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€Fly€ to overshadow €bug€ by year end?
In a worse case scenario, a millennium bug in the financial sector could lead to global financial meltdown. Brian Lynch examines some of the potential problems and asks how bankers and regulators should be reacting.
T he problems that Y2K present can be split into roughly 3 categories:

a) Customer Related Problems, b) Internal Problems and c) External Problems. The primary customer concern facing banks is that there will in all likelihood be a rush on hard cash in and around the millenium. There is a genuine concern that there could be a failure of all electronic banking devices (ATMs, POS systems etc) and thus cash will be in strong demand at a time of year (in the Christian world at least) when cash demand traditionally peaks anyway. This hits banks on both sides of its balance sheet as it will lose deposits and there is likely to be an increase in overdraft/loan usage over the turn. The failure of ATMs etc also presents a reputational concern for banks in that there could be a loss of confidence in the institution prompting a further run on deposits. Also of concern for banks is the whole problem of defaults on loans. Smaller businesses are seen as being a particular risk as they do not have the resources to invest in millenium compliance and thus there is a fear that they will have to shut down when their financial records or business applications fail.

Internal problems for banks have been more widely documented as most of the large financial institutions have publicly disclosed what they are providing in their accounts for the millenium problem. For the larger financial institutions it is primarily an issue of cost as the presumption is that they will throw enough resources at the problem to ensure that their internal applications work correctly. However, for smaller institutions - to whom the cost is also perhaps a more major concern- the danger is that they do not throw enough resources at the problem and their records fail after the millenium.

This latter problem leads on to External Relate problems. There is a significant concern that the Systemic Risk will be the most major issue for the financial sector over the millenium. Those that work in financial institutions will be familiar with the interdependency of the payments process: Bank A pays Bank B who funds from Bank C etc. This chain can be extremely long and span a number of continents in the global currencies (USD, EUR, JPY and GBP). The failure of 1 bank in the chain could cause the collapse of every subsequent payment. After completing all the work on your internal systems the worry is that your funds suppliers will let you down.

This problem not only relates to the suppliers of funds. Banks depend very largely on outsourcing for their financial processing and records and thus they have to ensure compliance of each of these suppliers as well.

The Response:
Apart from dedicating staff and resources to ensuring that both they and their suppliers achieve millenium compliance, banks have also been engineering themselves for some of the problems that are envisaged over the turn of the year.

The well known Millenium Fly (see below), which is the term used to describe the increase in interest rates envisaged over the Millenium as shown in the Futures Strip, indicates that the market as a whole expects liquidity to be at a premium over the turn. The fly is not as dramatic now as at stages over the past 12 months where implied rates jumped as high as 50bps on occasion. We do expect the fly to widen over the summer and accordingly, banks have been paying up for term funding to ensure that they minimise the short term funds they require at year end. This is seen in both the capital market activities of banks, where margins have increased significantly over the past six months in particular, and in the retail market where depositors are being wooed with attractive term rates and equity linked products etc. Finally banks are also engaging in better asset management and encouraging borrowers to agree now their year end funding requirements on the basis that they might be at best charged an excess for or at worst refused credit at year end.

The regulatory response has also begun in earnest as monetary authorities have begun printing notes to meet the likely increased demand. There is also the expectation that, as with the Euro changeover, they will be on hand to inject liquidity into the market over the year-end.

The impact of Y2K on the financial sector could be dramatic indeed and the real problem is the fear of the unknown. The best each bank can do is manage its balance sheet more prudently and ensure their own systems and their suppliers€ systems achieve compliance. After that they will depend on other houses having done the same, some rational consumer behaviour and prompt action from regulators at the first sign of any cracks. This issue might not be as big as the worry that nuclear warheads could be triggered accidentally but it is one of major concern for the global markets.

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