WASHINGTON (Reuters) - A top Federal Reserve official on Tuesday warned the biggest U.S. banks they will soon face capital surcharges that exceed international standards, a move he said could encourage some firms to shrink.

The comments from Fed Governor Daniel Tarullo on capital and other coming funding restrictions rattled investors. Shares of Morgan Stanley were trading down 1.9 per cent during early afternoon trading, while shares of JPMorgan Chase were down more than 1.5 per cent.

Tarullo did not specify how much the U.S. surcharge levels would outstrip the international requirements, but said it would be "noticeably so for some firms".

"You know, if the firm really thinks...that it has to be this big and this complicated to engage in a certain set of activities or to have a certain-sized balance sheet, then it can do so, but it has to have very high levels of capital," Tarullo told the U.S. Senate Banking Committee. "If, on the other hand, those highest levels of capital appear to not be worth it, then it has the option of changing what people have called its systemic footprint."

Those firms also would face additional capital charges if they use risky short-term funding methods, Tarullo said in the hearing, which was focused on regulators' progress implementing the 2010 Dodd-Frank law.

U.S. and international regulators have sought to make banks safer in part by forcing them to fund themselves more through shareholder equity and less through debt. That includes a surcharge for the largest firms, such as JPMorgan Chase and Citigroup, of up to 3.5 per cent of their assets, on top of other capital requirements.

Tarullo said U.S. regulators would set surcharges in the higher end of the range. International regulators have not imposed the top charge on any bank so far, keeping the capital surcharges between 1 and 2.5 per cent.

The comments were some of the most direct yet from Tarullo, a leading Fed voice on regulation, and showed that officials intend to remain tough six years after the financial crisis.

"The evidence on your screen is the market is telling you it's one thing for (Fed Chair) Janet Yellen to mention something in passing. It's another for Governor Tarullo...to say, 'We are working on this and this is what we are going to do,'" said David Hilder, an analyst with Drexel Hamilton.

Tarullo warned big banks, but he said regulators think the Dodd-Frank law was actually too tough on smaller and regional banks. He has called for exempting some banks from rules such as writing plans for going through bankruptcy in a crisis.

On Tuesday, he said community banks should not have to comply with the Volcker rule, which bans banks from making speculative bets with their own money.

Some lawmakers agreed.

"I think it is time for a fix-it bill around Dodd-Frank," said Senator Mark Warner, a Virginia Democrat. Tarullo also said the Fed is working on capital requirements for insurance companies.

Dodd-Frank requires non-bank firms that are declared too-big-to-fail to meet bank-style capital rules. Insurers American International Group and Prudential Financial say those requirements would not fit their business models.

The Senate passed legislation to let the Fed write rules that fit insurers, but the House of Representatives has not approved it. "You are caught in this limbo situation," said Senator Mike Johanns, a Nebraska Republican.

Tarullo said even if that legislation does not move forward, the Fed has some ability to tailor the rules by determining the risk level of insurance products that are not offered by banks. But he said a legislative fix would provide more flexibility.