Banking and Finance Law Daily Wrap Up, BANKING OPERATIONS—For community banks, the answer lies in the middle, (Feb 19, 2025)

By Sherri M. Schroeder, J.D.

Remarks by the President of the Federal Reserve Bank of San Francisco acknowledge the important role of community banks while highlighting the need for regulatory and supervisory frameworks that fit them.

In remarks given by Mary C. Daly, President and CEO of the Federal Reserve Bank of San Francisco, at the American Bankers Association’s 2025 Conference for Community Bankers, Daly highlights the need for regulatory and supervisory frameworks that fit the size, complexity, and risk faced by community banks. In her remarks, entitled “Community Banking: Aligning Ideals with Practices,” Daly notes that there is a growing gap between how the banking industry talks about the importance of community banks and the challenging environment created for them by regulatory and supervisory frameworks. For Daly, the answer to this dichotomy lies somewhere in the middle.

According to the FDIC, there are over 4,000 community banking organizations in the U.S. with roughly $2.8 trillion in assets. A 2020 FDIC study showed that from 2008 to 2019, federal financial regulators issued 157 final rules and programs applying to community banks—an average of one every 28 days.

“All this adds up to an environment where community banking has become harder. Between increased competition, compressed margins, and the growing costs of complying with regulations, it has become more challenging to become or stay a community banker,” states Daly.

According to Daly, the range of tradeoffs between “a lot and a little regulatory oversight” fall along a continuum. Allowing banks to do whatever they want with no constraints on behavior or risk taking could, in theory, mean more innovation, competition, and short-term growth, but this could also mean significant risks to customers, taxpayers, and the financial system. However, trying to “regulate the risk out of the system” would “bridle innovation, lending, and dynamism—things that have made the U.S. financial system one of the best in the world,” according to Daly.

For Daly, the answer lies in the middle ground. “The goal of regulation is not to remove all risk, but rather to ensure that banks manage it well. The middle ground,” opines Daly. To find the right place in that middle ground, however, you need a set of principles regarding regulation and risk. To that end, she lays out three basic principles: the job is never done, the cost-benefit ratio for any regulation must “pencil out,” and the sum of the regulation is what matters.

First, “[r]egulation is only as effective as our commitment to evaluating it,” per Daly. Getting it right is a continuous process of evaluating and changing when necessary, which is the underlying principle of the Economic Growth and Regulatory Paperwork Reduction Act (12 U.S.C. § 3311), which requires agencies, with input from the public, to review their regulations at least once every 10 years to identify outdated or unnecessary regulations. She also notes that federal bank regulatory agencies will hold their next public outreach meeting on March 6, 2025.

Daly’s second principle is that the cost-benefit ratio for any regulation must pencil out. She urges policy makers to look beyond the average because cost of compliance and the benefits of any rule will likely vary by bank size, complexity, and risk profile. “Taking that heterogeneity into account ensures that we get what we intend from regulatory policy and that we do so fairly, without unduly advantaging or disadvantaging any single institution or group of institutions,” she states.

Daly’s final principle is that the sum of regulation, meaning its cumulative impact, matters. “Rules and regulations are made individually,” she notes, “but their effects are felt as a whole.” She adds that this is particularly true for community banks.

“Regulations are tools,” according to Daly. Regulations need to balance consumer protection and the financial system against costs to financial institutions, innovation, and economic growth. Regulations also need to recognize that all banks are not the same, per Daly. She adds, “Carefully considered and appropriately tailored rules, that evolve as the economy does, can ensure that banks of all sizes take appropriate risks and continue to thrive.”

In her summation, Daly notes, “Regulatory policy is meant to set guardrails. It should not pick winners and losers. That is the job of the marketplace. No community banker I have ever spoken with wants a special deal, they just want a fair one. The onus is on us—those in the room, Reserve Bank presidents, regulators, and the public—to be sure that we match our practices and our ideals. The future of community banking depends on it.”

RegulatoryActivity: BankingOperations CommunityDevelopment GCNNews PrudentialRegulation