are highly uncertain, even if the probability of default is low. in general, interest rate risk is readily handled by adjusting maturities of assets and liabilities. but hedging prepayment risk is more complex. to manage this risk with little capital requires a conceptually sophisticated hedging framework. in essence, the current system depends on the risk managers at fannie and freddie to do everything just right, rather than depending on a market - based system supported by the risk assessments and management capabilities of many participants with different views and different strategies for hedging risks. our financial system would be more robust if we relied on a market - based system that spreads interest rate risks, rather than on the current system, which concentrates such risk with the gses. * * * as always, concerns about systemic risk are appropriately focused on large, highly leveraged financial institutions such as the gses that play substantial roles in the functioning of financial markets. i should emphasize that fannie and freddie, to date, appear to have managed these risks well and that we see nothing on the immediate horizon that is likely to create a systemic problem. but to fend off possible future systemic difficulties, which we assess as likely if gse expansion continues unabated, preventive actions are required sooner rather than later. as a general matter, we rely in a market economy upon market discipline to constrain the leverage of firms, including financial institutions. however, the existence, or even the perception, of government backing undermines the effectiveness of market discipline. a market system relies on the vigilance of lenders and investors in market transactions to assure themselves of their counterparties ’ strength. however, many counterparties in gse transactions, when assessing their risk, clearly rely instead on the gses ’ perceived special relationship to the government. thus, with housing - related gses, regulators cannot rely significantly on market discipline. indeed, they must assess whether these institutions hold appropriate amounts of capital relative to the risks that they assume and the costs that they might impose on others, including taxpayers, in the event of a financial - market meltdown. the issues are similar to those that arise in the context of commercial banking and deposit insurance indeed, they are the reason that commercial banks are regulated and subject to stringent regulatory capital standards. traditionally, questions of capital adequacy for financial institutions have been evaluated with regard to credit and interest rate risks. however, in the case of the gses and other

svein gjedrem : dialogue with boundaries introduction by mr svein gjedrem, governor of norges bank ( central bank of norway ), at the conference “ dialogue without boundaries ”, karlstad, sweden, 9 march 2005. the charts in pdf - format can be found on the norges bank ’ s website. please note that the text below may differ slightly from the actual presentation. the speech does not contain new assessments of the economic situation or of current interest rate setting. * * * introduction this year, norway is commemorating the centenary of the disolution of the union with sweden. in retrospect, the dissolution was a painless process. norway ’ s internal affairs were not affected by the union with sweden. historically, a national monetary system and central bank have been an important part of nation - building. the norwegian constitution of 17 may 1814 did not provide for a national monetary system. this was first included in the constitution in november 1814 because of fears that the union with sweden would bring the work on a national monetary system to a halt1. in 1875, the storting decided to join the currency union that denmark and sweden had established two years earlier. danish, swedish and norwegian notes and coins circulated and were used as legal tender in all three countries. open financial markets, close trade ties and a common labour market provided then as now opportunities for high economic growth and prosperity. an example is the norwegian company norsk hydro, which was established the same year as the dissolution of the union. substantial investments were required and foreign capital was crucial to the company ’ s establishment. moreover, it may be worth noting that the kinship between norway and sweden was important in this context. kristian birkeland and sam eyde, together with the swede marcus wallenberg, are considered as the founders of hydro. trade between norway and sweden was considerable, with a fairly high degree of labour flows between the two. in the 1800s, a law was enacted providing for a common market for trade in goods, but in 1888 sweden adopted a more protectionist stance. in 1897, sweden rescined this law, which led to a severe setback for norwegian exports. close ties between norway and sweden have thus been important. they also favour regional development, particularly for regions far from national centres but closer to the economic hub in the neighbouring country. monetary policy does not give any particular weight to regional considerations. but a monetary policy that safeguards monetary values in the long term