JPM JP Morgan Chase and Co

The Federal Reserve's point man on bank regulation said the central bank's annual stress tests are likely to get harder for the very largest banks.

Fed governor Daniel Tarullo said Monday that the Fed is likely to increase the minimum capital required for banks to pass the tests.

"I think there is a pretty good chance, in fact I think it's more than a pretty good chance, that in the end of the day…there will be some net increase in the post-stress minimum capital requirements," he said in an interview on Bloomberg TV.

That outcome has been among large banks' biggest fears since this summer when the Fed raised capital requirements for eight of the largest U.S. banks. Those requirements apply during normal times, but the Fed left it unclear whether they would apply under the stress tests, which simulate a severe recession.

Firms such as J.P. Morgan Chase & Co., Citigroup Inc. and Bank of America Corp. already have shed or shrunk business lines and spent millions of dollars rebuilding internal systems in order to pass the current versions of the stress tests. By raising the "post-stress minimum," the Fed effectively would be forcing them to take further actions to shed risky assets or raise more capital.

"With respect to the largest banks, you do have to be mindful of the fact that the financial crisis and the great recession cost this country trillions and trillions of dollars," Mr. Tarullo said in defense of the Fed's rules. "It's incumbent on us to make sure that the vulnerabilities that could lead to widespread financial distress are addressed."

In the wake of the financial crisis, the Fed has made the stress tests the centerpiece of its supervision of the very largest U.S. banks. If banks don't pass the tests, they are restricted from returning money to shareholders through dividends or buybacks.

The stress tests have two main components: an evaluation of banks' risk-management systems and a calculation of how much capital, or shareholder equity, banks must have in place to absorb losses.

Mr. Tarullo on Monday was referring to the capital calculation. In order to pass that part of the test, banks must show they have enough capital to absorb heavy losses and still stay above minimum capital requirements set by the Fed.

He said the Fed hasn't decided exactly how it would raise the minimum, but suggested two options. Each likely would affect only the very largest U.S. banks.

One way, Mr. Tarullo said, would be incorporating a higher capital requirement, known as a "surcharge," that only applies to eight of the largest and most systemically important U.S. banks. The Fed adopted the surcharge this summer, requiring banks to follow it during normal times. But it left unanswered whether those eight banks would have to meet the higher minimum during the stress tests.

Another approach the Fed could take, Mr. Tarullo said, would be to raise the capital requirements in a manner that takes into account "shared counterparties" between the very largest U.S. firms. Since the crisis, the Fed has been concerned about connections between large firms that could make vulnerabilities at one of them spread to another.

The Fed is engaging in a broad review of the stress tests. Earlier this month, Mr. Tarullo said that review could lead the Fed to relax rules for some of the smaller banks subject to the tests. About 30 banks with more than $50 billion in assets take the test each year.

Write to Ryan Tracy at ryan.tracy@wsj.com

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(END) Dow Jones Newswires

November 23, 2015 12:55 ET (17:55 GMT)

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