FRANKFURT The European Central Bank's balance sheet needs to be much smaller but cannot shrink back to levels seen in its early years, ECB chief economist Philip Lane said on Thursday, just as policymakers are discussing a new operational framework.

The ECB promised to devise by next week a new operational framework for steering short term interest rates and the key question is just how big its balance sheet should remain.

Total assets are already down by nearly two trillion euros since their peak but at seven trillion euros, they are still well above the one to two trillion euro range seen in the early years of the central bank.

"The appropriate level of central bank reserves can be expected to remain much higher and be more volatile in this new steady state compared to the relatively-low levels that prevailed before the global financial crisis," Lane told a conference.

"Even if much lower than the current level, the appropriate level of central bank reserves in the 'new normal' steady state should avoid the risks associated with excessively-scarce or excessively-abundant reserves," he added.

Such a 'middle path' was needed to underpin the willingness of commercial banks to extend credit in spite of the risks associated with illiquid assets in a world much more prone to macro-financial shocks, Lane argued.

These reserves should be provided both through a structural bond portfolio and a structural longer-term refinancing operation on top of standard short-term refinancing operations, Lane said.

These instruments would then provide longer-terms liquidity to the banking system and the supply should be elastic to reduce the need for banks to build precautionary reserves.

Lane also argued that the ECB should remain open to sustained surges in its balance sheet in case interest rates fall back to their effective lowest level, a problem that dominated the decade before the pandemic.

(Reporting by Balazs Koranyi; Editing by Toby Chopra)