Kevin Warsh is walking into the Federal Reserve with one of the clearest mandates in years...
The new Fed chair wants to shrink the central bank's footprint.
Right now, the Fed's balance sheet sits around $6.7 trillion to $6.8 trillion, swollen by years of bond buying after the 2008 financial crisis and the pandemic. That massive balance sheet has made the Fed an influential player in Treasury markets, repo markets, and the banking system itself.
Warsh's goal is to shrink government involvement and let the banking markets do more work. If successful, it could help interest-rate cuts become a more powerful tool again.
The process to get there is far messier than you might imagine, though.
As we'll explain today, the Fed's balance-sheet retreat will likely be slow. And there's one key signal investors should watch to know whether the plan is working.
Warsh has powerful allies...
Treasury Secretary Scott Bessent and Fed Vice Chair for Supervision Michelle Bowman share Warsh's same basic agenda.
They want the Fed to pull back from controlling the lending market, restore interest rates as the main tool for managing the economy, and loosen liquidity rules that keep banks sitting on huge pools of cash.
That last part matters most of all.
The reserves that make the Fed's balance sheet so large are the same ones banks use to satisfy liquidity rules that were established in the wake of the financial crisis.
See, the best way for the Fed to shrink its balance sheet is to let bonds mature and not replace them. However, doing so also removes bank reserves from the system.
In turn, that hurts how much banks can lend.
Bessent's team has pointed out that large banks now hold about 25% of their balance sheets in safe assets, up from roughly 10% before the 2008 crisis.
That cash is there for safety, as reserves help banks weather downturns. But the downside is that the cash is sitting there, not being put to use.
Basically, because of liquidity rules, banks now need so many reserves that the Fed is keeping its balance sheet unusually large to supply them. If those liquidity rules were loosened, banks could hold less cash and lend more money... And the Fed could shrink its balance sheet.
Banks don't like using the Fed's other liquidity tool...
The Fed's "discount window" tool allows banks to borrow money directly from the central bank to meet short-term funding needs.
However, borrowing from the Fed can make a healthy bank look weak. Bloomberg noted that this stigma is part of what doomed Silicon Valley Bank back in 2023.
That creates another problem for Warsh...
Fed Vice Chair Philip Jefferson – who oversees liquidity and lending at the central bank – has been more cautious than Warsh and his allies. Jefferson is afraid that encouraging banks to use the discount window could lead them to take on unnecessary risk.
So things are a bit deadlocked today... It'll take time for banks to rely on other liquidity options. So the Fed will have to unload its balance sheet slowly.
That process will take years.
Everything will be OK as long as banks keep lending...
Investors should focus on bank lending.
A smaller Fed only helps the economy if capital leaves the central bank's balance sheet and moves into productive credit.
The early data is encouraging. Commercial and industrial loans at all commercial banks rose from $2.7 trillion in December 2025 to nearly $2.9 trillion in May 2026, according to Federal Reserve Economic Data.
More bank lending can fuel the economy. And arguably, a slow-and-steady approach will help keep the economy afloat for longer than a quick surge in lending would.
Over the next several years, bank reserves should gradually decline, liquidity rules should ease, and bank lending should continue to recover.
Loan growth will be the clearest sign that the Fed's retreat is working. Investors should keep an eye on it.
Regards,
Joel Litman
June 16, 2026
