WASHINGTON -- Bank regulators are searching for a way to keep new accounting rules from whipsawing regulatory capital levels.

Jonathan L. Fiechter, acting director of the Office of Thrift Supervision, said Thursday that the four banking agencies are working to devise a solution to the paper volatility the new mark-to-market rule creates.

Regulators are afraid those paper losses could force banks out of compliance with stringent capital requirements - obligating regulators in some cases to shut down viable banks.

The trouble arose after the Financial Accounting Standards Board required banks to mark many of their assets to market value starting this year. Financial Accounting Standard 115 requires institutions to divide securities holdings into three categories: trading, available-for-sale, and held-to-maturity. A different accounting treatment applies to each category.

For most institutions, the effect of the rule was to increase the number of securities in the available-for-sale category, which must be carried at market value.

While unrealized changes in value for those securities do not affect institutions' earnings, they are reported in their capital levels, causing reported - but unrealized - fluctuations in capital levels during market turbulence.

"We are working with FASB to try to ensure that we minimize the quarterly fluctuations in regulatory capital that arise out of interest rate swings," Mr. Fiechter said. "There is a general disinclination on the part of the banking agencies to have either the income or the capital fluctuate widely based on interest rates."

Lenora Cross, a spokeswoman for the Office of the Comptroller of the Currency, said the agency is still reviewing comments on the new rule. "What we would like to do for calculating regulatory capital is put those unrealized losses back into tier one capital," she said.

FAS 115 requires only that banks mark their assets to market, but doesn't require a similar adjustment on the liability side of the balance sheet. As a result, even if a bank is hedged against possible interest rate changes, just half the hedge counts towards its capital for securities in the available-for-sale category.

For instance, if a bank holding a 10-year Treasury bond funds it with a 10-year certificate of deposit, the institution may lose money on paper when rates rise.

No Upside Accounting

That's because FAS 115 could force banks to take a hit against capital for the value of the bond's declining, but would not recognize the opposite effect on the CD. Both would still be on the books, but the unrealized decline in the bond's price is the only change counted towards capital.

"We encourage thrifts to hedge, but FASB doesn't recognize the hedge," Mr. Fiechter said. "It's perverse."

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