The BSE Sensex and the Nifty fell nearly 1% on Wednesday, snapping two days of gains, as lenders such as State Bank of India and ICICI Bank slumped on worries that a sell-off in government bonds would hit the value of their debt holdings.
A slump in global shares also dented sentiment after Wall Street fell overnight and on reports of a build-up of Russian troops near the border with Ukraine.
The falls mark a cautious start to the month in Indian shares after a record-setting July. The Nifty is down 0.6% so far this month, given concerns that weaker global markets will lead to reduced buying by foreign investors.
Overseas investors, who bought Indian shares worth $8.68 million on Tuesday, have sold shares worth $363.48 million so far this month. Foreign investors have bought $11.79 billion so far this year.
"Markets are likely to be choppy for the time being. Earnings are coming to an end. There is a lack of fresh triggers. It would be more of news-driven kind of movement for the time being," said Daljeet S Kohli, head of research at IndiaNivesh.
"However, the broader sentiment is still positive."
The Sensex ended 0.94% lower at 25,665.27 points, while the Nifty ended 0.96% lower at 7,672.05 points.
Banking stocks led the decline after bonds tumbled on Tuesday, raising worries about their debt holdings.
The Reserve Bank of India had earlier on Tuesday cut the banks' minimum bond holding requirements, known as the statutory liquidity ratio (SLR), as well as the debt that must be held-to-maturity (HTM) by lenders.
The existing benchmark 10-year bond yield surged 10 basis points to 8.83%, its biggest single-day rise in four months, on Tuesday and an additional 2 bps on Wednesday.
State Bank of India fell 1.93%, after gaining 0.5% in the previous session, while ICICI Bank Ltd ended down 2.7%.
Real-estate stocks were also hit by profit-taking. DLF Ltd fell 1.4% after gaining 2.2% in the previous session, while Indiabulls Real Estate closed down 5.6%.
Among other blue-chips, Tata Motors ended 2.02% lower on profit-taking after gaining 2.3% on Tuesday.
Hindalco Industries closed 1.99% lower, while Oil and Natural Gas Corp fell 2.1%.
However, Infosys Ltd gained 1.8%, adding to its 1.4% gain in the previous session, after former officers of the IT outsourcer wrote a letter calling for a 112-billion-rupee (1.82 billion US dollar) buyback.