Banks are sparring over looming U.S. mortgage-lending rules that could raise costs for millions of borrowers.

As regulators race to meet an April deadline for issuing the regulations, triggered by last summer's Dodd-Frank financial-overhaul law, the mortgage industry is sharply divided over how much borrowers should be required to put up as a down payment for loans that are classified as less risky by regulators.

Wells Fargo & Co. (WFC), the nation's largest mortgage lender, has asked U.S. regulators to set a down-payment standard of 30% on mortgages that wouldn't have to meet a new requirement that banks retain 5% of a loan if it is securitized. The so-called risk-retention requirement is aimed at preventing future housing meltdowns because lenders could face steeper losses if their loans go bad.

During the real-estate boom, it was common for home buyers to put down little or nothing. Many lenders now require buyers to put down about 20% for home loans that don't require mortgage insurance.

If regulators go along with the San Francisco bank's proposal, mortgage lenders still could make loans with down payments lower than 30%. But those loans would be more costly for the banks because of the risk-retention requirement. Lenders likely would pass those costs along to borrowers in the form of higher interest rates.

"Risk-retention is an important part of putting your money where your mouth is," said John P. Gibbons, who oversees capital markets for Wells Fargo Home Mortgage, a unit of Wells Fargo. Wells officials say that a liquid market for loans that require risk retention isn't likely to develop if regulators create a broad exemption, potentially freezing out creditworthy borrowers. Creating an "unambiguous" standard will also help restore investor confidence in privately securitized loans, he said.

Wells Fargo's request rattled the mortgage industry because many executives are hoping that the exemption to the risk-retention rule applies to most of the mortgage market. Much of the housing industry opposes the bank but they are concerned that, because of its size, Wells Fargo could shape regulators' views.

In a letter sent to regulators Tuesday, the Mortgage Bankers Association, National Association of Realtors, Center for Responsible Lending and other groups warned that an "inordinately narrow" mortgage definition "would mean that millions of creditworthy borrowers would be deemed, by regulatory action, to be higher risk borrowers."

"A lot of originators just aren't going to do" loans that require risk retention, said Steven O'Connor, vice president for government relations at the Mortgage Bankers Association. The trade group's members include Wells Fargo.

Tuesday's letter cited research from J.P. Morgan Securities that concluded mortgage rates could rise by as much as three percentage points for loans that are subject to risk-retention.

Since the recession, banks have ratcheted up their standards. The average loan-to-value ratio for mortgages used to buy a home was 84% in August, the most recent month for which data are available. For refinancings, the average loan-to-value ratio was 69% in August, according to CoreLogic Inc., a housing-data firm.

The spat reflects a broader debate over how much equity borrowers should have in their homes and how to make sure that lenders take appropriate risks. A down-payment requirement of at least 20% also would be particularly damaging for private mortgage insurers. Their business would suffer if regulators make it harder or more expensive to originate loans with low down payments.

Some lenders contend that the Wells Fargo standard would drive more business to the Federal Housing Administration, which is exempt from the risk-retention rules and guarantees loans with down payments as low as 3.5%. "That will move a substantial amount of risk from the private sector to the government," executives at U.S. Bancorp (USB), SunTrust Banks Inc. (STI) and Quicken Loans Inc. wrote in a letter to regulators.

Critics of the 30% standard also say Wells Fargo and other megabanks could simply use their large balance sheets to fund loans on their books for two years. After that, risk-retention rules aren't expected to apply, allowing banks to proceed with selling off entire loans through securitization.

Wells Fargo originated nearly one in four U.S. mortgages during the first nine months of 2010, according to Inside Mortgage Finance. Together with J.P. Morgan Chase & Co. (JPM) and Bank of America Corp. (BAC), the top three lenders accounted for more than 55% of all home-loan originations. The Community Mortgage Banking Project, a coalition of mortgage insurers and small and midsize mortgage firms, argued that the Wells Fargo proposal would give the industry's giants "the pricing power to fatten their margins" while creating "a shortage of lending capacity in underserved markets that banks traditionally avoid."

Wells Fargo responded that the criticisms are unwarranted, adding that it suggested the 30% requirement because about half of all mortgages already carry down payments of that size. "We see this as a way of establishing integrity in the market," Mr. Gibbons said.