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Structured Finance and the Social Contract: How Tranching Challenges Contractualist Approaches to Financial Risk

Published online by Cambridge University Press:  09 October 2018

Tobey Scharding
Tobey Scharding*
Affiliation:
Rutgers University
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Abstract:

Many ethicists argue that contract theory offers the most promising strategy for regulating risks. I challenge the adequacy of the contractualist approach for evaluating the complicated, novel risks associated with some structured financial products, particularly focusing on risks to third parties. Structured financial products like collateralized debt obligations (CDOs) divide a pool of financial assets into risk “tranches” organized from least to most risky. Investors purchase various tranches based on their individual risk-and-return preferences. Whereas contract theory holds that investment risks are ethically permitted (roughly) when everyone—including both parties directly involved in the investments and third parties—consents to them, structured financial products like CDOs show that even risks to which everyone consents are ethically problematic when they involve systemic risks of ruin.

Keywords

contractualismethics of risksystemic risks of ruinthird-party risksstructured financecollateralized debt obligations

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Type
Article
Information
Business Ethics Quarterly , Volume 29 , Issue 1 , January 2019 , pp. 1 - 24
Copyright
Copyright © Society for Business Ethics 2018 

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