WASHINGTON — Federal Reserve Board Gov. Elizabeth Duke sharply criticized key aspects of a pending accounting proposal that would expose a bank's assets and liabilities — including loans held to maturity and deposits — to fair-value treatment.

In a rebuke Monday to the Financial Accounting Standards Board, Duke echoed industry complaints that the approach fails to recognize how banks conduct operations and could cut off credit to small businesses.

Duke, a former banker and chairman of the American Bankers Association, took particular aim at efforts to account for assets that will be held to maturity at their current market value.

"If the business model is predicated on the realization of value through the return of principal and yield over the life of the financial instrument, then fair value is less relevant," Duke told the American Institute of Certified Public Accountants. "In this case, the accounting should incentivize the entity to maintain sufficient funding to hold the instrument to maturity and to hold a sufficient amount of capital to cover potential credit losses through the credit cycle, preferably in a designated reserve. Indeed, the use of fair value could create disincentives for lending to smaller businesses whose credit characteristics are not easily evaluated by the marketplace."

Though the FASB has yet to reveal a formal proposal, the accounting standards board met over the summer to discuss its development. The agency is aiming to provide investors with a better picture of a financial institution's holdings, but there is widespread concern its approach could force big writedowns at banks that have only recently begun to find their footing again.

At its meeting last month, FASB Chairman Robert Herz said any changes would not be adopted before 2011.

While the industry has opposed the idea, Duke's speech amounted to the most expansive rejection of the FASB's approach yet from a banking regulator. The daylight between the banking supervisors and the FASB could grow even wider when the chief accountants from each of the agencies participate in a panel discussion today.

Some observers took Duke's comments as a signal that banking agencies might not follow the FASB's lead. "This puts the regulators in the very uncomfortable spot of deviating from [generally accepted accounting principles] in a very significant way," said Bert Ely, an independent consultant in Alexandria, Va.

Regulators may force banks to report assets and liabilities a different way for the purposes of call reports, Ely warned. There would be "one set of rules for reporting to investors and a separate set of rules for reporting to regulators," he said.

Duke appeared more concerned about financial institutions' ability to comply with the rule — "We have very little actual experience in fair-valuing liabilities," she said — and its impact on small banks.

Most community banks do not use mark-to-market when given the option, but they must apply it to their investment portfolios.

"Smaller banking companies likely will incur substantial costs and experience great difficulty in applying the new standards," Duke said. "But will financial statement users see any real benefit?"

Duke acknowledged that some banks have attempted to get around accounting requirements by inappropriately moving some assets into the held-to-maturity category. But she argued the appropriate response is tougher oversight of how banks conduct their accounting.

Instead of following the FASB's approach, Duke said her "wish list" would allow banks to record assets held to maturity "at amortized cost with a reserve reflecting life-of-loan or through-the-cycle potential credit losses."

Duke emphasized the need to weave all the new regulatory requirements into a coordinated implementation. The FASB's proposal comes as the Obama administration continues to work toward revamping financial regulation, including a push to require originators to retain a portion of their loan before selling it into securitization markets.

"If the risk-retention requirements, combined with accounting standards governing the treatment of off-balance-sheet entities, make it impossible for firms to reduce the balance sheet through securitization and if, at the same time, leverage ratios limit balance sheet growth, we could be faced with substantially less credit availability," she said.

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