By Balazs Koranyi
FRANKFURT (Reuters) -The European Central Bank should keep a leaner balance sheet and have banks borrow from it when they need cash, ECB board member Isabel Schnabel told Reuters, just as the debate heats up on how central banks should operate in a world of revived inflation.
With the era of low inflation and zero interest rates now seemingly over, the ECB has to decide how it wants to supply euro zone banks with liquidity in the coming years - by lending to them or by buying bonds from them.
Schnabel defended the case she first outlined in March for a system in which banks choose how much to borrow from the ECB. Her board colleague Philip Lane has meanwhile argued that the ECB should supply lenders with at least some of that cash via bond purchases or longer-term loans.
She said her "demand-driven" approach fitted the euro zone, whose 20 countries vary in economic strength and have separate banking systems.
"A demand-driven system is well-suited for a heterogeneous currency union that may be prone to fragmentation," Schnabel said, referencing her March speech. "Such a system also likely limits the size of the central bank balance sheet."
She conceded, however, that "it could make sense to have a mix of different tools", suggesting policymakers may be looking for a compromise in this complex yet crucial debate for the euro zone financial system.
Schnabel argued that in this case longer-term loans are better than asset purchases because they reach deeper into the banking sector, while cash from bond purchases tends to concentrate around a limited number of larger entities.
Policymakers from cash-rich northern euro zone countries are likely to back Schnabel's view while those in the bloc's south, which relies on the ECB's bond purchases to a greater extent, are more likely to be in Lane's camp.
For now, however, the ECB will be mopping up cash it pumped into the banking system over the last decade as it tried to stimulate inflation and activity.
A discussion paper published by top staff in Lane's directorate said the ECB should more than halve its stock of bonds to 1.5 trillion euros ($1.63 trillion) by mid-2026 before resuming purchases to underpin banks' lending to the economy.
The authors found that banks extend more credit when they have these "non-borrowed reserves" than when they have to tap the central bank, and that owning too many bonds would be preferable for the ECB to getting rid of all them.
Schnabel expressed a preference for letting banks choose, saying: "This would mean the size would not be determined by us, which is a good thing, because we don't know precisely what the demand is."
She nevertheless estimated that the ECB's balance sheet, currently 7 trillion euros, would remain at a minimum "around three times as large as before the global financial crisis", when it just exceeded 1 trillion euros, as a result of so-called autonomous factors. These include demand for banknotes and government deposits.
But the debate mattered only "far out in the future", Schnabel said, because the ECB would have to shrink its balance sheet under all circumstances and it would end up "much smaller" than its current size.
Policymakers are arguing the merits of two systems, one in which the ECB provides ample reserves to keep a "floor" under the money-market rate, like the U.S. Federal Reserve, and another where it lends to banks at a "ceiling" rate, like the Bank of England.
A proponent of the latter option, Schnabel said any new auction of longer-term loans "would have to be offered at market rates" rather than at a subsidised rate as in the past decade, when such loans have been a mainstay of bank funding.
($1 = 0.9195 euros)
(Writing By Francesco Canepa; Editing by Catherine Evans)