WASHINGTON, July 31 (Reuters) - A pair of U.S. bank regulators proposed an update on Friday to some fair lending rules, which would place additional scrutiny on how banks dole out grants while exempting smaller firms from some requirements.

The proposal from the Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency is the latest attempt in a long-running effort to update rules policing the 1977 Community Reinvestment Act.

Conceived to prevent redlining - a discriminatory practice where banks refuse or offer only limited lending to certain areas or populations, primarily minorities - CRA regulations are central to banks' overall supervisory performance.

Poor CRA grades put lenders in a so-called penalty box, meaning they are barred from doing mergers and other deals.

The new proposal, if finalized, would require banks to prove that most of the funds distributed via so-called "community development" grants are spent in the relevant communities and that the organizations receiving those funds do not have excessive overhead costs.

It would also exempt more banks from the rule's requirements. Banks with under $10 billion in assets would be exempted from some data collection and reporting requirements, relief previously granted to banks with under $1.65 billion in assets.

The agencies touted the proposal as trimming burdens on banks and ensuring grants benefit communities, but the plan was quickly criticized by Democrats. Senator Elizabeth Warren and other Democrats on the Senate Banking Committee said the proposal would "gut" a critical tool for spurring community investments.

"This proposal would make America's housing crisis worse," the lawmakers said in a statement.

The rule faces an uncertain future, as the Federal Reserve, which shares responsibility for enforcing the CRA, did not issue its own complementary proposal. Typically, the three bank regulators prioritize issuing matching rules to avoid patchwork requirements for the banking industry. A Federal Reserve spokesperson declined to comment.

The three agencies previously updated those rules in 2023, but the new, stricter regulations were rescinded under President Donald Trump following a legal challenge to the new requirements from the banking industry.