An intensive study by the Securities and Exchange Commission has concluded that classic fears of credit quality and banks’ viability caused banks to fail and the financial markets to grind to a halt last year, rather than mark-to-market accounting rules.

The SEC study, mandated by Congress last fall when it passed the Wall Street bailout, recommends that Congress not suspend mark-to-market accounting standards. Rather, the SEC says the market could use some accounting rule changes related to impairments and guidance related to how fair value is measured, especially when markets are inactive and liquidity is a problem. The Financial Accounting Standards Board is already racing the clock to put some impairment changes in place in time for 2008 year-end reporting.

The 211-page study says investors generally believe fair-value accounting results in more transparent financial reporting and allows better investment decision making. The report says banks failed more as a result of credit losses, concerns about asset quality, and in some cases diminished lender and investor confidence, not fair-value accounting. It outlines some specific recommendations that would improve the application of fair-value accounting, according to the SEC, including:

Guidance and tools for determining fair value when market information is not available because markets are inactive; addressing how to determine when markets are inactive and therefore transactions are distressed; how a change in credit risk should impact the value of asset or liability; when it’s appropriate to rely on management estimates; and how to confirm assumptions represent the view of the hypothetical market participant, as required in Financial Accounting Standard No. 157, Fair Value Measurement;

Enhanced disclosure and presentation requirements regarding the effect of fair value in the financial statements;

Examination by FASB on the effect liquidity has in the measurement of fair value, including whether additional application or disclosure guidance might be helpful;

Consideration by FASB of whether credit risk should be factored into the measurement of liabilities, including whether current practice provides enough transparency;

Educational efforts, including those to reinforce the need for management judgment in the determination of fair-value estimates.

The report says FASB should consider reducing the number of impairment models, allowing management more leeway to tell investors whether declines in value are consistent with underlying credit quality, and allowing impaired assets to reflect recoveries as they regain value. FASB is working on short-term projects now (one looking at streamlining impairment models and one calling for a tabular presentation of measurement attributes in valuing certain debt securities) that address those issues. It is working on guidance related to the remaining issues as well.

Rick Ueltschy, a partner with Crowe Horwath, says the broad findings generally support what his firm has seen in practice. “The study indicates that credit losses have been a much greater contributor to bank weakening and failure than losses on investments recorded because of fair-value accounting,” he says. “While banks have taken some investment related hits, the credit losses have been more significant, except for certain, rare cases where banks had concentrations of investments in particularly troublesome securities.”

Cindy Fornelli, director of the Center for Audit Quality, said in a prepared statement that she’s pleased to see the study calls for improvements to rules, but not a retreat from fair value. “Any changes should be proposed and dealt with through the independent standard-setting process,” she said.