When the Fed reduces its balance sheet, someone needs to buy those Treasury and mortgage securities instead. There are the banks, and then there are the nonbanks: foreigners, households, mutual funds, pensions etc. If the banks don’t buy the securities – let’s say they have a fairly low elasticity of demand for more securities, so a small reduction in the price doesn’t lead them to buy more securities – and if the non-bank sector has a relatively higher elasticity of demand, then deposits in the banking system will fall. Foreigners or funds may switch cash assets for securities that the Treasury is no longer selling to the Fed; the Treasury will trot back to the Fed, hand over the cash, and the Fed will cancel that cash liability to match its reduced asset.The banking system has lost deposits.
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