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FEDERAL RESERVE BANK of NEW YORK ServingtheSecondDistrictandtheNation Remarks by William J. McDonough President, Federal Reserve Bank of New York at the Year 2000 Round Table of the Bank for International Settlements Basle, Switzerland April 8, 1998 I am delighted to have the opportunity to share with you my observations about financial market readiness for Year 2000 as it has increasingly become a priority issue for me. Similar to many of my colleagues here, I have seen this issue from varied perspectives. The Federal Reserve Bank of New York is both a bank supervisor and a provider of services to the financial industry. From that perspective, I would like to share some insights about how we are approaching the issue with entities we supervise and with respect to the payment systems we manage. The Committee on Payment and Settlement Systems has been dealing with the tremendous challenges the Year 2000 problem poses for payment and settlement systems around the world. In that vein, I will speak about efforts the CPSS has undertaken to address Year 2000 risks globally. This round table is one example of awareness-raising initiatives involving the CPSS. I hope this session encourages all of us to think more critically about strategies we have in place; provides a sense of the strategies that have been working in other markets; offers effective approaches for providing guidance to market participants, including emphasizing the responsibility of directors and senior management; and compels us to consider more deeply the outstanding Year 2000 issues, such as global connectivity and contingency arrangements. Given the short time before the millennium, I cannot over-emphasize the need for continued discussions and sharing of information after these meetings. Inevitably, strategies will require refining along the way. We can learn much from each others' experiences. Another recent effort by the CPSS that I would like to call your attention to is the creation of a simplified report through which operators of payment and settlement systems can indicate the state of preparedness of their systems for the Year 2000. The framework and the completed reports are accessible through the "Ongoing Activities" section of the Bank for International Settlements web-site. Copies of the framework as well as examples of completed responses are included in your conference materials, which you can review at your convenience. The framework identifies the key components of payment or settlement systems' technological infrastructure. For each of these components information is provided on the start and completion dates for internal testing as well as testing with external participants. An indication is also given as to the connections to other systems. The completed framework is returned to the CPSS and is posted on the web-site. The information provided is brief but highlights critical aspects of readiness preparations. Also, and importantly, it provides a contact for market participants to seek further information. Currently, over 100 payment and settlement systems around the world have completed the framework. I should point out that the responses are not certified or endorsed by the Bank for International Settlements or the CPSS. We are facilitating a flow of information. We hope that market participants will compare and analyze this information and, where additional questions arise, pursue them with system operators. The framework is intended as a catalyst for this sort of action. With the global interdependencies we face in clearance and settlement, the CPSS believes anything the public sector can do to enhance communication and understanding in this area will help mitigate Year 2000 risks posed by payment and settlement system arrangements. Concerns in this area arise from the fact that clearing organizations, settlement agents, securities depositories and the various direct and indirect participants in these systems, as well as network providers, are intricately connected. They may all be key parts of a payment and settlement arrangement. An operational breakdown resulting from insufficient Year 2000 preparations by any one of them may have an impact on participants across payment systems. For example, Year 2000- induced operational breakdowns which result in delayed funds payments may cause significant liquidity pressures for market participants. To the extent transactions with counterparties both within and outside of that particular settlement arrangement are affected by these delays, there may be further effects which in the extreme worst case could have systemic implications. Disclosure at this stage permits market participants the opportunity to raise timely and critical questions about payment and settlement arrangements. Market participants can make informed decisions concerning the risks they face only after the potential risks posed by these arrangements and indirect participants within those arrangements are made known. Some system operators may be reluctant to respond to the type of information required by the framework because it may reveal weaknesses in their Year 2000 preparations. This attitude is inappropriate and probably revealing. Failure to disclose the state of readiness may be taken as a signal about the quality of the Year 2000 plan. Non-disclosure may be interpreted as worse than the actual situation. Market participants can work together with a system to overcome problems but they need to know the true status for the efforts to be effective. Transparency of the size, nature and source of potential risks provides a level of predictability for market participants and facilitates the development of appropriate contingency arrangements. Of course, disclosure alone will not resolve Year 2000 risks. During the week of January 3, 2000, market participants are likely to experience stresses, even if every system operator in the world were to complete the framework. However, the framework is a positive step in inducing action to become as Year 2000 ready as possible. Turning to the United States, the market I know best as a supervisor, let me first say that no market, no matter how well-developed, is immune to the difficult issues presented by the Year 2000 problem. U.S. financial institutions are grappling with the same issues faced by firms in other parts of the world. How should market participants resolve issues with vendors and third party service providers? What steps should banks take in coordinating Year 2000 strategies with telecommunications and electrical power companies? What factors should participants include in their evaluation of Year 2000 counterparty risks? How should these risks be built into pricing and other business decisions? Even though it may not be effective or even desirable for supervisors to directly resolve such questions, there are ways in which we can play a role. In my view, the most important steps for a central bank to take is to lead by example and provide broad guidance for financial market participants. Specific action may be based on the following strategy: • Emphasize the responsibility of financial institutions' directors and senior management in developing comprehensive Year 2000 strategies. • Set aggressive but realistic targets for various financial institutions' systems becoming ready. • Identify and communicate sound practices. y p • Highlight issues needing particular attention. • Monitor developments. • Take supervisory actions as necessary. • Impose high standards for Year 2000 compliance on central bank managed payment systems. By June 30 of this year, the U.S. supervisors will have reviewed, at least once, the Year 2000 readiness of every institution we supervise. Where progress is deemed lagging, we are issuing supervisory letters indicating the nature of our concerns and requiring corrective actions within specified time frames. Where warranted, stronger supervisory actions are being taken. I should note that we apply the same standards for Year 2000 readiness to the U.S. operations of foreign banks as to domestic banking organizations. To that end, we expect that U.S. business managers of foreign institutions will be able to assure us that systems supporting U.S. operations are appropriately renovated and thoroughly tested. To the extent that we have concerns, these concerns are shared with the head office and with the home country supervisor. In addition to completing a detailed review of Year 2000 readiness by the middle of this year, U.S. supervisors established three other key target dates: • September 30, 1997 was the date by which all banks were expected to have completed their Year 2000 assessment phase. By that time a bank was expected to have a detailed inventory of all affected systems, established priorities among the systems and to have detailed plans in place for renovation, internal and external testing and implementation. • December 31, 1998 is the target for all U.S. institutions to complete renovation and to be well along with testing. For them, testing should be accomplished by year end. Because of the nature of the New York market, we set somewhat higher standards for those banks providing significant correspondent or other banking services to major financial institutions. • Finally, September 30, 1998 has recently been established as the target date for all U.S. banks to complete Year 2000 risk assessments of their customers and correspondents. We recognize that others may want to establish different targets based on their market size and complexity. In our experience, the specific date is less important than just having a target against which financial institutions can plan. Going forward, the Federal Reserve, in conjunction with other U.S. supervisors and regulators, will continue to monitor the progress of financial institutions and provide the necessary guidance as further Year 2000 challenges emerge. If the current outstanding issues are any indication, we will have our hands full. For example, U.S. banks currently are experiencing frustration in determining effective means of incorporating Year 2000 into credit, pricing and operational risk models. For the Federal Reserve's large-value payment system--Fedwire--we have developed both an internal and external strategy. Internally the approach has been, and will continue to be, identifying all processes that involve date processing; conducting design and code analysis for those processes, and performing extensive testing on the entire system. Both the funds and securities software applications of Fedwire are relatively new, implemented in 1994 and 1996 respectively, and the designers planned for the Year 2000. Nevertheless, it was important for us to test our systems. A few changes were required to make Fedwire Year 2000 ready. Those changes are complete, and acceptance testing is well underway. Externally, the primary goal is to enable Fedwire participants, that is, banks, to test their interfaces with the Federal Reserve in order to ensure Year 2000 readiness. The Federal Reserve will offer financial institutions extensive opportunities for testing applications that interface with Fedwire. A new test environment dedicated to Year 2000 compliance will be available for banks 19 hours per day on weekdays, and most weekends. In addition, during the second half of 1998, the Federal Reserve will offer six designated testing periods during which a number of Federal Reserve applications will support testing for the same future-dated test scenario concurrently. Four of these "periods" will focus on century rollover testing while the other two will provide testing for leap year 2000 processing. The objective is to give banks several occasions on which to test with multiple Federal Reserve services on a single future date on the same calendar day. Customers whose systems are dedicated to production most of the week will be able to use the weekend to test their Fedwire interface, as well as many other major services offered by the Federal Reserve. Beyond our own systems, we are working with industry groups and service providers to coordinate testing schedules so that banks have opportunities to simultaneously test their systems' interactions with multiple service providers. End-to-end testing, that is, testing between the initiation of a transaction and settlement, will also be available this year for sending funds or book-entry securities between customers. The Federal Reserve will offer opportunities for customer-initiated testing throughout 1999. This facility is based on the idea that it is prudent for institutions to retest in 1999 to confirm continued compliance first established during the comprehensive testing planned for 1998. Finally, the Federal Reserve also is developing a comprehensive contingency plan based on a three-pronged strategy, which, broadly speaking, addresses the following issues: alternative readiness plans to address those businesses unable to meet Year 2000 readiness schedules; business resumption plans to address unexpected internal problems for the century date change; and system contingency plans to address problems experienced by customers at the century date change. The Federal Reserve also has similar programs in place to achieve and test Year 2000 readiness for its other services, including cash, check and ACH services. Through comprehensive strategies for our own payment systems, the Federal Reserve has tried to set the tone and standard for what it expects from institutions it supervises. Although some institutions require us to deliver the message more assertively than others, thus far, the strategy of leading by example and providing a guiding hand has been productive. As all of us increasingly appreciate the global dimension of Year 2000 risk, I believe it will become ever clearer that central banks, other market supervisors, and market participants, by themselves, cannot effectively address the scope of the Year 2000 problem. Year 2000 risk serves as a reminder that, in a global economic system, payment systems and markets may only be as strong as those that are least prepared. For market participants, one approach may be private sector joint efforts. Such efforts are already underway and I am sure will be constructive in dealing with the outstanding Year 2000 issues. For the public sector, the only option is to take an active role in developing and shepherding Year 2000 strategy. This round table is valuable in that it makes us, central bankers and market supervisors, aware of the necessary tools in pursuing this goal. Thank you.
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