Friday, 3 May 2013
Solar activity and magnetic poles key to risk: Rogov
The modern risk management profession is currently going through an 'ideological crisis' according to a leading Russian risk management expert.
In a paper posted in blog form on the Ferma web site Mikail Rogov, PhD, Associate Professor RusRisk and Vice-President OJSC RusHydro, said that this crisis is reflected in the following symptoms:
- Failure to understand the nature of the majority of risks, 'eclecticism' of methods and concepts in both technologies and standards of risk management;
- Disregard of the interaction between operational risk, credit risk and market risk, lack of continuity in management processes, lack of common rating scales for the assessment of various risks;
- Inadequate tools for operational risk assessment;
- The virtual absence of portfolio approach to operational risk management;
- Difficulties with forecasting stress and crisis scenario generation and difficulties with explaining the nature of chaotic market processes;
- The problem of the recently increased relevance of previously uncommon factors. Mr Rogov believes the most important of these are cyber and industrial terrorism, influence of social networks, high frequency trading (HFT) and the threat of antibiotic resistance.
Mr Rogov said he believes that the coming decades will see the development of the following branches of risk management: human error, transfer of operational risks including hedging and portfolio diversification, prediction markets, new concepts of key risk indicator (KRI), risk management of small and medium enterprises (SMEs) and households, crowd-sourcing, including platforms like Ushahidi, Wiki, new generation of publicly available risk indices and the emergence of new asset classes.?Mr Rogov explained that it is critical to understand that risks are interrelated and that there are relationships between financial risks of all types-market, credit and operational ones.?He said that risk interactions have an important role because of the existence of close economic, organisational and technological ties between risk owners.
"The occurrence of risks (operational, credit, market) for some persons implies the emergence of other risks for their counterparties and the subsequent chain reaction of credit and market risks propagating through exchange within the economy," explained the RusRisk director. "In recent decades, these relations have been developing more intensively than ever before because of market globalisation and technological progress," he continued.
Mr Rogov said that this 'causal relationship' can be illustrated by a typical example of the domino effect in business environment.
For example discontent of the local population (a political risk, part of operational risks) in Nigeria led to the explosion of a pipeline operated by Royal Dutch Shell on 21 December, 2005.
As a result of this event, output was cut by 180,000 barrels per day (operational risk of business interruption). The company declared force majeure, which meant its failure to perform contract obligations (credit risks for the counterparties) and the price of oil rose by 48 cents per barrel (commodity market risk).
"The mechanism of risk factor influence on the emergence of credit and market risks can be illustrated using the well-known Merton approach, the basis of the Expected Default Frequency (EDF) methodology: distance to default of a firm (ie credit risks of its counterparties) is determined by risks associated with the firm's operations and expressed by the volatility of the market value of the firm's assets exposed to various types of risk: operational, market, credit ones," said Mr Rogov. "The asset's volatility determines the volatility of the market capitalisation (market risks of investors). Statistical analysis of relationships,?correlation and cointegration of market and credit risks are well known and can be explained by changes of risk premium; however, relationships of these risks with various operational risks cannot be adequately explained without identifying a common factor.?Let us define the global risk factor as a global-scale correlator of risk factor volatilities," continued the Russian risk expert.
Mr Rogov pointed out that human error is not the only risk factor, but it has acquired a global nature.
"The principal cause of the global influence of the human factor is that it often and strongly affects the sensitivity of assets' performance to the majority of other risk factors, no matter what their own nature. In the past decades, the influence of the human factor has been growing due to the increasing operator's role in business processes and globalisation. This is reflected by the increasing correlation of different types of risks," he suggested.?The professor said that investigations of technological operational risk in almost all sectors and regions show that most such events in the last half-century were initially caused by human error rather than technical failure.
Moreover, when caused by technical failure, risk events were mostly the result of accumulated hidden defects because of accumulated maintenance errors caused by organisational errors and again the human factor.
Mr Rogov pointed out that the 'human factor' is the main trigger behind the vast majority of transport accidents and disasters.
Human errors are responsible for 90% of all motor vehicle accidents. National statistics of individual countries do not differ much from the world average figures, he said. The human factor accounts for 70-80% of accidents in air and water transport, and for about 50% of accidents in railway transport, continued Mr Rogov.
He also said that the human factor is the dominant cause of industrial accidents and injuries. According to his analysis about 85% of lifting crane accidents are associated with violations of labour or technical discipline, pointed out Mr Rogov.
Mr Rogov then postulated that risks are 'heliogeotropic'. This means that human errors and failures actually depend substantially on preconditions such as the effects of heliogeophysical factors such as geomagnetic disturbances. ?"Geomagnetic activity depends on solar activity. According to the Svalgaard-Mansurov effect, the variations of the Earth's magnetic field are influenced by the sector structure of the interplanetary magnetic field (IMF)," explained Mr Rogov.
"These two major factors can disturb the heart rate and cause human errors, which in their turn, trigger chain reactions resulting in the occurrence of all types of financial risks (market, credit, operational ones) all over the world, depending on the assets' sensitivity to the risk factors," he continued.
"Besides, human intuition and emotions enhance in the periods of geomagnetic disturbances, and this enhancement influences market expectations. As concerns operational risks caused by risk factors non-correlating with heliogeophysical conditions, their impact depends on the asset sensitivity to these risk factors, while the asset sensitivity itself is heliogeotropic due to the human factor influence," explained the Russian.
"For a considerable part of risks, the dynamics of risk events can be explained by that of human errors under changing space weather that has a planetary effect. This risk source was termed the 'global risk factor'. Astrophysicists have shown the chaotic nature of solar and geomagnetic activity, and this can explain (based on the global risk factor theory) the nature of the observed widely discussed chaotic processes in the markets," he continued.
So the big question for any risk manager needs to be: 'How can I identify, measure and control these risks that are literally out of this world?'
Mr Rogov points out that there are many indices of solar and geomagnetic activity. To him the objective has to be to choose the best indicator for adequate description of the global risk factor or to develop a new one.
He believes the best global risk factor index should meet the following requirements: most fully explain the behaviour of market, credit and operational risks, allow for possible regularities discovered in heliobiology (the Mansurov effect), be based on uniquely determinable or measurable values (heliogeophysical data) and allow real-time updating.
Mr Rogov pointed out that the indices of solar activity are not suitable for describing the global risk factor. This, he said, is the basis for the scepticism of modern science towards the ideas of prominent scholars of the past.
"The failure to find correlations with solar activity (the Wolf number, also known as the sunspot number) has led to the substitution of this idea in modern science with the general idea of accounting for random factors in economics. Economists rebranded the term 'sunspots' by completely stripping it of the implication of Sun-Earth relationships and using it to denote an external non-fundamental variable that influences human behaviour," said the author.
"The RogovIndex(c) family of indices was developed for adequate description of the global risk factor; these indices satisfy the above requirements and are based on the widely accepted index of geomagnetic field variation averaged over several stations (storm-time variation Dst). The conclusion that the effect of heliogeophysical factors on risk is best described by storm-time variation than by any other of the great variety of indices is consistent by the findings of heliobiological research," he argued.
As a result Mr Rogov plans to create a market of space weather index derivatives.
Mr Rogov continued that industry specifics of preconditions for 'error proliferation' includes, among other things, the scope of error impact on business processes.
He explained that with a higher labour productivity, an error of one operator would affect more performance indicators and, generally, more business processes.
And the scope of business process regulation, including operator qualification requirements and other industry-specific barriers, the relative attractiveness of the industry pay rate against the average pay in the region's economy and the conflict intensity in the industry the number of strikes.
"Industry specifics result in different global risk factor exposures that should be taken into account by risk managers. For instance, diversified portfolios may be created using the correlation matrix or co-integrating vector approaches that take account of the global risk factor exposures of various assets and consider credit risks in accordance with the industry specifics," said Mr Rogov.
"A detector of those risks that cannot be explained by the global risk factor behaviour allows planning most topical areas of risk audit for identification of operational risks. The geographical specifics of global risk factor exposure is related to the distance of the region, where the main business process or asset (if appropriate) is located, from the magnetic poles constantly drifting relative to fixed geographic coordinates," he added.
Mr Rogov concluded that his proposed global risk factor theory describes the frequently observed interaction of different types of risks (market, credit, operational) at different assets and in different business processes.
"The theory opens prospects for risk benchmarking, analysis, detection of anomalies and hidden risks, classification of risks, particularly based on hierarchical clustering of time series," he said.
This in turn allows for the creation of new 'proactive' risk indicators for monitoring as well as applying the market mechanisms of operational risk optimisation through diversification and hedging with the use of index derivatives, continued Mr Rogov.