Mr. McDonough gives his perspective on the Year 2000 problem and the challenges it poses  (Central Bank Articles and Speeches, 19 Oct 98)
Central bank: fed | Type: speech | Date: 1998-10-19

Mr.

McDonough gives his perspective on the Year 2000 problem and the challenges it poses Remarks by the President of the Federal Reserve Bank of New Yor Mr. William J.

McDonough, before the Regional Y2K Meeting for Financial Regulators in Asia/Pacific Region, held in Sydney on 19/10/98.I am delighted to be here today at the first of several regional forums on 2000 problem that the Joint Year 2000 Council is organizing.

As an original sponsor officio member of the Council, I am especially pleased that it has been successful organizing today's events to coincide with the International Conference of Bank Supe meetings.

This gathering provides another example of how financial market superviso regulators such as yourselves are leading the way in tackling this issue around the worlIn my remarks today, I will provide my perspective on the Year 2000 problem the challenges it poses.

My experience with the issue draws first on my role at th Reserve Bank of New York, where we are addressing Year 2000 challenges as a central ban a bank supervisor, as a payment system operator and as a business much like any other b Internationally, I became involved with the issue through the G-10 Committee on Paymen Settlement Systems and spoke out about the need for payment system operators worldwi address the Year 2000 problem.

More recently, on the Basle Supervisors' Committee, I been learning about the Year 2000 issues that confront bank supervisors around the glob

## ScopeSimply put, I do not think it would be possible to overstate the importanc Year

2000 problem as an issue for the financial markets.

Naturally, the tendency turbulent times is to focus on day-to-day concerns, and to leave future problems to be later.

This tendency must be resisted strongly if we are to succeed in addressing the problem.I say this because the Year 2000 problem is an issue for every country, organization, government agency, bank and piece of critical infrastructure in the wor Year 2000 problems that exist within software programs and embedded computer chips are repaired by January 1, 2000, the affected systems will cease to function or will ma Those firms that have checked for Year 2000 problems overwhelmingly have found that systems were affected and would not have functioned normally in the Year 2000 without fixed.

Moreover, the efforts of firms around the world have demonstrated that while the the Year 2000 problem varies, no country or sector is immune from it or can afford to impact.Financial sector organizations such as banks, securities firms and ins companies are typically among the most highly affected organizations.

National and government systems and services are affected.

Critical infrastructure such as transp power and telecommunications systems are also likely to be affected.

Nearly all aspec economy in every country are therefore potentially at risk because of the widespread de on a country's core infrastructure.The unprecedented scope of the Year 2000 problem means that a critical aspe the issue is the management challenge.

Substantial management resources are neede coordinate the efforts to assess, repair, and test affected systems prior to the fixJanuary 1, 2000.

At the Federal Reserve, for example, we have created a number of manag positions within our organization that are focused exclusively on different aspects o 2000 preparations.A final point that underscores the need for urgent and sustained action increasing focus on the issue by the media, by the public and by market observers su rating agencies.

Over the course of 1999, the extent of Year 2000 preparations by organizations will become the subject of ever more intensive scrutiny.

As supervisors, we must do all we can to support the efforts of market participants to address the effectively, and to build confidence among others that this is being accomplished.

Whil make it clear that supervisors cannot solve the problem, we can help mobilize others t necessary steps.Of course, I realize that most of you are already fully convinced of the seriously address the Year 2000 issue and are more interested in advice on how to t problem.

In this regard, I will focus on approaches that supervisors can take in (1) encouraging cooperation and coordination; (2) encouraging information sharing disclosure; (3) developing assessment plans; (4) encouraging testing programs (5) developing and supporting contingency plans.

## Cooperation and CoordinationThe single most important piece of advice that can be given on the Year problem is to work cooperatively with others.

This applies at a number of levels.

Fi organization should develop an internal Year 2000 plan that encourages cooperation b different parts of the organization.

For example, a successful Year 2000 program organization will encompass not only the software programs that are maintained b information technology department, but will also address the Year 2000 risks that may by the embedded chips in the firm's buildings, including heating and cooling, building and safety systems.The benefits of cooperation include the sharing of information, so th resources required to obtain valuable information can be reduced.

Cooperation organizations is also essential to the development of joint industry initiatives, inc programs.

For example, we have seen industry associations play a very valuable role i industry awareness and providing a focal point for the sharing of information development of joint Year 2000 initiatives.

I strongly urge each of you here today to the industry associations in your countries to develop an aggressive Year 2000 program mutual benefit of all their members.In fact, a largely unprecedented amount of cooperation already is taking pla respect to Year 2000.

For instance, the Joint Year 2000 Council brings together more r and supervisors in one organization than has ever been done before.

In April of this ye sponsoring organizations realized that they needed to pool resources and bring toget respective experts to discuss the issue collectively and to develop a common dialogue global supervisory community.

The efforts of the Council to date have been valua communicating Year 2000 information to this community, and I support the continuatio expansion of these efforts.The Global 2000 Coordinating Group, which consists of internationally ac financial institutions, is another example of an important effort to foster cooperation 2000 issue.

The firms represented on Global 2000 are working together to tackle several aspects of the problem, especially the international dimension.

They have approach collective effort with a high degree of transparency and I applaud their efforts at coopCooperation is also needed between the supervisory community and the priv sector.

The New York Fed has hosted a series of informal meetings in New York bri together banks, securities firms, settlement systems, insurance companies and regulato each understand better the perspectives of others around the table.

The New York Fed participating in joint efforts with several industry associations that focus on contingency planning and on testing.

For these two issues, in particular, it is critica dialogue be established between the public and private sectors.The final element of cooperation needed for an effective approach to Year 2 cross-industry cooperation.

Most financial market participants are not accustomed to extensive information from other industries, such as the telecommunications indust financial firms, among others, depend critically on the proper functioning of sector transportation, electric power generation, and government services.

In the absence of c and coordination, the lack of information flowing across sectors can create serious o achieving successful Year 2000 outcomes.

Errors of omission in coordinating your broadly can be far more significant than you might realize.Based on our experience in the United States, the creation of a government to assist in coordinating preparations can play an important role.

In the United President's Council on the Year 2000 Conversion has been active in promoting cross-i discussions and tracking the progress of different industries.

Governments in other cou as Australia, Italy, Japan, Mexico, Saudi Arabia and the United Kingdom have also imple national Year 2000 strategies.As supervisors, our first task is to address the Year 2000 issues in the s which we have responsibility.

However, we cannot lose sight of the dependence of the f sector on the broader national and international infrastructure.

Year 2000 issues af infrastructure must be addressed.

Each of us must seek to ensure that these concerns appropriately tackled within our own countries and that information on these prepar being made available to financial market participants.

## Information Sharing and DisclosureThis last point brings me to my next topic - information sharing and disclo the absence of good information on Year 2000 preparations, we would naturally expect participants to take a conservative approach and to protect their own interests.

It market participants be encouraged to be as forthcoming as possible about the steps t taken to prepare for the Year 2000 conversion.There are a variety of different types of disclosure, and all may play fostering better information about Year 2000 preparations.

First, there is self disclosure, which is a form of information sharing, such as when firms discuss Y issues and strategies among each other.

In addition, financial organizations need t information on their Year 2000 efforts to their customers and counterparties, their inothers.

In the case of banks, for example, it is important for correspondent and customers to develop comfort that the bank will be able to function normally in the newBanks and other firms need to develop strategies for conveying appropr information efficiently to these constituents.

In response to a flood of Year 2000 que from their customers, some banks in New York are beginning to hold forums to co information and build confidence that they are addressing the problem.

Another practic seeing is organizations declining to fill out questionnaires regarding their Year 200 unless the firm asking the questions discloses the same information.

It is clear to me of market discipline is going to become a powerful force in the coming months for firms perceived to be lagging and failing to disclose.

A solid program of self-disclosure available approach to ensuring that all parties are willing to share information.Of course, supervisors and regulators may also need to develop mandat disclosure programs or to interpret existing disclosure requirements to cover Year 20 issues.

In the United States, the Securities and Exchange Commission has progres strengthened its efforts to require meaningful disclosure by all types of firms supervisors considering increased transparency need to act rapidly to ensure that requirements will become effective in time to be useful to market participants.An important challenge in considering either voluntary or mandatory disclos the question of what information should be disclosed.

Some information can in fact be d misleading.

For example, a firm may engage in internal testing and locate a number 2000-related problems in its systems.

Of course, it is the process of this testing th the firm to locate and overcome these problems.

Thus, disclosing its internal test isolation could give a false impression of its readiness.

In general, comprehensive sel in written form, supplemented by a willingness to answer specific questions, is proving most effective way of sharing information.Another issue that often comes up in this context is the question of cert External parties, whether auditors or examiners, cannot realistically certify Y compliance.

The best that they can do is focus on the effectiveness of the process organization has established.

Oversight by these third parties should not be seen as for an organization's own due diligence, an area in which internal audit departmen traditionally played a leading role.

Internal auditors also could be useful in helping their Year 2000 disclosures.Another concern is the existence of possible legal obstacles that may stan way of Year 2000 information sharing.

In the United States, several efforts have been limit or remove these obstacles, and such efforts may be needed in other countries as example, a ruling was issued by our Justice Department limiting the extent to which Ye information sharing could be viewed as a violation of antitrust laws.

Recent legislati the legal liability for statements made in good faith that later turn out to be Supervisors have been supportive of these efforts, and I encourage each of you to whether substantial impediments to meaningful information sharing may exist in your countries.The final point that I will make in this area concerns the power of lea example.

As supervisors and regulators, we should each strive to communicate frequent openly with our constituents about our own Year 2000 programs.

At the Federal Reservhave testified before Congress on our efforts and have made available a large amount of through the World Wide Web and numerous publications.

As leaders in the financial mark is important that we set the right tone in promoting information sharing and transpare own preparations.

## Assessment and the Role of the SupervisorI will now turn to the role of supervisors in promoting Year 2000 readiness the firms that we supervise.

The primary effort must be to communicate the seriousn urgency of the problem to the firms under our jurisdiction.

In the United States, supervisors are examining every bank operating in the United States regarding its Ye program.

As part of this program, the Federal Reserve conducted reviews of approximatel organizations, including a significant number of foreign banking organizations.These reviews have had a very substantial effect in increasing bank awaren the issue and in focusing senior management's attention on the problem.

Initial completed by mid-1998, indicated that 10-15% of domestic banks had inadequate Year 2 programs, with the US operations of foreign banks showing an even higher percentage.

In all cases, the supervisory attention led to immediate steps being taken by the banks in the percentage of banks now in this category is well below 5%.What can we do if we find banks that are not progressing rapidly enough? institution is judged to be deficient, we can communicate these findings through meet senior management and the board of directors.

We can call for the submission of detail and formal responses to the deficiencies noted.

Naturally, such institutions also will increased monitoring and supervisory review.

We can and have put restrictions in place expansion by banks judged to be behind schedule.

As a result of these measures, we hav virtually all banks willing to take seriously their Year 2000 responsibilities.We are now in the second phase of our supervisory program for Year 200 During this second phase, which will last through March 1999, we will conduct another r supervisory reviews focused on Year 2000 testing and contingency planning.

We also w looking at how banks are addressing Year 2000 risks arising from their relationshi vendors, customers and counterparties.

Even if banks are successful at tackling thei Year 2000 concerns, they may still face risks from critical services that they re vendors.

In addition, banks should assess their credit exposures to customers that face Year 2000 challenges of their own.I hope that all financial organizations sufficiently address the Yea conversion in time to limit possible disruptions.

If they do not, we will find it difficult to deal with the issues arising from deficient organizations over the cour There will likely be some chance that vigorous catch-up efforts on their part will all avert serious problems.

On the other hand, the closer the time until January 2000, difficult it will be for the customers of that firm to find an alternative provide services.

Many banks already are indicating that they will be reluctant to take on new customers in the latter half of 1999.

To avoid this bottleneck, supervisors need t possible steps to identify firms whose progress to date has been insufficient, and to p to adopt a plan that will address their Year 2000 problems.Inevitably, however, supervisors may face difficult enforcement issues d 1999 regarding those institutions that are not making appropriate progress.

The ti severity of these enforcement steps will not be easy to gauge, and I hope that Committee's Year 2000 efforts will provide some guidance for supervisors on the involved in making these choices.A key concern that I would have today about an organization is whether its management truly understands the scope of the Year 2000 problem and the need to tackle critical management challenge and not simply as a technical issue.

If appreciation of t is lacking at the upper levels of an organization, experience suggests that the lack of filter through to the entire organization, with potentially devastating results.

## TestingOf the many different elements of a sound Year 2000 project plan, perhaps no more crucial than testing.

In that regard, I will now turn to some of the most impor related to Year 2000 testing.

As a first step, it is important to distinguish the dif testing and test programs that are in place or being developed.

The Joint Year 2000 recently published paper, 'Testing for Year 2000 Readiness' contains a valuable discu these different types of tests.Internal tests are those over which the testing institution has full cont which external parties are not directly involved.

Firms that have engaged in multipl tests have reported that the internal future date testing phase was the most important uncovering remaining Year 2000 problems.

Uniformly, every institution that has engag internal testing also has indicated that this process indeed located further Year 200 that needed repair.

Thus, in spite of extensive repair efforts, some problems were n until internal future date tests were performed.

This underscores why every organizat build in a program of rigorous internal testing as a part of its Year 2000 project sc for applications designed to be Year 2000 compliant.

Moreover, the internal testing cannot wait until the last minute.

Experience has shown that testing programs overall consume over 50% of the resources allocated to Year 2000 projects.External tests are conducted by an institution to assess the risks in rep internally tested systems where they interface with systems of other institutions.

Ex are particularly important where the interface is proprietary or specific to the parti activity and the dependency on the external interface is critical.

For the most critic particular payment and settlement systems, external testing must be done, and should carefully.External tests can take a variety of forms.

Point-to-point tests verify the an institution to transmit and receive data with another entity.

End-to-end tests take further and verify the ability of an institution originating a transaction to transmit recipient through an intermediary which correctly performs business functions using t End-to-end tests are particularly appropriate for real-time, interactive applicat organizations are using a series of point-to-point tests to effectively simulate an testing process.With regard to Fedwire, the Federal Reserve's large-value funds transfer s we have made the system available for external tests from July of this year.

We have aa program of shared testing days that allows multiple customers to simultaneously perf to-end testing over the system.

These tests will cover the full range of payments and applications that we provide and will address both the century date conversion and the date in 2000, which many systems also may not handle correctly.One of the key lessons that has come out of our test process for Fedwire importance of extensive planning for each aspect of the testing program.

For example, testing schedule and test scripts required extensive efforts to develop.

Furthermore, very substantial amount of communication and advance planning by the Federal Reserve an banks involved, we could not be confident that the tests would provide a meaningful Naturally, appropriate internal testing must also be completed in order to derive maxim from the external testing program.These lessons are particularly pertinent in the case of industry-wide exter that are designed to permit most or all system participants to test simultaneously with For example, the Securities Industry Association in the United States has developed ambitious program of this type for the US stock market.

I believe that the Association the first to admit that the amount of work required to pull this off has been stagger grows ever shorter, such industry-wide tests may prove impractical for some markets.Many market participants are also considering the role of proxy testing, i the tests are conducted by a third party, such as a user group, rather than by each i itself.

Needless to say, there is some risk in such an approach.

However, proxy testi appropriate where it is not practical for every user of a service to conduct point-towith every other user.In terms of advice, Year 2000 testing obviously is critical, but each mark consider what is achievable in the time that remains.

Internal testing is the most cri institution should be allowed to go forward with a Year 2000 plan that does not allot for internal testing.

External testing also is important, and payment and settlement particular should make external test facilities available to participants.

The degree external testing that can be achieved will then be a function of the time available t plan for such a test.

It simply does not make sense to devote considerable resources to that is not likely to be realized.

A key goal of testing programs is to build confidenc will work as expected on January 3, 2000.

There is no doubt that having to call off a last minute because of insufficient planning will be counter-productive to reaching suc

## Contingency PlanningThe final issue I will discuss today is contingency planning.

Much has bee about the need to develop contingency plans for the Year 2000 conversion, and I fully these efforts.

We need contingency plans in place for two main reasons.

First, to ensu have considered how to handle the inevitable disruptions that will occur as a result of and, second, to help build confidence that disruptions will not have systemic consequ the process of contingency planning, we must also keep in mind that it is prudent to co possibility of some very serious, but improbable, events.Contingency planning for Year 2000 will not be limited to the century ro itself.

As my colleague, Roger Ferguson, has described it, there will be a Year 2000 that will affect financial markets both before and after the event itself.

This shadowthe uncertainty among market participants about the possible consequences of Year disruptions for particular firms and markets.

In some cases, this concern will le participants to consider conventions and procedures for limiting risks during the roll For example, some transactions that normally would be executed for settlement on Jan 2000 may be postponed.

In other cases, uncertainty about the possible consequences o 2000 disruptions could lead to over-reactions on the part of market participants.

As s we will need to be increasingly alert to the possibility of Year 2000 rumors affecting of firms during the latter half of 1999, and should support the disclosure of accurate in response.The Basle Committee's Year 2000 Task Force will be developing a contingenc planning document focused on issues relevant for bank supervisors.

I am pleased to see Joint Year 2000 Council also has formed a sub-group to address contingency issues, in sound practices for financial institution contingency planning as well as market-wide a I see it, there are three broad areas to consider in developing contingency plans.

Fir should have a contingency plan that covers business continuity issues in the case of o problems affecting its own systems.

Institutions also should develop contingency pl would help address Year 2000 problems arising from their vendors or customers, or as a disruptions to public infrastructure.

These plans should seek to assess the risks that each instance and should focus on the possible measures that may be available to mitig risks.Second, supervisors and regulators need to develop their own contingency p for how they will deal with problems affecting them or the institutions under their j Most organizations have some experience in contingency planning for various types of disruptions, so this will not be entirely new ground.

However, several aspects of the problem are unique and will require fresh thinking.

For example, the potential s operational problems that may be experienced across different markets globally is new time of the century change, there also may be significant uncertainty about how long will last, as well as the extent to which some participants are facing more than simply problems.

On both of these fronts, I am hopeful that the transition to the euro at th year will give us some insight into how supervisors and regulators should cope with theThe third major element of contingency planning that needs to take place i cross-industry and cross-border in scope.

The Year 2000 problem has reminded us of the of interdependencies in our global economy.

Financial markets in particular are depend mix of firms to provide liquidity in all of the various markets.

These firms are de vendors for market information and communications, on payment and settlement system complete transactions, and on power generators and other infrastructure providers to s of their activities.

In turn, these infrastructure providers are dependent on receivin for adequate supplies to keep their plants operating, as well as on relevant insurance ensure that they can operate without unlimited liability.We must consider the scope of these dependencies in formulating continge plans.

Needless to say, there is no way that the financial sector can completely ins from more widespread Year 2000 disruptions by developing contingency plans.

However, should do what we can to prepare realistically for a wide variety of outcomes, includ that may not be very likely.

We also should open lines of communication with re associations and regulatory bodies outside the financial sector in order to better und preparations and contingency plans, and so that they could understand ours.

## ConclusionsThese

thoughts represent my perspective on the key issues facing the g supervisory community regarding the Year 2000 challenge.

As you can infer, I am a very believer in the need for vigorous efforts to address the problem.

The scope of the c enormous and much work remains to be done before January 1, 2000.Nevertheless, I am not a doomsayer.

I believe the financial sector can a successfully address Year 2000.

I say this because I believe we are capable of harn unprecedented level of cooperation to tackle the problem.

I see this happening here todaI say this because the resources that are being devoted to address Year 2 large and growing.

We see a number of firms and systems testing successfully ahead schedules they have set for themselves, demonstrating the value of the Year 2000 inve that these organizations have made.I say this because I see governments taking the problem seriously and dev significant attention to Year 2000 issues throughout the economy.

I support these s encourage each of you to urge your government to move in this direction if it has no done so.As supervisors and regulators, we must continue our efforts to promote sol transparent programs covering Year 2000 information sharing, testing, and contingency pl I am convinced that through the aggressive efforts of the global supervisory community firms that we supervise, we can build confidence that the financial sector will rise to long before January 1, 2000, which I might remind you is only 439 days from today.