Going against the new chairman! Fed Governor Michael Barr: Balance sheet reduction is a mistake and ultimately threatens financial stability.

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The debate within the Federal Reserve over the size of its balance sheet is becoming public.

On May 14, Federal Reserve Board member Michael Barr gave a strongly worded speech, directly criticizing the currently hot proposal for balance sheet reduction as the "wrong goal," warning that related proposals would undermine banking resilience, hinder money market operations, and ultimately threaten financial stability.

Barr put forward two core judgments:

First, the size of the balance sheet is not the correct indicator for measuring the Fed’s degree of market intervention;Second, many current proposals for shrinking the balance sheet would greatly reduce the efficiency and effectiveness of monetary policy operations, while heightening financial stability risks.

It is noteworthy that on the same day, Walsh formally took the oath of office as Federal Reserve Chairman. He has consistently advocated significantly reducing the Fed’s $6.7 trillion balance sheet.

Barr emphasized at the start of his speech:

I believe reducing the balance sheet is the wrong goal, and some plans would actually increase the Fed’s involvement in financial markets.

This comment was quickly reposted by Nick Timiraos, the well-known financial journalist known as the "New Federal Reserve Bulletin," drawing broad market attention.

Logic for Balance Sheet Reduction, Refuted One by One

Barr systematically refuted the main arguments for reducing the balance sheet.

Regarding the idea of "reducing reserve requirements to shrink the balance sheet," he pointed out that reserves are the safest and most liquid assets in the financial system; adequate supply is crucial for the stable operation of the banking system, the normal functioning of payment systems, and the overall stability of the economy.

He cited previous comments by Fed Chair Powell, emphasizing that if bank reserves are insufficient, the payment system will be impaired, the funding markets may encounter bottlenecks and strains, and in extreme cases, panic triggered by depositor runs may ensue.

Barr also noted that providing reserves is almost costless to the Fed. The Fed pays interest on reserves while earning interest income from government bonds on the asset side, and all excess profits are handed over to the Treasury. Therefore, Barr stated:

Making a free good scarce is economically illogical.

In response to the view that "reducing reserve levels will decrease Fed market intervention," he made clear that the Fed’s role in financial system intervention is reflected not only in the balance sheet’s duration, composition, and size, but also in its role in bank regulation, payment systems, and safeguarding financial stability.

Discussing "reducing intervention" in isolation while ignoring these functions is one-sided.

Lowering Liquidity Regulation: The Wrong Goal, The Wrong Means

Barr directly criticized a widely discussed proposal—reducing the demand for reserves by loosening banks’ liquidity regulatory requirements. He made it clear this is both "the wrong goal" and "the wrong means."

Currently, banks are required to hold sufficient high-quality liquid assets (HQLA) to withstand stress scenarios—a core regulatory framework established after the 2008 global financial crisis.

Barr pointed out that banking stress events in 2023 showed liquidity requirements should be raised, not lowered.

Regarding proposals to allow banks to count non-HQLA assets pledged at the discount window (like corporate loans) toward liquidity requirements, Barr stated bluntly that this is just a disguised way of lowering liquidity requirements, which will only reduce banks’ self-insurance capabilities and weaken the resilience of large banks overall.

He is also skeptical whether such adjustments would have a substantive impact on reserve demand.

He also noted that there is historical precedent for the consequences of reducing banks’ self-insurance. When large banks cannot withstand shocks, unconventional interventions are often needed to maintain financial stability. Barr emphasized:

This is clearly not an outcome anyone wants to see, nor is it a way to reduce the Fed’s market intervention.

TGA and the "Minimum Adequate Reserve" Plan Also Have Flaws

Barr also assessed several other balance sheet reduction proposals.

For the suggestion of reducing the size of the Treasury General Account (TGA), he pointed out that TGA size is determined by the Treasury, not the Fed; even if TGA shrinks, it will not meaningfully reduce official sector intervention in the markets.

He stressed that ensuring the Treasury can meet its obligations under complex circumstances is in the common interest of all market participants.

As for plans to "hedge TGA balance fluctuations," he pointed out this would require the Fed to frequently conduct large-scale asset purchases and sales, especially before and after debt ceiling cycles, which is "simply another form of greater intervention."

On the "minimum adequate reserves" plan, Barr also expressed a cautious stance.

He cited the 2019 repo market rate spike as an example: operating with too low reserves results in sharp rate volatility and increases the risk of losing control.

If relying on standing repo facilities or the discount window to control interest rates, the Fed would have to inject liquidity into markets frequently. He said:

This too is greater, not lesser, market intervention.

The Fed took gradual expansionary actions by the end of 2025 to avoid a recurrence of such scenarios.

Back to Basics: Problem Awareness Before Policy Tools

At the end of his speech, Barr called for a return to fundamental policy logic.

He said that before considering any changes to the way the Fed manages its balance sheet, the first question should be: What problems are we actually trying to solve?

He reiterated that while the Fed plays an important role in the financial system, its degree of market intervention cannot be simply defined by its balance sheet size.

Some proposals to shrink the balance sheet in fact increase intervention by other means. And those most closely watched—especially lowering liquidity requirements—would cause substantial damage to financial stability.

Barr concluded his speech as follows:

Reducing the Fed’s balance sheet is the wrong goal, and lowering the resilience of the banking system is the wrong means.

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