By Al Yoon

NORWALK, Connecticut (Reuters) - U.S. accounting rulemakers bowed to congressional and financial industry pressure on Thursday by allowing more flexibility in valuing toxic assets, a move expected to boost bank earnings and improve their capital levels.

The five-member Financial Accounting Standards Board voted unanimously to let banks exercise more judgment in using mark-to-market accounting that has forced billions of dollars in writedowns and been blamed for worsening the recession.

But the board split 3-2 on backing guidance that would let lenders take smaller losses on impaired assets such as mortgage backed securities, a move critics said would let banks hide reality from investors.

The accounting changes were credited with helping U.S. stock rally for a third day, by supporting optimism the financial sector will stabilize in the short term.

Many lawmakers, banks and other supporters of the changes argue that pricing assets to firesale prices during a time of inactive markets has exacerbated the financial crisis through the writedowns, big earnings hits, damage to capital ratios, and a reduced ability to lend.

Investors and some former regulators take a different view, saying that more flexibility with the rules would let big banks hide the real value of their troubled assets.

"I think it's a mistake. If it's too cold in the room, you don't fix the problem by holding a candle under the thermometer," William Poole, former Federal Reserve Bank of St. Louis president, told Reuters at a conference in New Orleans.

"It may increase reported bank earnings by 20 percent, but it has nothing to do with the reality of bank earnings. It's very important to maintain that distinction," Poole said.