The biggest U.S. banks must decide whether to voluntarily reducetheir size and complexity or face capital charges that are some ofthe toughest in the world, the Federal Reserve's topfinancial-regulation official said today.

Fed Governor Daniel Tarullo outlined the central bank's plansfor capital surcharges surpassing those of international regulatorsat a Senate hearing on progress in implementing rules to prevent arepeat of the 2008 credit crisis. The Fed's formula for surchargeswill also hit hardest against those that lean most on short-termwholesale funding, he said.

“We're all trying to come to grips with what we really need inorder to provide more assurance that these firms do not threatenthe financial system,” Tarullo told the Senate Banking Committeesaid. Banks will have to weigh a tradeoff between complexity andcapital demand and may choose to trim the cost by shrinking their“systemic footprint.”

The surcharges, which would be applied in addition to therisk-based capital standards approved by the Basel Committee onBanking Supervision, are part of a U.S. effort to reduce the risksposed by complex global financial firms. Tarullo's comments came ata hearing to report progress on implementing the Dodd-Frank Act,Congress's response to the 2008 collapse that forced bailouts ofsome of the biggest banks.

“We believe the case for including short-term wholesale fundingin the surcharge calculation is compelling, given that reliance onthis type of funding can leave firms vulnerable to runs thatthreaten the firm's solvency and impose externalities on thebroader financial system,” Tarullo said in a statement.

Global financial regulators have published a list of 29banks—eight of them U.S.-based—set to face the capital surchargesbecause of the threat their failure would pose to the broadereconomy.

JPMorgan Chase & Co. and HSBC Holdings Plc were placed atthe top of the most recent list, published in November 2013,putting them in line for extra capital requirements equivalent to2.5 percent of their assets, weighted for risk. Other banks on thelist would have had surcharges of 1 percent to 2 percent under theinternational standard, and now face the prospect of a higher U.S.level.

'Broadly Negative'

“We see this as broadly negative for the biggest banks,especially those that rely on short-term wholesale funding,” JaretSeiberg, an analyst at Guggenheim Securities LLC, wrote in aresearch note on Tarullo's statement. “They will face much highercapital charges than the market has been expecting and could havetrouble boosting distributions in 2016.”

The 24-company KBW Bank Index fell as much as 1.2 percent today,the biggest drop in more than a month. JPMorgan slipped 83 cents,or 1.39 percent, to $59.06 as of 4:15 p.m. in New York trading,while Bank of America Corp. declined 21 cents, or 1.28 percent, to$16.14.

The Financial Stability Board, which brings together centralbankers, regulators, and government officials from the Group of 20nations, has said that it will publish its next update to the listin November. That version would be the one used when the extrarules begin phasing in during 2016. The capital surcharges wouldapply fully as of January 2019.

The Fed is also working on rules to overhaul how financial firmsuse short-term lending, beyond tying it to surcharges, Tarullosaid. The central bank may propose modifications to the so-callednet stable funding ratio adopted in the Basel rules to boostliquidity requirements when banks provide short-term funding toother market participants.

Industry Opposition

In addition to Tarullo, senators heard from the heads of theFederal Deposit Insurance Corp., Office of Comptroller of theCurrency (OCC), Securities and Exchange Commission, CommodityFutures Trading Commission, and Consumer Financial ProtectionBureau.

Senate Banking Committee Chairman Tim Johnson urged them to notweaken rules in the face of opposition from the banking industryand some lawmakers.

“As we get farther away from the crisis and calls to water downWall Street Reform grow louder, policy makers cannot forget thelessons from the crisis and how costly a weak regulatory system canbe,” the South Dakota Democrat said.

U.S. regulators last week adopted two rules that make newdemands on bank liquidity and capital, a re-proposal of a rule on swaps margin, and the OCC's new policy on how banksmust manage risk. One key measure sets requirements for the amountof high-quality, liquid assets big banks must stockpile to survivea 30-day liquidity drought. As with other rules that emerged fromBasel accords, that rule was stiffer than the internationalstandard.

Copyright 2018 Bloomberg. All rightsreserved. This material may not be published, broadcast, rewritten,or redistributed.