Testimony of Governor Edward W. Kelley, Jr.
The Federal Reserve's efforts to address the Year 2000 computer problem
Before the Committee on Commerce, Science, and Transportation, U.S. Senate
April 28, 1998
I am pleased to appear before the Committee today to discuss the Year 2000 computer systems issue and the Federal Reserve's efforts to address it. The stakes are enormous, nothing less than the preservation of a safe and sound financial system that can continue to operate in an orderly manner when the clock rolls over at midnight on New Year's Eve and the millennium arrives. So much has been written about the difficulties ascribed to the Year 2000 challenge that by now almost everyone is familiar with the basic issue -- specifically, that information generated by computers may be inaccurate or that programs may be terminated because they cannot process Year 2000 dates. The Federal Reserve System has developed and is executing a comprehensive plan to ensure its own Year 2000 readiness, and the bank supervision function is well along in a cooperative, interagency effort, to promote timely remediation and testing by the banking industry. This morning I shall first focus on the potential macroeconomic consequences of the Year 2000 issue. Then I shall discuss actions being taken by the Federal Reserve System to address its internal systems, including Reserve Bank testing with depository institutions, and its bank supervision efforts.
The Macroeconomic Effects of the Millennium Bug
Corporate business is spending vast amounts of money to tackle the Y2K problem. To try to get a handle on the magnitude of these Y2K expenditures, we have reviewed the most recent 10-K reports filed with the SEC by approximately 95 percent of the firms in the Fortune 500. These are the largest businesses in our economy, with revenues of around $5-1/2 trillion annually, and are likely to be on the cutting edge of efforts to deal with the millennium bug. Before the end of the decade, these firms report that they expect to spend about $11 billion in dealing with the Y2K problem. (Of this total, financial corporations are planning expenditures of $3-1/2 billion, while companies in the nonfinancial sector have budgeted funds of around $7-1/2 billion.)
These estimates undoubtably understate the magnitude of the Y2K reprogramming efforts. In culling through the 10-K reports, we found that many companies reported incurring no additional costs associated with Y2K remediation efforts. I doubt such firms are unaware of the problem. Rather, I suspect that some firms did not view their Y2K spending as having a "material" effect on their bottom line, and some companies probably have funded Y2K programs with monies already budgeted to their information technology functions. Making an allowance for all costs--whether explicitly stated or not--and recognizing that these Fortune 500 firms are only part of the picture, an educated guess of the sunk cost of Y2K remedial efforts in the U.S. private sector might be roughly $50 billion. To put this number into perspective, the Gartner Group has estimated that Y2K remediation efforts will total $300 to $600 billion on a worldwide basis. The U.S. economy accounts for about one-fifth of world output, and thus our estimate seems broadly consistent with the lower end of their range. Given the experience of our own Y2K efforts to date, I would expect to see costs rise further once all these Y2K programs are fully under way--ultimately pushing costs up within the Gartner Group range.
Corporate efforts to deal with the Y2K problem are affecting economic activity in a variety of ways. On the positive side, an important element in some Y2K programs is the replacement of aging computer systems with modern, state-of-the-art hardware and software. Such capital expenditures--which I should note are not included in the $50 billion cost estimate--will raise the level of productivity in those enterprises, and, in general, the need to address the Y2K problem has increased the awareness on the part of senior executives of the complexity and importance of managing corporate information technology resources. The increased replacement demand also has contributed to the spectacular growth recently in this country's computer hardware and software industries--a process that I would expect to continue for a while longer. But, ultimately, we are largely shifting the timing of these investment expenditures: Today's added growth is likely "borrowed" from spending at some time in the future. And, if analyzing the dynamics of this situation were not already complicated enough, some firms may "freeze" their systems in the middle of 1999--effectively forgoing the installation of new hardware and software systems just before the millennium. This, too, could influence spending on computer equipment--shifting some of it from 1999 into 2000.
While Year 2000 remediation efforts may give a temporary boost to economic activity in some sectors, the net effect probably is negative. I suspect the majority of Y2K expenditures should be viewed as increased outlays for maintenance of existing systems, which are additional costs on businesses. Other than the very valuable ability to maintain its operations into the year 2000, few quantifiable benefits accrue to the firm---and overall productivity gains are reduced by the extra hours devoted to reprogramming and testing. Conservative estimates suggest that the net effect of Y2K remediation efforts might shave a tenth or two a year off the growth of our nation's overall labor productivity, and a more substantial effect is possible if some of the larger estimates of Y2K costs are used in these calculations. The effects on real gross domestic product are likely to be somewhat smaller than this but could still total a tenth of a percentage point or so a year over the next two years.
The United States is not alone in working to deal with the millennium bug. Efforts by our major trading partners also are under way, although in many cases they probably are not yet at so advanced a stage as in this country. In Europe, the need to reprogram computer systems to handle the conversion to the Euro seems to have taken precedence over Y2K efforts, although there may be efficiencies in dealing with the two problems at once. The financial difficulties of Japan and other Asian economies certainly have diverted attention and resources in those countries from the Y2K problem, increasing the risk of a Y2K shock from one or more of these countries. But, on the positive side, large multinational corporations are acutely aware of the Y2K problem, and their remediation efforts are independent of national boundaries. There also are anecdotal reports that many of these companies are extending their influence by demanding that their extensive networks of smaller suppliers prepare themselves as a condition of maintaining their business relationship.
Obviously, a great deal of work either is planned or is under way to deal with the Year 2000 problem. But what if something slips through the cracks, and we experience the failure of some "mission critical" systems? How will a computer failure in one industry affect the ability of other industries to continue to operate smoothly? The number of possible scenarios of this type is endless, and today no one can say with any confidence how severe any Y2K disruptions could be or how a failure in one sector would influence activity in others.
We have many examples of how economic activity was affected by disruptions to the physical infrastructure of this country. Although the Y2K problem clearly is unique, some of these disruptions to our physical infrastructure may be useful in organizing our thinking about the consequences of short-lived interruptions in our information infrastructure. In early 1996, a major winter storm paralyzed large portions of the country. Commerce ground to a halt for up to a week in some areas but activity bounced back rapidly once the roads were cleared again. Although individual firms and households were adversely affected by these disruptions, in the aggregate, the economy quickly recovered most of the output lost due to the storm. In this instance, the shock to our physical infrastructure was transitory in nature, and, critically, the recovery process was under way before any adverse "feedback" effects were produced. Last summer's strike by workers at the United Parcel Service is a second example. UPS is a major player in the package delivery industry in this country, and the strike disrupted the shipping patterns of many businesses. Some sales were lost, but in many instances alternative shipping services were found for high-priority packages. Some businesses were hurt by the strike, but its effect on economic activity was small in the aggregate. Hopefully, any Y2K shock to our information infrastructure would also be transitory and would share the characteristics of these shocks to our physical infrastructure.
What can monetary policy do to offset any macroeconomic effects? The truthful answer is "not much." Just as we were not able to plow the streets in 1996 or deliver packages in 1997, the central bank will be unable to reprogram the nation's computers for the year 2000. The Y2K problem is primarily an issue affecting the aggregate "supply" side of the economy, whereas the Federal Reserve's monetary policy works mainly on aggregate "demand." We all understand how creating more money and lowering the level of short-term interest rates gives a boost to interest-sensitive sectors (such as homebuilding), but these tools are unlikely to be very effective in generating more Y2K remediation efforts or accelerating the recovery process if a company experiences some type of Year 2000 disruption. We will, of course, be ready if people want to hold more cash on New Year's Eve 1999, and we will be prepared to lend to financial institutions through the discount window under appropriate circumstances or to provide needed reserves to the banking system. But there is nothing monetary policy can do to offset the direct effects of a severe Y2K disruption. As a result, our Year 2000 focus has been in areas where we can make a difference: conforming our own systems, overseeing the preparations of the banking industry, preparing the payments system, and contingency planning. Additionally, we are doing all we can to increase awareness of this problem and to energize preparations both here at home and in other parts of the world.
Background on Federal Reserve Year 2000 Preparations
The Reserve Banks also operate check processing systems that provide check services to depository institutions and the U.S. government. In addition to centralized applications on the mainframe, the Reserve Banks operate a range of applications in a distributed computing environment, supporting business functions such as currency distribution, banking supervision and regulation, research, public information, and human resources. The scope of the Federal Reserve's Year 2000 activities includes remediation of all of these processing environments and the supporting telecommunications network, called FEDNET. Our Year 2000 preparations also address our computerized environmental and facilities management systems, such as power, heating and cooling, voice communications, elevators, and vaults.
Year 2000 Readiness of Internal Systems
Our Y2K project is being closely coordinated among the Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and government agencies. We are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally.
A significant challenge in meeting our Y2K readiness objectives is our reliance on commercial hardware and software products and services. Much of our information processing and communications infrastructure, as well as our administrative functions and other operations, is composed of hardware and software products from third-party vendors. As a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are Year 2000 ready. In many cases, compliance requires upgrading, or, in some cases, replacing, equipment and software. We have a complete inventory of vendor components used in our mainframe, telecommunications, and distributed computing environments, and vendor coordination and system change are progressing well. We are particularly sensitive to telecommunications, an essential infrastructure element in our ability to maintain a satisfactorily high level of financial and business services. We have been working with our financial institutions and our telecommunications servicers to find ways to facilitate preparations and testing programs that will ensure Y2K readiness. Nonetheless, this is an area that many financial institutions regard as needing attention. We strongly support the FCC's program to draw increased attention to the Y2K issue and the progress of the telecommunications companies in the United States.
Oversight of Banking Industry Preparations
Preparing the Payments Systems
We are also researching, in conjunction with our counterparties, the benefits of Y2K testing that would span the entire business process. As part of this effort, the Federal Reserve is coordinating with the Clearing House for Interbank Payment Systems (CHIPS) and the Society for Worldwide Interbank Financial Telecommunication (SWIFT) to provide a common test day for customers of all three systems on September 26, 1998. The New York Clearing House is coordinating an effort to establish common global test dates among major funds transfer systems during April and May 1999.
We are also coordinating with the international community of financial regulators to help mobilize global preparations more generally. These efforts are discussed more fully in the Addendum. In particular, through the auspices of the Bank for International Settlements, international regulators for banking, securities, and insurance along with global payments specialists recently jointly hosted a Year 2000 Round Table, which was attended by over 50 countries. A Joint Council was formed that will promote readiness and serve as a global clearing house on Year 2000 issues. In the final analysis, however, the regulatory community recognizes that it cannot solve the problem for the financial industry. Every financial institution must complete its own program and thoroughly test its applications with counterparties and customers if problems are to be avoided.
The Federal Reserve has formed a task force to address the contingency readiness of our payments applications. Although we have no grounds for anticipating that specific failures could occur and we cannot act as an operational backstop for the nation's financial industry, we view it as our responsibility to take action to ensure that we are as well positioned as possible to address major failures should they occur. We are currently focusing on contingency planning for external Y2K-related disruptions, such as those affecting utility companies, telecommunications providers, large banks, and difficulties abroad that affect U.S. markets or institutions. The Federal Reserve has established higher standards for testing institutions that serve as the backbone for the transactions that support domestic and international financial markets and whose failure could pose a systemic risk to the payments system.
We recognize that, despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others. These problems could be manifested in a number of ways and could involve temporary funding difficulties. The Federal Reserve plans to be prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. The System will also be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available.
Our preparations for possible liquidity difficulties extend as well to the foreign bank branches and agencies in the U.S. that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank. Such circumstances would necessitate coordination with the home country supervisor. Moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any of their banking organizations that experience a funding shortfall.
As a provider of financial services to the economy, we are on schedule with our own internal remediation efforts and will shortly begin testing our interfaces with financial institutions. While we have made significant progress in our Year 2000 preparations, our challenge now is to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. In particular, we shall be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience.
As a bank supervisor, the Federal Reserve will continue to address the financial services industry's preparedness, monitor progress, and target for special supervisory attention those institutions that are most in need of assistance. In addition, we shall track the Y2K progress of external vendors and critical infrastructure suppliers, such as telecommunications and electrical power utilities.
The problems presented to the world by the potential for computer failures as the millennium arrives are real and serious. Because these problems are unique to our experience in many ways, and because the impact of computer-driven systems has become so ubiquitous, the event is unlikely to be trouble free. While we can't predict with any certainty, there clearly is the potential for problems to develop, but these need not be traumatic if we all do our part in preparation. As the world's largest economy, the heaviest burden of preparation falls on the U.S. But it is truly a worldwide issue and, to the extent that some are not adequately prepared and experience breakdowns of unforeseeable dimension, we shall all be affected accordingly. There is much work to be done. We intend to do our utmost, and hope and trust that others will do likewise.
In this spirit, Mr. Chairman, I want to commend the Committee for inviting this panel to testify together on Y2K issues. This is the first time that the Board has testified next to representatives of the Departments of Commerce and Transportation, and the FCC. This is wholly appropriate because our success in preparing for the millennium will ultimately depend very much on one another's efforts.
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