CS99 Pre-Y2K Report

The Financial Sector

Wilhelm E. Paukert and Rob Simik

Computer Science 99

Dartmouth College Computer Science

March 15, 1999

In this paper, we offer a summary of the Year 2000 (Y2K) problem as it pertains to the institutions that constitute the United States' financial sector. More specifically, our paper will focus on several key areas: government financial institutions, investment banks and services, commercial banking and credit, insurance companies, and organized exchanges. In each section, we include a description of the nature of its Y2K problem, the scope and status of its compliance programs, and pertinent Y2K-related developments. The paper concludes with forecasts of the potential economic impact of the Y2K problem from leading industry analysts and spokesmen.

1. Introduction
2. Background
3. Government Institutions
4. Commercial Banks and Investment Services
5. Organized Exchanges
6. Insurance Industry
7. Economic Forecasts
8. Summary
9. References

1. Introduction

Domestic and international financial markets depend heavily on the reliability of their information technology (IT) infrastructure. Information is essential for the markets and the economy to function properly. If this flow of information were severely disrupted by Y2K problems, the consequences would be serious. In response to the growing concern over the possibility of Y2K-related market failures and ensuing economic crisis, John Koskinen, Chairman of the U.S. President's Council on Y2K Conversion, stated that most economists in the United States "saw no risk of a local or global recession or depression" in his keynote speech at the second global Y2K conference [Reu99]. Other industry analysts, however, are not as optimistic. Some experts, including economist Edward Yardeni of Deutsche Bank Securities, predict a significant likelihood of an economic recession. Results from recent industry-wide testing and Y2K readiness disclosures from numerous publicly-held firms suggest that the financial sector is closer to compliance than other sectors. A September, 1998 study by the Gartner Group, a leading IT consulting firm based in Connecticut, indicates that the insurance, investment services, and banking industries are ahead of the other industries in terms of Y2K compliance (see Figure 1) [Mar98]. Nonetheless, industry analysts caution that Y2K problems may arise from external sources such as non-compliant third-party vendor products and services, business partners, and foreign markets. The growing importance of international transactions in the financial sector underscores the potential impact of overseas Y2K problems on domestic firms and markets.

2. Background

The financial sector consists of the markets and institutions that provide fundamental services to investors and borrowers. The creation of new securities, exchange of existing securities, facilitation of trade, and rendering of savings and investment services are its activities. The following constitute the institutional structure of financial markets: government financial institutions, investment banking and services, commercial banking and investment services, non-bank financial institutions, and organized exchanges. The government financial institutions revolve around the Fed, as it has the power to set interest rates, print money, and has control of banking practices throughout the nation. This category also involves government-backed financial services such as Fannie Mae and Freddie Mac that create a liquid market for mortgages on family houses. Commercial banking and investment services define the savings and investment of the financial market. In particular, commercial banks provide loans, savings and checking accounts, as well as mortgages. Investment banks as well as Brokerages make up Investment Services. They provide an access to the markets for individual investors, service mergers and acquisitions, and help companies go public. Non-bank financial institutions may be viewed as alternative savings vehicles. Pension funds, mutual funds, special-purpose finance companies, and insurance companies fall under this category. These institutions form the part of the financial market that is growing most rapidly. Organized exchanges are the clearing and trading facilities for financial securities such as stocks, bonds, options, and derivatives. The New York Stock Exchange (NYSE) is the world's largest exchange in terms of equity trading volume. The Nasdaq stock exchange ranks second.

The institutions that constitute the financial sector all face a similar set of potential Y2K problems. That is, these problems may be present in their business software systems, embedded chips, communications systems and networks, products and services from third-party vendors, foreign financial markets and firms. Securities transaction systems, mortgage and other valuation software, payroll accounting software, and general office programs are among the software systems that may be affected by Y2K bugs. Embedded chips in computer systems, ATMs, credit card systems, point-of-sale systems, and even internal facilities such as security and other building systems, office equipment, and elevators are another potential source of problems. External telecommunications systems and networks are particularly important to the financial sector, because these industries are quite dependent on the smooth functioning of transactions and information retrieval. Industry experts are also concerned about the Y2K compliance of third-party vendors. Finally, even if the financial sector in the United States is largely Y2K compliant by the deadline, it could be affected adversely by Y2K problems experienced in overseas markets.

3. Government Institutions

The Government's approach to the Y2K problem covers a broad range of industries. We will focus on the financial infrastructure and how it potentially could be affected by the new millenium. There are several financial institutions that the government must focus on if a smooth transition to the year 2000 is to take place. We will focus mainly on the Federal Reserve, Fannie Mae and Freddie Mac.

3.1 The Federal Reserve

The Fed, like other institutions, has both its optimists as well as pessimists. The Fed's responsibilities in the Y2K challenge not only involve the Fed itself, but also more than 1600 financial institutions it must examine. There are two main problems with the Fed's approach to solving its problems according to the General Accounting Office (GAO.) First, the Fed was six months late in assessing the banking industry's Y2K preparedness. Second, there are simply not enough workers devoted to assessment, testing and modifications. As of September 1998, only 4 percent or about 120 workers were devoted to the issue full-time according to a report by GAO and Bert Ely, a Virginia-based financial industry consultant. Not only did it devote a mere 4 percent, but the problem has been compounded because of the limited Y2K training of the examiners [Reg98].

The Fed initiated their Y2K efforts in June 1996, but according to the GAO recommendations, they should have started no later than January 1996. According to the GAO and the Office of Management and Budget, organizations should have completed assessment phases by December 1997, but the Fed was lagging behind again, finishing awareness and assessment in June 1998.

There are, of course, optimistic reports about the Federal Reserve. In February 1998, Alan Greenspan spoke to Congress to inform them about the progress of the Fed and its readiness for Y2K. According to Greenspan, the Fed has now completed remediation and testing of 101 of 103 of its mission-critical systems. [Fed98]

contingency issues - The Fed has several responsibilities to take care of before the year 2000. Since it is expected that people will hold some extra cash during the days prior and following the New Year's 2000, the Fed will be ready to issue more currency into the circulation -around $50 billion. This is an increase of about 33 percent from what the Fed would print annually. Since printing of money would lead to inflation, the Fed will be printing $50 billion less in 2000. "We are neither as badly off as some of the doomsayers would have us believe nor at a point where we can stop worrying," commented Chester Feldberg, head of the Federal Reserve of New York.[Fed98]

3.2 Fannie Mae (Federal National Mortgage Association)

Fannie Mae is a Government secured private lending institution that pools money from millions of investors in mortgages, sells bonds backed by mortgages providing a liquid market for thrifts. Fannie Mae has been working on the Y2K problem since 1996, and according to their internal report, have been Y2K-compliant since December 1998. In 1999, Fannie Mae is conducting rigorous tests to ensure that all systems will work come year 2000.

Since Fannie Mae has many lenders who are dependent on Fannie Mae, and vice-versa, Fannie Mae is making these lenders be compliant no later than March 31, 1999. One reason for this is that Fannie Mae wants to protect itself from pushbacks that occur frequently in the Y2K problem solving. If the lenders are compliant by March, Fannie Mae will continue doing business with them. For the non-compliant lenders, Fannie Mae will not use their services until they become Y2K compliant and tested to work with Fannie Mae's systems. Fannie Mae wants no mishaps when the new year comes, hence the many strict deadlines and requirements. Fannie Mae is currently conducting tests with business partners with which it interfaces electronically. The testing started earlier this year and is expected to finish by June 1999. Currently, 65 percent of the testing has been done.

3.3 Freddie Mac (Federal Home Loan Mortgage Corporation)

Freddie Mac is an institution that is chartered by Congress but owned by stockholders. Freddie Mac buys home mortgages from banks and sells them as securities on Wall Street. Mortgages include a substantial amount of date information such as expiration date, monthly payments, interest rates (based on length of mortgage), etc. Freddie Mac buys more than one million mortgages annually, so ensuring that all systems are Y2K compliant is a necessity.

Because of the large dependence on date correctness, Freddie Mac started its efforts in 1994. Currently, 75 percent of its systems are fixed and tested, with a plan of being Y2K compliant by June 1999. Compared to the Fed, which only put 4 percent of its workforce on the Y2K team, Freddie Mac has allocate more than 300 workers (or about 10 percent) to solving the Y2K problem. This is mostly in part due to more than 1,200 pieces of software that has to be tested. In total, they will have to examine more than 12million lines of code, most of which is date-sensitive. In going through one of the applications following a date-related operation, the comments of the programmer included the following, "This code will not work on 1/1/00. I hope that's not a problem."

In addition to fixing the Y2K problems, Freddie Mac has been testing their fixed software extensively. For precautionary measures, they have created fake databases similar to ones they currently have. They have been testing these databases on different dates to see how they would function. Testing dates from December 1999 through March 2000, their fixed systems seem to be compliant and functioning properly. Not only is Freddie Mac doing these tests to ensure themselves that systems will work properly come 2000, they are also trying to demonstrate to their potential investors that they really are ready to go.

4. Commercial Banks and Investment Services

Commercial banks all across the nation are preparing to face the Y2K problem. Whether it is the small, one-branch banks, or giant firms like Citicorp/Citibank and Chase Manhattan, the Y2K problem might be responsible for causing transaction mishandling, denial of service, or system shutdown (among many others.) In addition, banks must be able to deal with concerned customers who are feeling insecure about leaving money in banks or not being able to take money out when they most need it.

In addition to having information about Y2K on their websites, many banks, such as Wells Fargo, First Union Corp., have set up Y2K hotlines where their customers can call in and ask questions relating to Y2K. "We're trying to educate our customers so that they don't take out three months of cash and stick it in the cookie jar," commented Bob Waynne, a representative for Bank of America. As the year 2000 approaches, more calls and questions are inevitable. Bank of America is the nation's third-largest bank with $23 billion in annual revenues. The bank plans to spend more than $380 million fixing the Y2K problem. Most of that money will go to more than 1,000 full-time employees working on Y2K. In total, workers will have to check 90,000 personal computers, rewrite 200 million lines of code from 300 different software packages. Such extensive measures are very similar in other giant banks. [Ant98]

An extensive problem that banks are facing deals with interdependence. In particular, this implies to large banks with central offices and smaller, regional offices in different locations. The major concern is that if central offices cannot function normally come 2000, regional offices might have to shut down as well. Since most loan requests, approvals, and general communication has to go through the central branch, without proper communication or system-failure, the capabilities of the regional offices will be very limited. This is why a lot of emphasis has been on getting central branches to be Y2K ready. There are interdependent factors such as the communication working properly for approvals, on-time mail deliveries of sensitive documents, and the ability to communicate with the Federal Reserve just to name a few. [Lut99]

Although the bigger institutions are said to be better prepared than smaller firms, a recent study proves otherwise. A study of 815 community (generally one-branch) banks showed great improvement over last year's results. In February 1998, three-quarters of the bankers said they planned to spend less than $10,000 on Y2K. Only 44 percent said they had begun testing their security systems and vaults, and a mere 36 percent said they had a contingency plan in place. Last month, the same survey was conducted, and the results improved greatly. Of the 815 banks, 98 percent were confident that their banks' computer system will not malfunction January 1. In case there are glitches, however, 90 percent of the banks said they have board-approved contingency plans. [Lut99]

The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises national banks to insure a safe, sound and competitive banking system. According to their most recent evaluations in December 31, 1998, the banking industry is looking very prepared for the year 2000. Below is a table of the different-sized firms as well as their preparedness.

4.1 MasterCard

Credit cards are a good example of the financial services' readiness for the year 2000. One reason for this is that many already have expiration dates that go into the 21st century. The payment industry (credit cards, checks, etc.) was one of the first to identify the problem and work on solutions. Since most credit cards have expiration dates at least two to three years into the future, MasterCard started addressing the problem in 1994, so that by 1997, new cards with expiration dates 00 could be processed and accepted worldwide. MasterCard needed to ensure that the fifteen million locations worldwide where MasterCard can be used for payment would be able to accept cards expiring after '99. This operation was immense since it included 23,000 financial institutions that issue MasterCard cards, and all had to comply with the year 2000 problem.

Although this example describes MasterCard, all other credit card institutions (Visa, AmericanExpress, etc.) have had to modify their systems in order to comply with the year 2000 expiration date. Compared to the rest of the financial industry, where the main problems will appear at year-end, credit card companies have resolved a significant part of their problem. What the credit card companies now have to focus on is modifying their own internal systems for Y2K readiness.

4.2 Investment Services

Investment Banks are an integral part of the financial infrastructure. Not only do they provide services for large institutional investors such as advice on mergers and acquisitions, they are also the link between businesses wanting to go public and the individual investors. Amongst the major investment banks, 80 percent should be Y2K-compliant between June and August of this year, with the remaining 20 percent to be finished by December 31st. [Doh99]

Amongst the leaders in top-tiered investment banks is Morgan Stanley Dean Witter. Morgan Stanley & Co. (prior to merger with Dean Witter) began Project Odyssey, its Year 2000 project August 1995 and currently has approximately 300 professionals modifying and testing Morgan Stanley Dean Witter's systems. As is evident in the figure below. Morgan Stanley has finished up the remediation process, as well as internal testing of systems. It is currently working on external/streetwide testing that will continue throughout the year.

JP Morgan is also in the process of modifying its systems, and is expected to be finished with remediation and internal testing in June of this year, afterwhich extensive external tests will take place. JP Morgan's estimated pricetag for fixing Y2K: $300 million dollars, or about $1.65 per share (largest cost per share of any Dow30 firm), most of which is going to the Y2K professionals. [Doh99] Along with doing its own testing, JP Morgan (along with others) is helping out other smaller firms on which they might be dependent. These smaller firms might involve small accounting offices, check processing centers and brokerages. Brokerages are especially important to investment banks as they provide an easy way for individual investors to get their hands on shares of companies. Without their services, investment banks would have a hard time generating revenue.

Brokerages such as Paine Webber, Merrill Lynch, or The Prudential are an indispensable part of the financial infrastructure. They provide every-day people a chance to be involved in the stock market, and are relied on heavily to buy and sell shares for individuals. Merrill Lynch, the largest of the brokerages (that also provides investment banking services), has upgraded its total Y2K costs to $425 from an original estimate of $275. However, the investment seems to have worked as last July when industry-wide tests were conducted, Merrill Lynch's systems ran 99 percent of the scripts correctly at least 1 out of the 4 days. More industry-wide tests have started, and should be completed in early spring.

5. Organized Exchanges

The NYSE and Nasdaq exchanges are the world's largest and account for nearly 90 percent of total equity trading in the United States. The NYSE officially began its Y2K compliance program in 1996 when it designated its Securities Industry Automation Corporation (SIAC) subsidiary as coordinator of Y2K conversions in 1996 [Gra98]. It estimates that the total cost of conversion will reach 20 million [Gra98]. Y2K-compliant versions of their mission critical systems, including their Online Comparison System, Common-Message Switch, PC Designated Order Turn Around System (PCDOT), and Automated Bond System, were expected to go online by December 31, 1998 [NYS98]. NYSE also announced that members are expected to establish "command centers" for the weekend of 12/31/1999-1/2/2000. That is, they are expected to have a technical staff on-hand to resolve any problems that may occur during the rollover. Furthermore, members are expected to have written contingency plans prepared by the end of 1999. The Nasdaq also planned to have its compliant systems in place by the end of 1998 [ITA97]. It has a highly heterogeneous computing environment of 56 different systems with 5700 different programs running on top of Unisys, Tandem, Sun and PC platforms [ITA97]. Nasdaq's transaction systems alone contain over 5.5 million line of Tandem TAL, Unisys Assembly, and C code while the National Association of Securities Dealers (NASD) Parent Company and its NASD Regulation subsidiary operate system based on 11 million lines of mostly COBOL code [ITA97]. The SIA estimates that Wall Street alone will spend $5 billion over three years (1997-2000) on Year 2000 conversions, an amount equal to almost half of annual broker-dealer profits [SIA99].

5.1 Status

In July of 1998, Wall Street's first simulated tests of stock trading in the year 2000 took place. The firms that account for approximately half of Wall Street's trading volume, including twenty-eight major securities firms, all major U.S. stock exchanges, and some clearing and settlement firms, took part. Merrill Lynch & Co.; Spear, Leeds & Kellogg; the New York Stock Exchange, Nasdaq, and the Depository Trust Corporation were among the participants in the testing, which was sponsored by the Securities Industry Association (SIA). Each of the participating firms executed roughly five hundred transactions in stocks, corporate bonds, municipal bonds and options per day during the four days of testing on systems specifically designated for testing only. The first round of testing, which occurred on July 13 and July 15, simulated trading conditions on December 29 and December 30, 1999. According to officials at the SIA, these tests revealed no date-sensitive problems [Hof98]. A second round of testing took place on July 20 and July 23 to simulate trading with mock orders dated December 31, 1999 though January 3, 2000. The purpose of this set of tests was to actually simulate the date rollover and settlement time. Aggregate results, which were released on August 10, 1998, revealed very few problems. Only about two or three of the twenty-eight firms had transactions that could not be completed due to Year 2000 problems according to the SIA [Fra98]. These failed transactions accounted for approximately one percent of the total simulated trading volume. Additional testing of the future markets occurred on September 12, 1998 followed by testing of the money markets on September 17, 1998. A round of industry-wide simulations began on Saturday, March 6, 1999. These tests will run on each Saturday from March 6 through April 24, 1999. About 400 brokerage firms, banks, exchanges will take part in this new round of testing, which will cost the SIA $10 million and the participants $100 million [NYT99]. Unlike the systems that were tested in July, the ones used during these new tests will be the same systems that are relied on for regular business operations. Like the July simulations, these tests will run mock trades with transaction dates of December 29, 1999 through January 4, 2000. Additionally, January 22, 2000 will be simulated, because it is the first exercise date of the year for options.

Although SIA officials and industry spokesmen from the large firms that participated in the tests were upbeat following the release of the July simulation results, some analysts remain apprehensive. Lou Marcoccio, the Year 2000 research director at the Gartner Group consulting firm based in Westboro, MA cautions that "as you go down to smaller companies that spend less and started later, the possible risk of failure is higher (see Figure 3) [Fra98]." Some analysts are also quick to point out that the total volume of simulated trading that occurred is only a small fraction of the New York Stock Exchange's average daily trades of 490,087 shares and that the 1 percent reported failure rate might be cause for concern. Furthermore, it is possible that millenium problems were corrected during the simulation but not reported. A final criticism is that the simulations were run on systems earmarked for testing instead of actual business systems, reducing the credibility of the results. In light of these facts, some claim that the largely positive reaction to the tests was far too optimistic. Even the 1999 round of industry-wide testing has been criticized, because some individual dates, such as February 29, 2000, will not be tested due to costs [NYT99]. Concerns were also raised in the fall of 1998 following the October 26 delay on the New York Stock Exchange. A single malfunctioning network switch resulted in a 59-minute suspension of trading, raising questions about the consequences of potentially numerous failures resulting from Year 2000 problems. October was also the setting for another alarming incident in the financial world. The Securities and Exchange Commission (SEC), a government regulatory agency in charge of overseeing the issue of financial securities and corporate information disclosures, announced on October 20 that they had charged thirty-seven brokerage firms with failing to fully disclose their computer systems' Year 2000 readiness status and costs by the August 31, 1998 deadline. This marked the first time federal regulators have taken enforcement action related to the Year 2000 disclosure requirement. The National Association of Securities Dealers also announced in October that it had reprimanded 59 member firms for filing of Year 2000 readiness disclosures late. The SEC has set an additional Year 2000 readiness disclosure deadline for publicly-traded companies for April 30, 1999.

Perhaps of even more concern is the status of foreign exchanges' Y2K readiness, as failures in oversees markets may have a serious effect on domestic markets. The Australian Stock Exchange (ASX), French COB exchange, and Hong Kong Exchange are among the foreign exchanges that have begun to require Year 2000 readiness disclosures from companies [Hoc98]. Of additional concern is the amount of resources that have been diverted, particularly in Europe, away from Year 2000 conversion to Euro conversion, compounding the problem. Chairman of Software Productivity Research Capers Jones wrote: "The timing of the Euro is one of the worst public policy decisions in human history, because it pits the world's second largest software project (the Euro project) against the world's largest software project (the Year 2000 project) [Rat99]." It is estimated by Software Productivity Research that the total global cost of the Euro conversion for software and hardware systems was approximately $100 billion [Rat99].

6. Insurance Industry

According to the aforementioned United States industry Y2K readiness study conducted in September, 1998 by the Gartner Group, the insurance sector appears to be the furthest ahead of all industries (see Figure 1). Moreover, a January, 1999 survey of insurance industry leaders conducted at the Property/Casual Joint Forum suggests that most do not expect to be adversely affected by Y2K problems and claims. Of those polled, 64 percent did not believe that Y2K would have a significant negative financial on their companies in 2000 or in subsequent years [Bes99a].

Although there may be some reason for optimism, most insurers are taking the Y2K problem seriously. The National Association of Insurance Commissioners (NAIC) agreed to a moratorium on new state regulations for six months before and after January 1, 2000, so insurers would not be burdened while repairing Y2K bugs. In January, 1999, the NAIC created a "Year 2000 Industry Preparedness Task Force" to survey insurance companies' readiness. Some industry spokesmen, including senior counsel Eric Goldberg of the American Insurance Association, believe that this additional regulation "would take a massive amount of time" away from repair efforts rather than help [Bes99b]. Insurers are also concerned about the Y2K compliance of their counterparties. That is, their external dependencies and business partners need to be compliant as well. Those who deal with the government, such as health insurers, may be particularly vulnerable if government efforts to deal with Y2K continue to fall behind schedule [Tre99]. Furthermore, some experts are concerned about the immediate economic impact of fixing the Y2K problem in the years leading up to 2000. Mark Trencher, Assistant Vice President of Insurance Research at the Conning & Co consulting firm, estimates a 1 percent annual reduction in life and health insurers' earnings during the 1998-99 period because of Y2K expenditures and indirect opportunity costs from having to pass up other projects [Tre99]. On the other hand, he also believes that many Y2K conversion projects may actually lead to productivity improvements as systems are upgraded.

An example of the scope of the problem faced by some large insurers is provided by State Farm's disclosure of its Year 2000 program. The insurer expects that it will have spent $250 million and inspected 167 million lines of program code from internal software systems to achieve compliance [Sta99]. They currently have 1,400 employees working full-time or part-time on the project. The project also involves assuring compliance in over 1,550 corporate and regional offices. They also have to verify that over 2,741 distinct products from 513 third-party vendors are compliant as well.

6.1 Status

The data gathered from the SEC-mandated August, 1998 disclosures of the thirty largest publicly-traded insurers, which account for 80 percent of total revenues generated by all 200 U.S. public insurance companies, reveal that they have committed $1.79 billion to the Year 2000 conversion (see Figure 4) [Bes98]. The estimated total for the United States insurance industry is roughly $6.51 billion [Bes99c]. Citigroup, Inc. alone, which formed from the resulting record merger between Travelers Group, Inc. and Citicorp Insurance Group and earned the highest revenues in 1997, estimates its Year 2000 costs at $275 million [Bes98]. It began its Year 2000 conversion in 1996 and planned to have contingency plans in place by December 1998, citing its third-party vendors' lack of Year 2000 compliance as one of its primary concerns. Aetna, Inc. had the next highest projected Year 2000 costs at $195 million [Bes98]. Although it had completed the assessment phase of its Year 2000 conversion in 1997, it will not have a contingency plan in place until September of 1999. Allstate Corporation, the third largest grossing insurance company of 1997, finished its Year 2000 program at the end of 1998, a year ahead of schedule and below cost. It also began marketing a Year 2000 software conversion product they had developed with IBM. Although most companies reported that their conversion projects would be complete by the beginning of 1999, many were careful to express their concern about the potential unexpected Year 2000 problems that might arise from third-party vendors' lack of compliance and other factors.

7. Economic Forecasts

Although most experts agree that the total cost of preparing systems for the Year 2000 is going to be enormous, the estimates of its value vary greatly. Software Productivity Research estimated in 1997 that the total cost in the United States would approach $276 billion [Jon97]. A less conservative estimate of the cost to United States private companies has been calculated by the Gartner Group. Their most recent estimate places the cost at $2 trillion, which is substantially higher than their previous estimate of $600 billion [Dun99]. According to research director Lou Marcoccio of the Gartner Group, these costs are higher because of revised estimates of risk assessment and contingency planning cost [Dun99]. Investment firm Morgan Stanley Dean Witter estimates that the total spending in the United States will only total between $78 billion and $89 billion, predicting a much smaller dent in corporate profits than had been expected previously [Sim99]. In any event, the potential costs of litigation may further inflate Year 2000-related expenses, which prompted the SIA to work closely with Congress to enact the Year 2000 Disclosure Act to reduce liability concerns that may inhibit businesses from disclosing their Year 2000 information.

Analysts also seem to disagree over the potential overall economic impact that the Y2K problem will have. John Koskinen, the United States' Y2K czar, announced on March 2, 1999 that "the consensus of economists in the U.S. is that the overall impact on the gross domestic product of the U.S. will only be two-tenths of a percent and that they saw no risk of a local worldwide recession or depression resulting from this." Some experts, including economist Edward Yardeni of Deutsche Bank Securities, are much more pessimistic. Edward Yardeni, one of the leading experts on the potential economic impact of the Year 2000 problem, has presented five possible economic scenarios that may arise because of the Year 2000-related problems and has assigned probabilities to each (see Figure). These scenarios are: minor disruptions, same impact as natural disasters, six-month recession, major global recession lasting 1-2 years and deflation and economic depression lasting 2-3 years [Yar99]. Yardeni assigns a joint probability of seventy percent to the recession scenarios, citing the prevalence of just-in-time manufacturing and the high degree of interdependency in industrial supply chains as his main reasons for doing so. He also predicts "fortressing" behavior among firms that are Year 2000 compliant. That is, he foresees a reluctance of compliant firms to engage in business with firms that have not passed certification.

8. Summary

 Government institutions appear to be doing well. According to Alan Greenspan, The Federal Reserve is doing well and should be ready by December 31st. A contingency plan to print $50 billion in case people panic and start withdrawing their money. The market needs to stay liquid, and the Fed wants to be prepared. As for the other agencies, Freddie Mac and Fannie Mae, they also have things under control and are conducting rigorous tests to see if what they have completed through December 1998 is working properly. With their early starts in 1994 and 1995, the going has seemed quite straightforward with few setbacks.

Commercial Banks and Investment Services also appear to be doing quite well in preparing for the year 2000. Banks are interdependent on other industries so total testing cannot occur until the new year comes. However, most large banks should be complete by June 1999 with the rest of the year to be spent on testing. Surprisingly, smaller banks are also catching up and seem to be on track for completing by December 31st. Credit cards have already faced the Y2K problem once with expiration dates. Although this time around, central programs will have to be modified and upgraded, having gone through the same problem a couple of years ago should make the transition be smoother. Investment Banks and brokerages are spending in the hundreds of million of dollar repairing their systems, and in some cases are helping smaller companies so that business can flow smoothly on January 1st.

Organized exchanges in the United States appear to be on schedule for the year 2000 rollover. The first large-scale tests of July, 1998 did not reveal any major Y2K problems in the eyes of the SIA and leading industry officials, and an industry-wide test is currently underway. Some experts are critical of the optimism expressed regarding the Wall Street tests. They argue that the tests were not a good measure for readiness of systems. These critics are often quick to point out possible flaws in the testing such as the small number of trades undertaken, misreported results, the absence of smaller firms from the testing, and the use of designated test systems. The possibility of market failure due to a lack of overseas and third party readiness is perhaps of greater concern.

Although studies indicate that the insurance industry is ahead of other sectors, most firms are still in the process of devising contingency plans. Industry spokesmen are particularly worried about the readiness of third-party vendors of goods and services and the government. These potential external risks suggest that even if insurers are themselves ready for the year 2000, problems may arise that are beyond their control.

Finally, there is still disagreement over the likelihood of a major economic impact caused by the year 2000 problem. Some experts expect costs to skyrocket as the deadline nears while other analysts believe that the problem has been overstated. The debate is still out over whether the Y2K problem will trigger a worldwide recession. Some experts believe that the recent success of the Euro conversion and results from financial industry testing are reasons to remain optimistic. Other analysts, however, fear that it may in fact be too late to adequately test systems and that interdependencies between sectors and nations complicate matters.

9. References

Last modified March 15, 1999.