But as a nation, we must also accept responsibility for what we permitted to occur. Collectively, but certainly not unanimously, we acquiesced to or embraced a system, a set of policies and actions, that gave rise to our present predicament.
– Final Report of the National Commission on the Causes of the Financial Crisis in the United StatesFootnote 1
In the run-up to (and in the wake of) the financial crisis of 2008, business ethicists have explored topics related to risks in financial markets (Boatright, Reference Boatright2014; Donaldson, Reference Donaldson2008; Nielsen, Reference Nielsen2010). During the same time period, contractualism has emerged as the most promising approach to the ethics of risk (Hansson, Reference Hansson2003; Hayenhjelm & Wolff, Reference Hayenhjelm and Wolff2012; Oberdiek, Reference Oberdiek2004).Footnote 2 The present article brings these two fields of research together by investigating contractualist resources to evaluate when investors are permitted to expose third parties, or parties not directly involved in the investments, to risks of financial loss. While defending contractualism’s usefulness in evaluating routine financial risks, I argue that it falters on systemic financial risks of ruin.Footnote 3
I begin by setting forth some terminology. In the context of financial risks to third parties, contractualism holds (roughly) that an investor, X, may impose a risk of loss on a third party, Y, only if Y has reason to consent to the risk exposure—e.g., because Y benefits from the risk exposure—even if Y does not explicitly consent to the risk exposure. Having reason means that the risk is justifiable to Y. The fact that Y benefits, or gains materially, from the risk of loss typically justifies the risk to Y. I understand risk in the standard way: as the (known, numerical) probability that a loss will occur (Knight, Reference Knight1921). A risk of ruin is the probability of a loss so large as to be unrecoverable via further risking: the loss would ruin the risker. Systemic financial risks of ruin, in turn, involve probabilities of cascading failures in interconnected financial systems, such that a failure in one part can produce failures throughout the system, ultimately risking system-wide ruin (Bernanke, Reference Bernanke2006; Donaldson, Reference Donaldson2008).
To demonstrate the challenges contractualism faces in evaluating systemic financial risks of ruin, I contrast a routine form of risky financial behavior, purchasing a home on credit, with a novel financial activity that can involve systemic risks of ruin, transacting in structured financial products: issuing them, buying and selling them, holding them. Structured financial products are investments that are tailored to investors’ particular risk-and-return preferences (Hull, Reference Hull2015: 113). I focus on one form in particular: tranched securities. Firms create tranched securities by pooling, or grouping together, large numbers of financial assets, such as mortgages. They separate the mortgage pool into tranches, or tiers, of assets based on their credit risks, or risks that a given number of borrowers will not repay the loans. Next, the tranches are organized hierarchically from least to most risky; investors purchase various tranches based on their individual risk-and-return preferences. Other firms often create further tranched securities by pooling some tranches from a tranched security with tranches from other securities and structuring the pool into more hierarchically organized tranches, which are then sold to investors. I show that contractualist approaches to risk permit large financial institutions to transact in tranched securities in highly interconnected financial systems that are prone to systemic risk, such as the US financial system, and that such transactions are unethical. Because contractualism permits unethical risks, then, it is unreliable as an ethical theory.
I begin by discussing (part one) recent contributions to the ethics of risk, which have advanced contractualism as the most promising strategy for evaluating risk. I set forth several appealing approaches: equitable system (Hansson, Reference Hansson2003); shared aims (Oberdiek, Reference Oberdiek2004); and a third approach, suitable standpoint, which is broached in Hayenhjelm and Wolff (Reference Hayenhjelm and Wolff2012) and I develop herein. I motivate the problem these theorists address, use the approaches to evaluate routine risks to third parties associated with home mortgages, and defend the suitable standpoint as the most promising of the contractualist approaches.
Next, I present (part two) the novel form of risks I seek to evaluate: the risks to third parties created when large financial institutions transact in tranched securities. I focus on tranched securities created out of a particular financial product, CMLTI 2006-NC2 (CMLTI), which have been analyzed in a US government debrief of the financial crisis (US Government, 2010). I discuss these well-examined securities because of the degree of consensus that exists about their roles in precipitating the crisis (US Government, 2010: 386). Examining tranched securities whose causal roles are relatively well understood allows me to focus on the adequacy of the ethical approach used to evaluate them.
Then, I show (part three) how tranched securities created out of CMLTI challenge the suitable standpoint approach. Suitable standpoint permits people to engage in transactions involving these securities in the conditions in the US in the run-up to the financial crisis of 2008. But these conditions included systemic risks of ruin: large financial institutions had risked their own failures by becoming heavily indebted and these institutions were interconnected by webs of transactions, including those involving tranched securities, such that if one of the large institutions failed, its failure could spread through the financial system as a whole, risking the ruins of third parties to the transactions (here understood as the entire US population). The problem for contractualism is that these very people—the third parties themselves—had reason to consent to the systemic risks of ruin associated with the tranched securities created out of CMLTI under the suitable standpoint approach.
I then isolate (part four) the problem in contractualism that systemic risks of ruin reveal. Contractualism distinguishes permitted from forbidden risks based on whether the people exposed to a risk have reason to consent to it on an individual basis; this individual basis neglects systematic issues in a way that appears ethically problematic when products like tranched securities create deep interconnections among large financial institutions. While contractualism’s basis in individual consent is one of its appealing qualities as an ethical theory, the advent of novel, complicated financial risks directs business ethicists to demand a more comprehensive standard of right and wrong from the ethical theories we use to evaluate those risks.
I close by discussing (part five) some promising (nascent) strategies to address these challenges in evaluating financial risks.
1. CONTRACTUALIST APPROACHES TO RISK
Financial risk raises a distinct problem for ethical theories, with which they have only recently begun to grapple (Brinkmann, Reference Brinkmann2013; Chakrabarty & Bass, Reference Chakrabarty and Bass2015; Petrick, Reference Petrick2011). The ethical worries about financial risk addressed in this article include: (a) the (known, numerical) probability of financial losses, (b) the relation of those probable losses to well-being, duties, and rights, and (c) the distributions of the losses over an affected population.Footnote 4 In ethically evaluating a financial risk, theorists try to determine whether imposing the risk on a person or population is ethically permitted. This problem is particularly acute when the person or community is a third party to the financial risk who has not explicitly consented to it (in the manner that the people who undertake the financial risks, e.g., by issuing, buying, selling, or holding financial products, explicitly consent to the risks associated with them). Prominent ethicists of risk (Hansson, Reference Hansson2003; Hayenhjelm & Wolff, Reference Hayenhjelm and Wolff2012; Oberdiek, Reference Oberdiek2004) have criticized utilitarian and deontological approaches to risk while defending contractualist approaches; as such, it is especially important to understand contractualism’s weaknesses as regards the evaluation of financial risks. Before embarking on that part of my article, I briefly set forth the advantages that contractualism appears to enjoy over these other two ethical theories.
Classic utilitarianism permits the action with the highest expected value and prohibits all others (Bentham, Reference Bentham and Bowring1843). As such, it seems apt as regards ethical worry (a) and the well-being aspect of ethical worry (b), above (Audi, Reference Audi2007; Harsanyi, Reference Harsanyi1955). It seems less adept, though, at evaluating risks to rights and duties, as in ethical worry (b) (Kamm, Reference Kamm1989: 256; Nozick, Reference Nozick1974: 30) or the distribution of losses across affected populations (including third parties) as in ethical worry (c) (Brinkmann, Reference Brinkmann2013: 576; Hayenhjelm & Woolf, Reference Hayenhjelm and Wolff2012: 11).Footnote 5 Deontology, by contrast, focuses on enforcing rights and duties (Bowie, Reference Bowie1999; Nozick, Reference Nozick1974), making it well suited to attend to these aspects of ethical worry (b). Because deontology does not address the consequences of actions, its usefulness in evaluating how risks affect the probabilities of losses, well-being, or the distributional consequences of risks—as in ethical worries (a), (b), and (c)—appears limited.
Contractualism, by contrast, specifically addresses well-being, rights, and distributive consequences (Scanlon, Reference Scanlon1998). Contractualism holds, generally speaking, that actions are ethically permitted only if the people affected by the actions, including third parties who do not participate in the actions themselves, consent to the actions. With regard to most actions, it is obviously impractical to gain the explicit consent of all those who are affected (Nozick, Reference Nozick1974: 287); this is why most forms of contractualism pragmatically require only that people have reason to consent to an action (Rawls, Reference Rawls1980: 517-18), e.g., that the action accords with principles that the people choose to govern their own activities, even if they do not explicitly consent to the actions when others undertake them.Footnote 6 Contractualism thus captures ethical values associated with well-being and rights in the sense that people have reason to consent to only those risks that support their well-being or their rights; that a risk undermines something as important as a person’s well-being or rights typically gives the person a reason to withhold consent from the risk. Contractualism supports just distributive consequences, in turn, by requiring that all members of an affected population have reason to consent to the risk, including third parties and those who feel the downside of the risk more severely. Of the three ethical theories discussed herein, then, it appears most promising as regards the regulation of risk.
To see contractualism’s apparent strengths as regards the evaluation of risks, take a simple example concerning household leverage, in which a homebuyer, Anne, wonders whether it is ethical to increase her debt-to-income (DTI) ratio from 3.0 to 4.5. Assume that homebuyers with a DTI of 3.0 have a default rate of 5 percent; homebuyers with a DTI of 4.5 have a default rate of 15 percent.Footnote 7 Having a higher DTI would allow Anne to afford a more expensive home that better meets her needs, creating (say) ten times as much utility for her. The more expensive house makes it three times more likely that Anne will go into foreclosure, reducing third parties’ (e.g., her neighbors’) expected utility as property values decline and neighborhood crime increases. So long as expected losses are not too great, utilitarianism endorses Anne’s higher DTI ratio. It ignores, though, the consequences for people’s rights (e.g., to their property values) and duties (e.g., to maintain their community) associated with the higher DTI ratio, along with its distributive consequences. The risks of lower property values and higher neighborhood crime may affect Anne’s poorer neighbors more acutely than her richer neighbors, for example.
Deontology encounters even greater difficulties in evaluating this simple example. To evaluate risk, deontology could either prohibit people from imposing any risk on third parties (if there is a duty not to expose others to risk) or permit people to impose any risk on third parties (if there is no such right or duty) (Hansson, Reference Hansson2003: 297-99). In the example concerning Anne’s DTI ratio, the first strategy prohibits both ratios on the ground that both expose neighbors to risk. It might permit a lower ratio; as all debt involves risk, though this strategy seems to prohibit taking out loans. The second strategy, in turn, offers no basis to decide between alternative risk thresholds (Oberdiek, Reference Oberdiek2009: 370); as such, it seems unhelpful in resolving Anne’s dilemma.
Contractualism, by contrast, appears promising. According to this theory, Anne may take on more debt when, and only when, other homeowners (third parties) have reason to consent to the risks associated with her higher DTI ratio (including those who would be harmed most greatly), i.e., when the ratio is justifiable to them. The contractualist evaluation thus takes probabilities, well-being, duties, rights, and distributions into account, as broached above. To understand whether third parties have reason to consent to risks, ethicists of risk have offered three contractualist approaches: (1.1) equitable system; (1.2) shared aims; and (1.3) suitable standpoint. After setting forth these approaches and applying them to Anne’s question about permitted DTI ratios, I discuss (1.4) the upshot of these applications.
The Equitable System Approach
Hansson argues that it is ethical to expose a person (i.e., a third party) to risks so long as two conditions obtain, namely, that the exposure belongs to (a) an “equitable social system of risk-taking” that (b) works to the advantage of all people affected by it (2003: 305), including third parties. As regards the first condition, Hansson specifies that equitability requires each person to receive a “fair share” of the social advantages created by the risk (305). It thus prohibits a two-class social system that exposes the lower class to a great deal of risk, of which the upper class is the primary beneficiary, even as the upper class bears little risk (305). On ensuring that the system of risk taking works to each person’s advantage, Hansson notes that the equitable system is compatible with either individuals subjectively determining their advantage or independent (more objective but perhaps worse informed) assessors determining advantage (305).
Consider again the case of purchasing a home. People who take out mortgages impose risks on others, including third parties who do not actively participate in the system: neighbors who rent, local employees, and so on. The risks can be regulated by law—legal requirements for loan eligibility, and the like—but non-payments will still occur, imposing losses on third parties. Hansson’s rationale permits the risks so long as they are part of an equitable social system in which everyone who is exposed to the mortgage risks benefits (i.e., gains materially from the risks). The social system might be equitable if all people are permitted to take out home mortgages—no prohibitions based on race, religion, gender, and so on—and everyone has access to a home loan if they want one (i.e., no one is too poor to afford a home).
It is not clear, though, that everyone needs to be able to take out a mortgage (who wants one) in order for the system to be equitable by Hansson’s lights. Non-homeowners—even involuntary ones—still gain materially from home ownership in terms of being able to rent a place of residence from a homeowner, along with downstream effects such as the widespread availability of credit (discussed further below). A possible weakness in the equitable system approach is thus that the approach seems imprecise: it is hard to pin down what “equitability” requires.Footnote 8
Take the problem broached above: May Anne increase her DTI ratio from 3.0 to 4.5? According to the equitable system approach, this action is permitted so long as the higher ratio is equitable—every homebuyer can equally assume a DTI ratio of 4.5—and the ability to take on additional debt works to the advantage of those put at risk. The assumption specified in section one (ten times the utility from the more expensive house) supports the higher DTI ratio on this approach. How the possible disparate impact on Anne’s neighbors influences this support is unclear, though. Anne might suffer a foreclosure that lowers the values of her neighbors’ homes; if so, her neighbors will obviously be affected by the higher DTI ratio. Does it alter equitable system’s evaluation if Anne’s poorer neighbors experience greater hardship as a result of their reduced home values than her more prosperous neighbors? There is no obvious answer to this question.
Moreover, as Hayenhjelm and Wolff object, the equitable system approach does not clarify an acceptable level of risk (2012: 28). If DTI ratios of 6.0, or higher, were part of an equitable social system that worked to everyone’s advantage, then the much higher risks associated with this extent of indebtedness could be acceptable under the equitable system approach. Thus, the equitable system approach begins to address the distributive consequences of risk but remains vague on two key points.
The Shared Aims Approach
Oberdiek offers a way of responding to the latter problem. His contractualist approach to risk, the shared aims approach, determines an acceptable level of risk based on people’s shared aims. People’s aims are the risk-benefit ratios of the activities in which they participate as they work to achieve their individual goals. Two people share aims when they pursue activities that have the same risk-benefit ratios. The activities can be very different; what matters for the shared aims approach is that the risk-benefit ratios are (numerically) identical. In fact, even the risk-benefit ratios may differ in the shared aims approach; the “shared aim” is simply the highest risk-benefit ratio pursued by all of the people in a community that is exposed to a risk, including third parties who do not actively participate in the risky activities. The shared aims approach permits risks when they are lower (less risky) than the community’s greatest common risk-benefit ratio; it prohibits risks when the risks are higher (riskier) than the community’s greatest common risk-benefit ratio (Oberdiek, Reference Oberdiek2004: 202).
It is in this sense that the shared aims approach to contractualism can address the problem that Hayenhjelm and Wolff noted in the equitable system approach: by determining an acceptable level of social risk. People are committed to accepting as much risk in other people’s activities to which they are third parties as they accept in activities in which they participate, regardless of any (possibly relevant) differences between the activities. All that matters for purposes of ethical evaluation is (a) that the activities involve comparable levels of risk and (b) that the person participates in one of the activities—thus consenting to that risk (level).
These standards give the shared aims approach a rationale for resolving the problem posed above. Anne may increase her DTI ratio to 4.5 so long as all the people put at risk by this activity, including third parties, engage in activities that have a risk level comparable to a 15 percent probability of mortgage default in the relevant time frame. That is, they must be willing in their own lives to take a relatively small risk of a serious loss in order to secure significant benefits. It seems plausible that most people participate in such risks (at least at some point in their lives).
It also seems plausible, though, that not all people participate in such risks. The shared aims approach requires universality among people who could have very diverse risk preferences. Some members of a community might reject small risks of serious losses in order to secure even significant benefits. Oberdiek could respond that in order to prohibit DTI ratios of 4.5, community members must also prohibit all other activities that involve this level of risk. From his point of view, such a ban on risky activities would restrict people’s activities too greatly (Oberdiek, Reference Oberdiek2004: 203). An extremely risk-averse person or someone who withdraws from society, though, might not hesitate to curtail even very mundane activities. This problem—along with the sense that it would be unreasonable to prohibit activities that has as many benefits as mortgage debt— appears to stymie the shared aims approach on risk regulation.
The Suitable Standpoint Approach
Hayenhjelm and Wolff (Reference Hayenhjelm and Wolff2012) offer a strategy that can address this worry, albeit perhaps only partially.Footnote 9 They discuss an interpretation of contractualism such that people may expose others to risk only when the others have reason to consent to the risk from a “suitably defined standpoint” (25). Although they do not specify what makes a standpoint suitably defined, the idea of suitability appears to prohibit extremely risk-averse people from vetoing routine (third-party) risks that have widespread social benefits, such as home mortgages. In this way, suitable standpoint escapes the stultification to which the shared aims approach seems subject, as discussed above. As in equitable system, Hayenhjelm and Wolff interpret contractualism as holding that acceptable risks must be “part of a larger pattern from which everyone benefits” (2012: 28).
In seeking to develop this interesting approach more fully, it seems to me that theorists can determine a suitable standpoint for evaluating risks by combining the strategy used in the shared aims approach with a form of utilitarianism.Footnote 10 Shared aims defines a proto-suitable standpoint for risk evaluation: as the greatest risk in which any person, who is exposed (as a third party) to the risk whose permissibility is being evaluated, participates. So, as noted above, risk-averse citizens who do not (a) take out loans to buy their homes might still (b) purchase goods from stores that are paying off commercial mortgages or (c) rent their residences from people who owe money on those properties. The fact that these risk-averse citizens participate in certain risks helps to define an (initial) standpoint from which to determine whether they have reason to consent to other, more questionable risks.
The suitable standpoint approach itself seems to permit more risks than the shared aims approach, in the sense that many routine risks seem “suitable.” Such risks facilitate social functions in which a wide majority of people participate—even if everyone does not “share [the] aims” of these risks. A plausible way of defining the standpoint, then, could be either: risks are permitted when they are lower than either the average risk-benefit ratio of the population put at (third-party) risk or the risk-benefit ratio of activities in which the majority of that population participates. These definitions permit more socially beneficial risks than the shared aims approach while capturing that approach’s ability to include well-being, rights, and distributional consequences in its evaluations.
It is in this sense that the suitable standpoint approach seems helpfully understood as modified utilitarianism. The acceptability of a risk, for the suitable standpoint approach, depends on overall social benefit to the extent that the suitable standpoint is engineered to facilitate social functions in which many people participate. The approach differs from classic utilitarianism in that it rejects certain distributions of risks. For example, the suitable standpoint approach rejects risks that benefit only a minority of those exposed to risk (even if the minority stands to benefit a lot). In that respect, it resembles the equitable system and shared aims approaches. It differs from those approaches in permitting more risks than shared aims: when these risks have widespread, though not necessarily universal, benefits (understood as material gain accruing to those put at risk). Unlike equitable system, suitable standpoint offers a permitted level of risk: the (e.g.) average level of risk that people personally undertake (even if the risks used to calculate the average attach to very different activities from the risk being evaluated).
In the problem discussed above, the suitable standpoint approach seems likely to permit Anne to increase her DTI ratio to 4.5, given the higher DTI ratio’s greater utility. Even if some people would reject the gains to avoid the risk, the benefits associated with risks like home mortgages are clear; thus, it is straightforward to determine when the suitable standpoint approach would permit them. Higher risks, such as a DTI ratio of 6.0, would be permitted when the average (or majority) benefits and prohibited otherwise.
Upshot and Challenges
Suitable standpoint contractualism thus offers a justification of home mortgages that partakes of the social benefits of home mortgages but is not limited to those benefits. Its basic claim is that a suitably defined standpoint from which to determine whether a risk is permitted must pay some heed to social benefits but need not, and should not, determine ethical permissibility solely in terms of benefits. Suitable standpoint improves on the other two contractualist candidates for evaluating risks in the sense that it offers a risk threshold, unlike equitable system, and is not limited by the socially disadvantageous risk-benefit ratios of outliers, as was shared aims.
The suitable standpoint is vulnerable to several objections, however. Whereas equitable system was vague about the requirements of “equitability” and imprecise about the level of permitted social risk, suitable standpoint appears vague about what makes its evaluative standpoint “suitable” and, therefore, imprecise about what level of third-party risk its standpoint permits. Although this imprecision confers flexibility upon the approach, freeing it to permit risks that have widespread benefits but in which not all people participate, it could incapacitate the approach (making it unreliable in distinguishing permitted from prohibited risks) when the average (or majority) of third parties have reason to consent to unethical risks.
2. THE BENEFITS AND RISKS OF STRUCTURED FINANCE
In this section, I provide background information for my argument that contractualism wrongly permits large financial institutions to transact in tranched securities in highly interconnected financial systems that are prone to systemic risk. This background information concerns: (2.1) the nature of structured financial products, (2.2) the benefits of structured financial products and (2.3) the risks of structured financial products. Finally, I describe (2.4) an example of a structured financial product, which I evaluate in the following section.
Structured Financial Products
Structured financial products are complex financial instruments whose cash flows are determined by the values of one or more financial securities or derivatives of securities; their complexity, as detailed below, allows them to offer specific risk-and-return alternatives to investors. Simple (non-structured) financial products like fixed-rate bonds or stocks, by contrast, are less able to be tailored to individual investment preferences (Bennet, Reference Bennet2011: 814).
There are many different kinds of structured financial products (Hull, Reference Hull2015: 93-120). My analysis focuses on one variety in particular, which involves tranching to create different risk-and-return alternatives within a single product. To issue a tranched financial product, a financial institution (typically a large bank) first securitizes a group of assets it owns, creating an asset-backed security (ABS) (or mortgage-backed security [MBS] when the underlying assets are mortgages). Securitizing the assets gives them standard features that potential buyers can evaluate easily.
Next, the bank divides the security into different tranches based on risk. The bank divides the security pool into different tranches so that investors can purchase those tranches, and only those tranches, that match their individual risk preferences. The least risky are senior tranches; riskier tranches are junior. Junior tranches are often divided between mezzanine (medium risk) and equity (the riskiest class). This well-ordered asset pool is a tranched security (specifically, an ABS or MBS).
Investors purchase different tranches based on their risk-and-return preferences. As borrowers repay the loans pooled in the structured financial product, their payments are also pooled. The owners of senior tranches are paid (according to the terms of their investments) first; that is why senior tranches are the least risky. The owners of the mezzanine tranches are paid next, then the equity tranche. Because nearly all borrowers must repay their loans in order for investors in the equity tranche to earn return, this tranche is the riskiest. The equity tranche also, though, represents the greatest opportunity for profit (because it is the least expensive to purchase). If an investor’s tranche is not repaid, the investor both fails to realize any gains from the investment and loses whatever capital the investor used to purchase the tranche (Hull, Reference Hull2015: 125-30).
Because of their tailoring to individual risk-and-return preferences, tranched securities tend to beget more tranched securities. In particular, the mezzanine tranches of ABSs are often transformed into collateralized debt obligations (CDOs), another form of tranched securities. CDOs are structured financial products that are comprised of pieces of many different debt securities, most popularly ABSs, also organized into tranches from most to least risky. Because investors tend to seek high- and low-risk tranches above all, firms often create CDOs from the medium-risk tranches of ABSs, thus putting more high- and low-risk tranches on the market.
Tranched CDOs, in turn, are often further repurposed into additional tranched securities such as CDOs-squared and synthetic CDOs. CDOs-squared are tranched securities created out of pieces of CDOs. Synthetic CDOs, in turn, are tranched securities created out of credit default swaps (CDSs). CDSs are wagers about whether the mortgages supporting a given CDO tranche will default. They are not funded by underlying securities or derivatives of securities in the way that ABSs, CDOs, and CDOs-squared are. Rather, CDSs are side bets about whether CDO tranches will be profitable. Synthetic CDOs pool CDSs into (further) tranches, hierarchically organized from least to most risky.
Benefits of Structured Finance
In order to understand the risk-benefit ratios of structured financial products, I begin by examining their benefits. Broadly speaking, structured products facilitate the large-scale, ambitious activities that help organize society and allow people to pursue their goals (Shiller, Reference Shiller2012: 6-7). They facilitate these activities primarily by making credit more widely available. This takes place (roughly) via the following procedure. First, commercial banks extend credit to people via loans. The banks’ capital limits how many loans they can make. Banks can gain access to more capital, though, by selling their loans to investors, such as investment banks. Investment banks, in turn, create structured financial products, which they sell to other investors. The ready supply of debt-purchasing investors allows financial institutions to extend more credit to people, allowing more people to participate in the activities they wish to. The material gains of structured finance are, in this sense, extraordinarily widespread.
As broached above, tranching increases investors’ interest in structured financial products by tailoring the products to investors’ individual risk-and-return preferences. Some investors are risk averse: they want to make investments that are very likely to produce the returns they promise. Other investors are risk loving. Tranching targets a range of risk-and-return preferences, as described in the foregoing section: thus increasing demand for structured securities, providing more cash to make loans—including to third parties who do not purchase tranched securities—and allowing entire populations of people to gain materially.
Do all tranched securities make credit more available? Some regulators answer no: they claim that synthetic CDOs are a form of gambling, which do not help to extend credit any more than a casino does (US Government, 2010: 142, 146). There is controversy about this issue, though. Executives of the US investment bank Goldman Sachs have argued, for example, that synthetic CDOs increase liquidity and—by creating more investment opportunities—allow people to select investments that better match their investment and risk-and-return preferences (US Government, 2010: 146) thereby also benefiting third parties, as discussed above.
Risks of Structured Finance
In the run-up to the 2008 financial crisis, structured financial products also introduced large amounts of risk into the financial system. Even as they helped to make more credit available, tranched products like CDOs, CDOs-squared, and synthetic CDOs encouraged mortgage lenders to make as many mortgages as possible, including loans that presented a high probability of default. In this section, I discuss the distinctive risks of structured finance. My aim, as in the foregoing section, is to understand these products’ risk-benefit ratios for use in the contractualist evaluations in the next section. To this end, structured products present both localized and systemic risks. Localized risks are probabilities that investors will experience individual (local) losses; systemic risks threaten system-wide losses. Several kinds of localized risks are relevant to tranched securities, including credit, operational, market, and liquidity risks (Christofferson, Reference Christoffersen2011: 6-7), which I discuss in turn.
As broached above, credit risks are risks that borrowers might not repay the loans upon which the tranched securities’ cash flows depend. Operational risks capture risks associated with human errors, including fraud or poor underwriting standards, which generally undermine investors’ abilities to assess credit (and other) risks accurately. Market risks, in turn, include the probability of a downturn in an entire market, such as the US housing market. These risks make groups of borrowers, as opposed to individual borrowers, more likely to default. Liquidity risks pertain to markets in illiquid goods (including real estate) in which one or more party’s efforts to sell assets can push prices lower. They also make groups of borrowers more likely to default. Liquidity risks, like market risks, influence credit risks and can be augmented by operational risks when people fail to anticipate them.
Systemic risks, in turn, reverberate throughout entire systems—such as financial systems, power grids, or computer networks—effecting losses throughout the systems by exploiting the interconnections within those systems. Systemic risks can threaten the systems’ abilities to perform well. They are more often, though, defined in terms of failure: when one part of the system fails, the entire system can fail. The latter kind of risks are called systemic risks of ruin, as defined above. They expose everyone who participates in a system, including third parties, to probabilities of ruinous losses.
Systemic risks of ruin depend on two factors: (a) possibilities of local failures, which can cascade to effect system-wide failures, and (b) interconnections in the system, through which the failures cascade (US Government, 2010: 352). In the run-up to the 2008 crisis, large financial institutions were susceptible to local failures in virtue of being highly levered, or heavily indebted to other financial institutions. When their investments produced inadequate income to maintain repayment obligations to the banks holding their loans, the institutions became insolvent. These debt relationships were one kind of interconnection in the financial system: as debtor banks missed payments, the banks holding the loans became unable to fulfill their own repayment obligations, producing strings of defaults (US Government, 2010: 299-300).
Another important kind of interconnection resulted from the tranched securities themselves (US Government, 2010: 386). CDOs are typically purchased by institutional rather than individual investors: investment banks, pension funds, hedge funds. In the run-up to the 2008 crisis, institutional investors took interest in the senior tranches of CDOs because the risk transformations associated with tranching made these tranches (appear to be) as secure as the safest kinds of debt. Given certain assumptions about the underlying mortgages—including that borrowers were very unlikely to default all at the same time—such risk transformations enabled tranches comprised entirely of risky subprime mortgages, whose borrowers have short or flawed credit histories, to have the same quality rating as a US government bond (US Government, 2010: 147-48). The risk transformation process involved overcollateralization, such that the value of the mortgages in the tranche was greater than the value of the tranche itself, along with subordination, such that investors in the junior tranches experienced losses prior to investors in the senior tranches (IMF, 2008: 59), as discussed above. By connecting many large financial institutions, and exposing the institutions to the same credit risks of the subprime mortgages on whose cash flows the CDOs depended, such CDOs thus created the possibility that many large financial institutions could fail at the same time.
An Example of a Tranched Security: CMLTI
To investigate the challenge that tranched securities present to contractualist theories, I turn to an example of a particular MBS, CMLTI 2006-NC2 (CMLTI), which was issued in 2006 by a US bank, Citigroup. This security consisted of 4,499 mortgages, worth 947 million dollars. All of the mortgages were subprime. In exchange for the greater risk they present, as discussed in the foregoing section, subprime borrowers pay higher interest rates. These higher rates mean that subprime mortgages are more profitable (US Government, 2010: 71). Most had 30-year terms, representing opportunity for greater (interest-driven) profits than shorter terms. More than 90 percent were created in May-July of 2006, which was the peak of the US housing boom. That meant that prices were highest and mortgages biggest (US Government, 2010: 111).
CMLTI consisted of 19 tranches organized from least to most risky (US Government, 2010: 71). The senior tranches were purchased by the Federal National Mortgage Association (better known as Fannie Mae, the government-sponsored enterprise created to purchase US mortgages) along with several US, European, and Asian banks. Many of the mezzanine tranches were transformed into CDOs, as discussed above. Citigroup retained ownership of half of the equity tranche; a hedge fund purchased the other half (US Government, 2010: 116).
My evaluation focuses on CDOs created out of one of CMLTI’s mezzanine tranches, M9, which contained 12 million dollars in bonds rated BBB (only two notches above non-investment grade). Via the risk transformations associated with tranching structured financial products, as discussed in the previous section, perhaps 80 percent of the CDOs created out of CMLTI’s mezzanine tranches, which were 100 percent comprised of low-quality subprime loans, had the same rating as a US government bond (i.e., the highest possible quality rating) (US Government, 2010: 148). Several synthetic CDOs contained CDSs that referred to this tranche, including Auriga, Volans, and Neptune CDO IV. About 50 million dollars were at stake in the synthetic CDOs referencing tranche M9 (not including the bonds themselves). The synthetic CDOs thus multiplied by a factor of five the amount of money that could be won or lost on CMLTI’s tranche M9 (US Government, 2010: 145).
The CDOs’ quality levels were certified by rating agencies, including Moody’s and Standard & Poor’s.Footnote 11 The rating agencies ran mathematical models to estimate how many loans had to fail before senior investors experienced losses (US Government, 2010: 122). CDO investors typically referred to these estimates rather than performing their own analyses. The agencies considered both (a) the likelihood that enough borrowers would default such that a tranche would not be paid and (b) how correlated were the defaults (US Government, 2010: 146).
Operational risks affected agencies’ assessments of (a). The most significant issue was that the agencies relied on the risk assessment performed when the mortgages were initiated, rather than independently reevaluating the mortgages. This meant that any flaws in the initial risk assessment were carried into the agencies’ assessments. Many of the initial assessments had involved weak underwriting standards or outright fraud (US Government, 2010: 147). Moreover, the agencies assessed credit risk, only. They ignored market and liquidity risks: such as how the housing boom, and its likely end, influenced probabilities of default (US Government, 2010: 149).
The rating agencies were also subject to operational risks in their assessment of (b). As noted in the previous section, the agencies viewed mortgage defaults as largely uncorrelated; in fact, defaults turned out to be highly correlated. The problem here was that evaluators had little data on which to base their probability assessments. Thus, they relied on their judgment (US Government, 2010: 147-48). When the collapse of housing prices in 2007 led to waves of defaults—unleashing systemic risk, as discussed in the foregoing section, in addition to demonstrating that the agencies’ assumption of non-correlation was wrong—the agencies downgraded their ratings (US Government, 2010: 148).
3. HOW STRUCTURED FINANCE CHALLENGES CONTRACTUALISM
In the introduction to this article, I stipulated that it is unethical for large financial institutions to transact in tranched securities in highly interconnected financial systems that are prone to systemic risk. As noted above, contractualism appears well suited to evaluate these activities in the run-up to the 2008 crisis in the sense that it considers the full range of relevant concerns: well-being (including the distribution of well-being), rights, and duties. In this section, I evaluate the decisions to issue, purchase, and hold CDOs based on CMLTI’s tranche M9—thus amplifying the amount of risk associated with the original financial product, replicating the risk across interdependent players, and (contributing to) creating systemic risks of ruin. I consider the synthetic CDOs Auriga, Volans, and Neptune CDO IV, in particular. While focusing on the (3.3) suitable standpoint approach, as defended above, I also discuss the evaluations of (3.1) equitable system and (3.2) shared aims, as relevant. In the next section, I explain my stipulation that these transactions are unethical.
Equitable System on Tranched Securities
To evaluate large financial institutions’ decisions to issue, purchase, and hold synthetic CDOs composed of CDSs referencing CMLTI’s tranche M9 via the equitable system approach, the first step is to determine whether the risks to third parties associated with these transactions arose in an equitable system. Immediately difficulties arise. The risk taking occurred in the US economy. With its widespread socioeconomic inequalities, the US economy might not appear to establish equitability in Hansson’s sense. It does, though, go some distance to ensure that all citizens can benefit (i.e., gain materially) from the US economy: by prohibiting discrimination based on race, religion, gender, and so on, as discussed above.
On the “working to each person’s advantage,” rationale, moreover, Americans have reason to consent to investment risks associated with tranche M9 of CMLTI (i.e., the risks are justifiable to them) by Hansson’s lights. Because such risks help to secure the advantages of the US economy, from which both investors and third parties gain materially (as discussed in section 2.2, above), they appear justified on the equitable system approach.
Towards the possibility that the risk taking did not take place in an equitable system, Hansson might point out that lower-class people bore much of the (third-party) risk associated with CMLTI, such as by borrowing the subprime mortgages that comprised tranche M9. They received few (lasting) benefits, however, in the sense that many lost their homes to foreclosure and did not subsequently receive bailout money from the federal government.Footnote 12 Upper-class people, by contrast, were subject to fewer third-party risks and benefited more. The rich were subject to fewer third-party risks in the sense that they were investors more than borrowers: losing money in investments but not their homes. They benefited more, or so one might interpret, in the sense that the bailed-out banks allowed them to continue in their profit-seeking activities.
This issue is also contestable, however. Many wealthy investors lost great sums of money in the financial crisis. And wealthy people contributed to the US tax funds used in the bailout along with other Americans. Moreover, many poorer Americans became able to purchase homes for the first time as a result of the interest in subprime mortgages created by structured financial products like CMLTI. In this sense, the equitable system approach, though helpful, seems vague at key points in its analysis (as broached in my summary of this view, above). Most importantly, it does not clearly prohibit large financial institutions from transacting in tranched securities in highly interconnected financial systems that are prone to systemic risk.
Shared Aims on Tranched Securities
The shared aims approach, in turn, might challenge the idea that transacting in tranched securities in highly interconnected financial systems that are prone to systemic risk really is a shared aim of the people of the United States. Although transacting in tranched securities does create advantages for society as a whole—in particular, by making funds available for entrepreneurial activities, as discussed above—it could be argued that people’s shared aims include only more limited forms of risk.
It might seem difficult for shared aims to make much progress in this argument, though, given the analysis of risk associated with CMLTI’s tranche M9, offered above. Because of the ways in which tranching changes the risk characteristics of a structured financial product, as discussed above, 80 percent of CDOs had the highest possible quality rating: AAA (US Government, 2010: 148)—even when they were composed of low-quality subprime mortgages such as those in CMLTI’s M9. This quality rating, AAA, is the same as a US government bond. It seems implausible, then, to claim that the risks associated with CMLTI’s tranche M9 are not part of the shared aims of the people of the United States. If anything, the extremely high-quality rating of (most of) the tranches of synthetic CDOs composed of CDSs referencing CMLTI’s tranche M9 suggests that they were more risk averse than what the shared aims approach permits.
Against this interpretation, of course, one could emphasize that 80 percent figure. All of the tranches of CDOs created out of CMLTI’s tranche M9 did not enjoy the highest quality rating. The other 20 percent of the CDO tranches were much riskier. Oberdiek could argue that the third parties threatened by systemic risks of ruin did not share the aim of systemic risk. In the first place, he might claim that these parties had reason to consent only to the lower risk associated with the CDOs’ highly-rated tranches. Second, he could point out that individual people do not create systemic risks of ruin in their own activities; only interconnected activities across systems create systemic risks of ruin (as discussed above).
I respond to each of these worries in turn. First, the claim that third parties to synthetic CDOs composed of CDSs referencing CMLTI’s tranche M9 (arguably) had reason to consent only to the AAA risks associated with these products itself highlights a problem for the shared aims approach as regards tranched securities. That is, these instruments seem predicated on the idea that there is no shared risk-preference level among the members of a community. The financial instruments were explicitly created to serve people’s variable risk-preferences in the sense that the different tranches were established to allow individuals to make investments whose risk profiles match the investors’ risk preferences. There is no general “shared aim” of risk in the structured financial products I have been examining: only people’s individual investment choices. Even the very risky equity tranches appeal to some investors. The problem with the shared aims approach as regards tranched securities, then, is that it seems unable to separate permitted from forbidden risks where a diversity of risk preferences exist.
Second, while individual people cannot create systemic risks of ruin in their individual activities, they can and do create risks of ruin. For example, people who borrow large amounts of money for home mortgages without maintaining adequate capital to cover their repayment obligations in the case of (e.g.) an economic downturn create risks of personal ruin: foreclosure, personal insolvency, bankruptcy. Willingly exposing themselves to risks of personal ruin gives people reason (from their individual perspectives) to consent to investments that create systemic risks of ruin in the sense that systemic risks of ruin threaten the third parties’ personal ruins, to which they have consented (according to this approach) by willfully participating in activities that have a similar risk level in their own lives.
Suitable Standpoint on Tranched Securities
In the case of Anne’s decision to raise her DTI ratio from 3.0 to 4.5, discussed above, the suitable standpoint approach helped to solve a similar difficulty (about diverse individual risk preferences) in the shared aims evaluation. Moreover, in my analysis of three contractualist approaches to risk, suitable standpoint appeared the most promising—building, as it did, on the other two approaches. Unlike the equitable system approach, suitable standpoint can specify a level of ethically acceptable risk. Unlike the shared aims approach, suitable standpoint can justify risks to which some people object without reverting to a (classic) utilitarian account of risk. Ethicists can justify such risks by appealing to a suitable standpoint for ethical evaluation.
To evaluate large financial institutions’ decisions to issue, purchase, and hold tranched securities based on CMLTI’s tranche M9, then, the suitable standpoint approach seems fruitful. The suitable standpoint in this case might be the one that allows for many different levels of risk in the financial industry, as broached in the previous section. It would permit risks that are (a) instrumental to the benefits that the financial industry produces and so long as they are (b) fairly distributed. It would prohibit risks that do not secure overall benefits and risks that are not borne fairly.
For guidance in this evaluation, I consider details relating to Auriga, Volans, and Neptune CDO IV. In July 2007, around the time these synthetic CDOs were being originated, 11 percent of CMLTI’s original loan pool was either in foreclosure or more than 90 days late on a mortgage payment.Footnote 13 In order to use suitable standpoint to evaluate the decision to form synthetic CDOs from CMLTI’s tranche M9, then, evaluators need to know if the people whom transactions in these synthetic CDOs exposed to systemic risks of ruin had reason to consent to the risks from a suitably defined standpoint.
One suitably defined standpoint, as broached above, might be the average level of risk of ruin that third parties (whom the synthetic CDOs exposed to risk) willingly accepted in their own lives. The parties exposed to risk include everyone who depends on the US economy, viz. the US population. As a starting point in determining that risk level, I refer to Mian and Sufi’s (Reference Mian and Sufi2010) observation that the average default rate on home mortgages for the 450 largest US counties in the fourth quarter of 2006 was approximately 4 percent; by the second quarter of 2009 it was approximately 8.5 percent (86). The 90th percentile default rate for those mortgages was approximately 6 percent in the fourth quarter of 2006; by the second quarter of 2009 it was approximately 16 percent (2010: 86). By defaulting on their loan payments (or having agreed to mortgage loans without possessing sufficient capital reserves to avoid default) I take it that these mortgage borrowers willingly risked personal ruin, as discussed in the previous section. The average default rate is lower, though, than the mortgages referenced in CMLTI’s tranche M9, suggesting that if the suitable standpoint is defined as average mortgage-risk preferences, this approach prohibits trading in structured financial products that rely on CMLTI’s tranche M9.
That suggestion can be challenged, however, on several grounds. First, this average risk level relates only to American homeowners, not the US population. Those unable to purchase a home in 2006 had reason to prefer greater access to credit (i.e., even more risk) in the sense that greater access to credit would have allowed them to purchase homes as well. Second, the (a) average default rate of American mortgages differs from the (b) likelihood that enough borrowers in a given tranche would default such that investors in the tranche would lose their investments (thus potentially becoming insolvent and setting off chain reactions that threaten the financial system as a whole, as discussed above). The average default rate on home mortgages for the 450 largest US counties in the relevant time period could produce a similar likelihood that investors would not be paid as the average default rate in CMLTI’s tranche M9. Finally, the empirical evidence on which my comparison relies relates to different years in the crisis, which plausibly influences the average default rate. Given these problems, a more general perspective seems useful.
Towards this end, another plausible standpoint for evaluation is the level of risk to which the majority of the people (who are exposed to risks associated with CMLTI’s tranche M9) willingly expose themselves, as discussed above. In this case, the people exposed to the risks are the people of the United States. A financial policy commentator cites evidence that, in 2007, “half of all US mortgages were of inferior quality and liable to default when housing prices were no longer rising” (Wallison & Burns, Reference Wallison and Burns2011: 448, emphasis omitted). A suitable standpoint of majoritarianism, then, justifies risky activities like investing in CMLTI’s tranche M9. The majority of the people affected by the investment risk, including all investors and (as discussed above, at least) half of third parties, consented to risks of ruin.
Indeed, even without referring to these details, the suitable standpoint seems to permit the risks associated with these tranched securities. Some of the risks associated with the subprime mortgages in CMLTI’s tranche M9 were created by predatory lenders who targeted unsuspecting borrowers for high-risk loans whose repayment terms the borrowers were unlikely to be able to meet. Others were caused by predatory borrowers who benefited from weak mortgage underwriting standards to take out loans they would not be able to pay unless real estate values continued to rise (Wallison & Burns, Reference Wallison and Burns2011: 447). Still others were caused by lazy and avaricious ratings agencies, as discussed above. The majority of parties involved in (or implicated by) transactions in tranched securities in the run-up to the 2008 financial crisis—people borrowing money for mortgages, mortgage-lending institutions, banks, other investors—behaved in strikingly similar ways. They took inadequate caution, were selfish, and sought to impose the costs of their actions on others. The causes of the crisis seem, in this sense, to have been genuinely shared by the majority of the parties affected by the crisis, including people who were third parties to the tranched securities. The suitable standpoint, then, permits these risks. And yet transacting with tranched securities in a highly interconnected financial system that is prone to systemic risk, such as the US financial system in the run-up to the 2008 crisis, seems straightforwardly wrong—for the reason that such transactions risk the destruction of that financial system as a whole.
4. THE PROBLEM THAT SYSTEMIC RISKS OF RUIN REVEAL IN CONTRACTUALISM
This tension—between the wrongness of some risks in the run-up to the 2008 financial crisis and contractualism’s endorsement of those risks—arises because systemic risks of ruin subvert contractualist standards. Contractualism permits A to participate in activity m, which exposes B to risk, if: (a) A and B reside in an equitable community and m benefits B; (b) m has a risk-benefit ratio that resembles activity n, in which B willingly participates; or (c) the average risk-benefit ratio of the people in A and B’s community is (or the majority willingly participates in activities) as risky as m. I defended the contractualist decision-making rationales for routine risks, such as buying a home on credit. Such risks seem ethical and the contractualist approaches offer useful evaluations based in individual consent.
With respect to a new kind of risk, p, however, I argued that contractualism fails to guide reliably. When C is a large financial institution and p is the risky activity of transacting in tranched securities, I argued that the most promising interpretations of contractualism permit C to do p in highly interconnected financial systems that are prone to systemic risk (e.g., in the conditions in the US preceding the 2008 financial crisis). Because doing p in those conditions threatened to undermine the entire US economy, however, it seems wrong for ethical theories to permit p in those conditions.
In the previous section, I showed that equitable system permits p under such conditions because p materially benefited the third parties—the US population—whose financial losses p risked. Suitable standpoint, in turn, permits p because the majority of the US population participated in activities that were as risky as p at the time that p was undertaken. In this section, I investigate these standards for permitting risk, widespread benefits, and widespread risk-taking behavior more deeply. I argue that the onset of systemic risks of ruin entails that these standards are no longer adequate for evaluating risks.
Part of contractualism’s appeal as an ethical theory is its ability to respond to people’s individual consent (or withholding thereof) with respect to welfare-, rights-, and distribution-affecting risks, including the individual consent of third parties who are affected by the risks but do not directly participate in the decisions to undertake them. In the case of routine mortgages, risks and benefits are localized, in the terminology introduced above. They do not do not reach beyond the direct participants (borrowers) and third parties (e.g., neighbors) involved in the mortgages. People’s individual consent to mortgage risks is, in this sense, an appropriate measure of which mortgage risks are permitted: the risks and benefits are individual, too.
Risks associated with CDOs, however, reach beyond merely localized concerns. As discussed above, they interconnect the large financial institutions that issue, trade, and hold them, creating one of the conditions for systemic (as opposed to localized) risks of ruin. Contractualism’s standard of individual consent, though, permits such risks. First, the CDOs created benefits for the same individuals (third parties) whose financial losses they risked. Second, the risks they created were comparable to risks into which the majority of Americans willingly entered around the same time. If business ethicists use contractualism to evaluate these risks, then, the risks appear permitted.
The problem with permitting these risks is the extent of their reach: in addition to threatening individual ruin, they also expose the entire US financial system to a risk of complete collapse. This system’s value, though, transcends that of the benefits accruing to the participants and third parties upon whose individual consent contractualist evaluations rely. It extends to a wide range of possibilities and opportunities, both within the US financial system and beyond it. Within the system, the continued existence of the US financial system offers individuals who have experienced personal financial ruin the opportunity to begin again (i.e., following bankruptcy proceedings). Beyond the system, the continued existence of the US financial system makes it possible (i.e., will make it possible) for future generations to benefit themselves and others.
The (possible) benefits associated with these possible transactions and possible parties are not included in the contractualist evaluations because they relate to structural aspects of the US financial system, not individual consent. That is to say, the complexity of the US financial system presents benefits and risks whose purview is obscure. The abilities of members of the US population to declare bankruptcy and begin again, and of the people of the future to use the system for their (future, and to present-day people, unimaginable) purposes, are created by the dynamism of the system itself. That is to say: these benefits are not (like the other benefits discussed in this article) created by risks in the financial system. Rather, they are systemic benefits of the financial system itself. To capture and evaluate risks to these structural possibilities—which arise from the integrity of the system as a whole rather than from any individual contributor—business ethicists need resources different from (or in addition to) contractualism’s standard of individual consent.
5. EVALUATING SYSTEMIC FINANCIAL RISKS OF RUIN
As alternatives (or supplements) to contractualist evaluations as regards the ethics of risk, business ethicists face two possibilities. First, we can look to other ethical theories: either by trying to rehabilitate utilitarianism or deontology, as broached above, or by developing novel ethical theories that are better suited to attend to systemic issues. Second, we can attempt to modify contractualism’s dependence on individual consent. I discuss these possibilities in turn.
As regards utilitarianism and deontology, these viewpoints may appear more promising following this article’s evaluations and analysis than they did beforehand. In particular, suitable standpoint adopted a (self-consciously) modified form of utilitarianism that was mediated by individual consent (via shared aims’ reliance on individual risk-benefit ratios) and distinguished between permitted and forbidden risks based on whether the risk being evaluated fell below or above the average risk-benefit ratio of third parties (or the risk-benefit ratio that the majority of third parties willingly accepted in their own activities). A further modified utilitarianism, such as one that imposes lower risk threshold in conditions in which systemic risks are present, is one strategy that business ethicists could develop to address the problem of systemic risk.
Turning to deontology, this ethical theory appeared to face significant obstacles in addressing issues concerning risk, as discussed at the beginning of the article. Certain aspects of the theory appear well suited, though, to evaluate systemic risks. In particular, the formula of universal law (FUL) associated with Kantian ethics naturally attends to systemic issues by permitting financial risks only when it is possible for all firms to engage in them. If a firm is able to achieve a benefit (e.g., a financial profit) in virtue of transacting in tranched securities in highly interconnected financial systems that are prone to systemic risk only because other firms refrain from such risky activities, then FUL would prohibit the transactions (Scharding, Reference Scharding2015). In order to avail themselves of these resources, business ethicists can try to modify Kantian ethics to make it better able to address issues concerning well-being and probabilities.
In terms of alternatives, business ethicists are enthusiastically investigating novel ethical theories such as ethical pluralism, ethical particularism, Kantian intuitionism, rights theory, and climate change ethics (Arnold, Audi, & Zwolinski, Reference Arnold, Audi and Zwolinski2010). The resources of these ethical theories to evaluate questions about systemic financial risk have not yet been plumbed; some of them may prove to be promising.
Moreover, strategies from other disciplines could play a role in business ethicists’ evaluations of financial risk. Hansson, for example, discusses how a strategy from engineering, safety barriers, can be used to address risk more generally (2009: 428–30). Safety barriers are physical blockades erected to restrict risks in engineered structures: bridges, nuclear power plants, boats. They consist of three orders. An initial safety barrier offers cushioning to prevent accidents. The second barrier contains the fallout from accidents that occur despite the cushioning. A final order communicates with emergency personnel that an accident has occurred, which requires remediation that the structure itself cannot provide. These safety orders both diminish the likelihood of an accident and limit the consequences of accidents. In response to the problem of systemic risk discussed herein, business ethicists might investigate financial analogues to these safety barriers.
Finally, contractualism itself presents opportunities for modification. The first was broached above with respect to utilitarianism. Another possibility is adding strategies for including the features of decisions that go beyond individual consent, such as exposure to systemic risks of ruin. In this vein, business ethicists could develop a form of contractualism that relies not on individual consent but on the consent of something like an impartial spectator (Smith [1759] Reference Smith, Raphael and Macfie1976: 129, 135) who considers systemic issues in addition to individual concerns.
CONCLUSION
I conclude that business ethicists either should not use contractualism (in its present forms) to evaluate novel financial products or should do so only with great caution (i.e., with particular focus on aspects of the products that go beyond individual consent). This conclusion follows from my examination of investment activities involving some structured financial products prior to the 2008 financial crisis. I argued that these products’ systemic risks of ruin prove difficult to evaluate for three important recent contractualist approaches to the ethics of risk: equitable system, shared aims, and suitable standpoint. The approaches appear to endorse the risks—even though these risks nearly undermined the entire US economy. I showed that the approaches endorsed the risks because the people whose financial losses were risked by the structured financial products had reason to consent to the risks (i.e., the risks were justifiable to them from their individual perspectives). Going forward, then, we should seek a tool for evaluating (novel) risks that goes beyond individual perspectives.
The wake of the financial crisis of 2008 offers unparalleled opportunities for finance professionals to reflect on our evaluative strategies. Just as financial analysts have considered why their tools were inadequate to avoid the crisis, business ethicists should acknowledge the weaknesses in our own strategies. This article has shown that contractualism faces significant challenges in evaluating systemic risks of ruin. I infer then, that contractualism’s current popularity is potentially problematic.
ACKNOWLEDGEMENTS
I am grateful to the audience at the 2015 Annual Meeting of the Society for Business Ethics in Vancouver, British Columbia, for useful feedback on a previous version of this article. Conversations about earlier drafts with Maretno Harjoto, David Dick, Michael Santoro, Joanne Ciulla, Danielle Warren, Sara Parker Lue, and Michael Simonetti were especially helpful. I also wish to acknowledge Denis Arnold, Thomas Donaldson, and three anonymous reviewers at Business Ethics Quarterly for extremely valuable comments on earlier versions.
