The biggest U.S. banks must decide whether to voluntarily reduce their size and complexity or face capital charges that are some of the toughest in the world, the Federal Reserve’s top financial-regulation official said today.

Fed Governor Daniel Tarullo outlined the central bank’s plans for capital surcharges surpassing those of international regulators at a Senate hearing on progress in implementing rules to prevent a repeat of the 2008 credit crisis. The Fed’s formula for surcharges will also hit hardest against those that lean most on short-term wholesale funding, he said.

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

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

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

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

JPMorgan Chase & Co. and HSBC Holdings Plc were placed at the top of the most recent list, published in November 2013, putting them in line for extra capital requirements equivalent to 2.5 percent of their assets, weighted for risk. Other banks on the list would have had surcharges of 1 percent to 2 percent under the international 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,” Jaret Seiberg, an analyst at Guggenheim Securities LLC, wrote in a research note on Tarullo’s statement. “They will face much higher capital charges than the market has been expecting and could have trouble 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 central bankers, regulators, and government officials from the Group of 20 nations, has said that it will publish its next update to the list in November. That version would be the one used when the extra rules begin phasing in during 2016. The capital surcharges would apply fully as of January 2019.

The Fed is also working on rules to overhaul how financial firms use short-term lending, beyond tying it to surcharges, Tarullo said. The central bank may propose modifications to the so-called net stable funding ratio adopted in the Basel rules to boost liquidity requirements when banks provide short-term funding to other market participants.


Industry Opposition

In addition to Tarullo, senators heard from the heads of the Federal Deposit Insurance Corp., Office of Comptroller of the Currency (OCC), Securities and Exchange Commission, Commodity Futures Trading Commission, and Consumer Financial Protection Bureau.

Senate Banking Committee Chairman Tim Johnson urged them to not weaken rules in the face of opposition from the banking industry and some lawmakers.

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

U.S. regulators last week adopted two rules that make new demands on bank liquidity and capital, a re-proposal of a rule on swaps margin, and the OCC’s new policy on how banks must manage risk. One key measure sets requirements for the amount of high-quality, liquid assets big banks must stockpile to survive a 30-day liquidity drought. As with other rules that emerged from Basel accords, that rule was stiffer than the international standard.

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