Just how much have mark-to-market accounting rules contributed to the current upheaval in the banking sector?

“The application of these rigid accounting rules, in times like these, is much like throwing gasoline on a raging inferno,” said Thomas Bailey, president and CEO of Brentwood Bank in Pittsburgh, testifying today before a congressional panel on behalf of the Independent Community Bankers of America. (His and others’ testimony is available at http://www.house.gov/apps/list/hearing/financialsvcs_dem/hr031209.shtml.)

For instance, under current mark-to-market rules, a company must mark down a security to current fair value, even if it has no intention of selling it. Given the lack of liquidity in the markets today, the writedowns can greatly exceed any reasonably expected loss. So, banks and other financial institutions aren’t buying any assets that they fear could be subject to large write-downs later on simply as a result of immaterial credit losses.

Brentwood Bank, Bailey said, had to take $2 million in questionable OTTI, or other than temporary impairment, writedowns, even though its ratio of delinquent loans to assets is less than .25 percent. That’s made the bank less likely to approve new loans. The same situation occurring across many banks is exacerbating the current crisis, Bailey said.

On the other hand, Carla Fornelli, executive director of The Center for Audit Quality, testified in support of fair value rules. “Significantly altering or suspending fair value would not only fail to mitigate the crisis, but such a move would make it worse by further undermining investor confidence by raising suspicions that the rules were changed in order to obfuscate current asset values.”

Fornelli highlighted two examples in which a revision of fair value rules — during the U.S. savings and loan crisis in the 1980s, and in the face of steep losses in Japanese banks in the 1990s — ultimately led to greater uncertainty and losses.

Fornelli also referred to an SEC report from December that concluded that recent bank failures primarily were caused by the quality of the loan portfolios and inadequate liquidity, and by fair value or mark-to-market accounting.

Both Bailey and Fornelli offered potential fixes. Among other recommendations, Bailey said that any OTTI should reflect probable credit losses based on rigorous analysis, and OTTI on debt that will be held to maturity should be reported in two ways: through earnings for probable credit losses, and in footnotes to disclose the fair value of the securities.

Fornelli indicated that banks’ capital regulatory requirements, which are affected by any writedowns they have to take, should be kept separate from accounting standards. “If there is a problem with a financial institution meeting capital requirements, the solution should focus on regulatory requirements, not on denying the current valuation that results from the underlying fair value principle.”

Yet another expert testifying, Robert Herz, chair of the Financial Accounting Standards Board (FASB), indicated that additional guidance on the application of mark-to-market will be coming in the next few weeks. ###