Banking and Finance Law Daily Wrap Up, BANKING OPERATIONS—Federal, state banking regulators warn on AI risks and large bank deregulation, (Oct 8, 2025)

By Shashi Kant, BALLB, LLM.

The officials highlighted community banks’ strengths, rising compliance costs, and potential fallout from deregulation while warning of AI-driven fraud risks.

Federal Reserve officials and state banking regulators addressed the future of community banking at the 13th annual Community Banking Research Conference in St. Louis on October 7-8, 2025. Michael S. Barr, Member of the Board of Governors of the Federal Reserve System, spoke about technology adoption and the risks of deregulating large banks. Michelle W. Bowman, Vice Chair for Supervision of the Federal Reserve Board, delivered welcome remarks via pre-recorded video on October 7, outlining regulatory reform initiatives. Brandon Milhorn, President and CEO of the Conference of State Bank Supervisors, addressed compliance costs, stablecoin legislation, and federal preemption authority on October 7.

Community banks face mounting competitive pressures. Barr emphasized that community banks often serve as the only banking option in a community and differentiate themselves through higher customer satisfaction. At larger banks, customer experiences can involve multiple layers of authorizations with remote decision-makers who may not understand local conditions. In contrast, community bankers rely on “soft information” about their neighbors to make better credit decisions. Relationship banking, especially with local business owners, gives community banks an edge over larger banks and nonbank lenders, Barr said.

Technology adoption ranks as a top concern. According to the 2025 CSBS Annual Survey of Community Banks, “technology and related costs” ranked second among concerns, behind only cybersecurity. Most respondents said adopting new or emerging technologies was very or extremely important, and none said it was unimportant. The survey also reported the largest-ever increase in respondents citing heightened competition from nonbank payment firms. Barr noted that many community banks turn to third-party service providers to deliver competitive products and services.

AI presents opportunities and risks. AI appeared in the CSBS survey for the first time in 2024, when 31 percent of banks highlighted AI for customer support; in 2025, that share rose to 47 percent. Barr warned that generative AI can also enable fraud, citing deepfake technology that recreates voices and images to conduct convincing scams. He referenced sources estimating that the global costs of cybercrime have grown from 1 percent to 10 percent of world GDP, and another source reporting a twentyfold increase in deepfake attacks over the past three years.

Compliance costs hit smaller banks harder. Milhorn highlighted CSBS research showing that smaller banks consistently devote 11–15.5 percent of personnel expenses to regulatory compliance, compared to 5.6–9.6 percent for larger institutions. The number of community banks has declined from more than 6,100 in 2014 to about 4,050 at the end of 2024. Only 62 de novo banks were formed in that period.

Fed launches regulatory review initiatives. Bowman said the Federal Reserve is refocusing supervisory efforts on core material financial risks, reviewing the CAMELS ratings framework, revising the community bank leverage ratio, and considering ways to improve treatment of mutual banks. She described key building blocks for a more effective framework: indexing asset-size thresholds across regulation, weighing tradeoffs of new rules, identifying hidden supervisory costs, streamlining merger reviews, and promoting new bank formation.

Stablecoin legislation raises deposit concerns. Milhorn discussed the Guiding and Establishing National Innovation for U.S. Stablecoins Act, signed July 18, 2025, which creates a national framework for payment stablecoins. The law allows banks to form stablecoin subsidiaries and permits nonbanks to become issuers under federal or state law. He cited Treasury estimates that the addressable stablecoin market could grow to $2 trillion by 2028, up from about $300 billion today. Milhorn cautioned that if this growth comes at the expense of community bank deposits, a $1.7 trillion migration could translate into a $1.4 trillion reduction in lending capacity. As of Q2 2025, banks under $10 billion in assets had an average net loans-to-deposits ratio of 83.6 percent, according to FDIC data.

Large bank deregulation draws criticism. Barr argued that community banks were not the drivers of the 2008 financial crisis; rather, it was the largest, most complex firms whose excessive risk-taking nearly collapsed the system. He warned that recent proposals to weaken capital standards, supervisory oversight, and stress testing for large banks risk eroding protections and could expose community banks to fallout if those institutions stumble.

Banker sentiment on regulation improves. Milhorn noted that the Regulatory Burden component of the Community Bank Sentiment Index stood at 114 in the third quarter of 2025, only the third time it has exceeded 100. The measure had been below 30 for fifteen consecutive quarters from early 2021 through late 2024 but is up 94 points compared with a year earlier.

Companies: Conference of State Bank Supervisors

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