. Visited 11 March 1999. | |
|
Dr. Ed Yardeni. Latin America: Clueless. Visited 11 March 1999. | |
|
Dr. Ed Yardeni. Europe: Late & Vague. Visited 11 March 1999. | |
|
Dr. Ed Yardeni. Shadows Over The Market. Visited 11 March 1999. | |
|
Dr. Ed Yardeni. G10 Bank Officials Warn of Global Chaos. Visited 11 March 1999. |