Meyrick Chapman is Director of Hedge Analytics and former Portfolio Manager at Elliott Management and Fixed Income Strategist at UBS.

Does the crypto explosion have a real-world consequence? Will a real banker lead a major central bank again? There are a number of pressing and unanswered questions. Here’s another: With the Federal Reserve’s balance sheet under unprecedented scrutiny, why such disregard for the effects of its liability structure?

Almost all statements on or by the Fed in its balance sheet focus on the asset side: how many bonds bought, what type of bonds, their duration, and the rate at which assets will roll. But a balance sheet has to, well, be balanced.

Central bank liabilities are the basis of money. So where are the serious discussions and research papers on how changes in the composition of the monetary base can affect monetary conditions? It may be too complicated. Or maybe it’s a question whose time has come.

Here is a case of assumptions that seem to go astray. One of the few mentions of the Fed’s accountability structure came in January from Atlanta Fed Governor Raphael Bostic. He suggested in a Reuters interview that the Fed intended to quickly withdraw at least $1.5 billion of pure “excess liquidity” from financial markets.

This figure appears to refer to the $1.5 billion held by money market funds, as a liability of the Fed, in reverse repurchase agreements (RRPs). If that was the plan, he’s badly on the right track. As of June 18, RRP holdings of money market funds had grown to $2.2 billion. At the current rate, the Fed’s commitments to money market funds will exceed those to banks by mid-October. It might be useful to spend more time analyzing the behavior of liabilities, and in particular their circulation in the financial system.

Maybe time will sort things out. It is possible that money market funds are simply like the option to hold the RRP at the Fed during a period of rising rates. After all, the expected return on reserves as predicted in Fed Fund futures is only marginally different from the return on Treasuries for next year. Maybe it doesn’t matter.

More likely, it matters. The reason money market funds have been hoarding reserves is because commercial banks have aggressively reduced their own holdings since late 2021. The latest data shows they are continuing to do so. Money market funds have no choice but to hold excess reserves paid in by banks.

The loss of reserves by banks is due to the fact that the perceived opportunities change. There is a direct correspondence between the reserves held in banks’ balance sheets and their willingness to lend. Lending declined as a percentage of banks’ balance sheets from 2010 to 2015, driven by reserves, then increased as the Fed reduced reserves from 2017 to 2019. Now banks are actively increasing their loan portfolios.

Part of it is just math. As reserves increase with QE, banks have to reduce other assets, of which loans make up the bulk. But there is another consideration. Banks may have changed their view of the efficient use of their balance sheets. The reserve assets of commercial banks are not, as is commonly thought, dead money. As reserves grew, so did the daily transfer of reserves between banks through FedWire Fund Services. These transfers are dominated by settlements of securities transactions for bank customers – a kind of fractional securities system. Presumably, this was more profitable than loans. Until now.

Banks are (usually) efficient allocators of capital. If they foresee problems, they will try to anticipate them. And in anticipation of the reversal of QE and its likely effect on securities markets, banks are now turning away from reserves.

Recent quarterly results from major capital markets and investment banking divisions show that securities markets are no longer profitable for banks. JPMorgan Chase reported a 35% drop in investment banking gross revenue in the first quarter of 2022 from a year earlier. Bank of America announced lower fees for investment banking, market making and similar activities. Wells Fargo reported lower revenue due, in part, to lower investment banking and asset revenue. Citigroup reported a 51% drop in net income from its institutional client group.

The biggest banks are losing money on securities-based activities. It may be time to move on to less volatile and less prestigious loans. Of course, as the Fed raises interest rates and the economy perhaps slows sharply, lending may turn out to be a mistake. Yet loans seem much safer than securities markets. And if banks exit the securities markets, they don’t need as many reserves as a means of settlement.

A shift of reserves from banks to money market funds means that these reserves are actually just parked at the Fed. This is certainly a big drawdown of liquidity, as Raphael Bostic suggested, but the pullback may already affect broader securities markets. SIFMA reports a decline in daily turnover across all US equity markets of 13% so far this year, while turnover from triparty repo (used by money market funds to deposit in day to day at the Fed) is up 7%. This is consistent with the redistribution of Fed liabilities from banks to money market funds.

Tentatively, some conclusions can be drawn. First, it seems unlikely that QT will lead to a repeat of the September 2019 repo crisis. There is simply too much downward pressure on repo from desperate money market funds. All major repo rates (SOFR, DVP, GCF, Tri-party) have recently fallen below the RRP level and repo liquidity appears to remain elevated.

Instead, liquidity in securities markets could continue to decline if banks continue to turn away from reserves. In many ways, this represents a return to traditional banking practices. But securities markets are unlikely to thrive if settlement liquidity is withdrawn.