Extending that point, the literature may too easily dismiss the possible effects on prices of the demand and supply of financial assets more generally. But we need testable theories as to why, and the circumstances in which, they might matter. Finally, looking beyond the ex ante compensation for risk, we also need to have better models for exploring what can happen – in the financial system and in the macroeconomy – when nasty forms of risk do actually crystallise. Default comes to mind. 24 Bank default is a special case, given the special role of banks in a monetary economy. And, guess what? Banks don’t really feature in modern macro models. Of course, incorporating those features of the real world is incredibly hard, involving heterogeneous agents, incomplete contracts and markets, and uncertainty. Uncertainty needs to be underlined. It isn’t clear whether existing models could explain the swings we have been experiencing in some asset prices. Is that something to do with market participants having become radically uncertain about the nature of the underlying distributions? And do asset prices become actors in those circumstances? Over many decades now, 25 elegant models have been developed for studying financial market distress in the abstract – whether affecting banks or asset markets. This, of course, involves strategic interaction amongst agents.
Andres Sutt: Are ROEs peaking? Luncheon speech by Mr Andres Sutt, Deputy Governor of the Bank of Estonia, at the 9th Annual Nordic Financial Services Conference, Stockholm, 31 August 2006. Background slides (PPT) for the speech can be found on the Bank of Estonia’s website. *  *  *  Ladies and Gentlemen, It is my honor to address you at this conference. You represent financial institutions that control the flow of money, the lifeblood of the economy. I as a central banker can contribute the experience of someone who stands in the middle. Central banks, as you know, have a double task: to safeguard the price stability on the one hand and the wellbeing of the financial system on the other. It is with this balance in mind that I would like to address three topics today. •  Firstly, what are the characteristics of a Nordic-Baltic region as a closely integrated economic and financial market;  •  Secondly, the challenges posed by recent economic and credit growth;  •  Thirdly, some financial sector policy and supervisory challenges in this highly integrated regional market. Not surprisingly, the focus of my examples will mostly be on Estonia. Some special characteristics of the Nordic-Baltic region The economic situation in the Nordic-Baltic region is outstanding, especially in comparison with other regions of the EU. Output growth in the Nordic countries is up to two and in the Baltic countries even 4 to 5 times higher than the EU average.