U.S. banks poured more than $200 billion into state and local-government debt since the onset of the financial crisis six years ago, boosting their share of the $3.7 trillion market to a two-decade high.

Now, if federal regulators have their way, California Treasurer Bill Lockyer says banks next year will have more incentive to buy debt sold by Saudi Arabia or Botswana than by U.S. municipalities. The result, he says: higher costs for taxpayers.

California, Georgia, and New York City are among issuers pressing regulators, including the Federal Reserve, to ease a rule, proposed last October, that may curb buying by banks. The regulation, intended to guarantee that banks have enough easy-to-sell assets during a cash crunch, wouldn't let them use munis to satisfy the requirements, giving the companies less reason to hold the debt.