Banks, especially state-owned ones, were further hurt after the Reserve Bank of India also increased the amount of provisioning against restructured assets for the sector to 2.75 percent from 2 percent, as part of its monetary policy review.
By keeping the repo rate unchanged at 8 percent because of inflation concerns, the RBI defied political pressure from the government for lower rates, turning Indian indexes into the worst performers in Asia on Tuesday.
The falls came even after the RBI cut the cash reserve ratio, or the amount of deposits that lenders must keep with the central bank, by 25 basis points to 4.25 percent.
"There was definitely lot of expectations in the markets for a rate cut, but people will have to wait for some more time. It is disappointing for the markets," said Srividhya Rajesh, a fund manager at Sundaram Mutual Fund in the city of Chennai.
"Whatever the government has announced on the reforms front, if they get implemented that will give some comfort to the RBI.
They are waiting for that to happen."
India's BSE index fell 1.1 percent, or 204.97 points, to end at 18,430.85 points, marking the biggest percentage decline since Oct. 8.
The 50-share NSE index lost 1.2 percent or 67.70 points to 5,597.90, closing below 5,600 for the first time since Sept 20, and also marking the biggest fall in three weeks.
The disappointment over the RBI's decision threatens to leave stock markets with few triggers, as both indexes head for their first monthly declines since July.
The RBI saw a "reasonable likelihood" of further policy easing in the January-March quarter, according to its statement, also dashing hopes for a rate cut at its next policy review in December.
State-run lenders were among the leading decliners on Tuesday: State Bank of India fell 4.3 percent, while Punjab National Bank slipped 3.5 percent.
The head of industry body Indian Banks' Association K.R. Kamath, who is also chairman of state-run lender Punjap National, said higher provisioning is likely to impact average net profit of banks by 3 percent in this fiscal year.
Private sector banks were also hit, with ICICI Bank down 2.2 percent even as a cut in the CRR should benefit the sector by freeing up funds that earned no interest when deposited at the central bank.
Interest-rate sensitive property shares also slipped: DLF declined 2.2 percent, while Housing Development and Infrastructure Ltd lost 4.9 percent.
Auto makers, which are also sensitive to interest rates, declined as well, with Tata Motors falling 3.54 percent.
Some analysts had hoped a rate cut ahead of the Diwali holidays in November would have boosted sales of big ticket items.
However among gainer, Dr. Reddy's Laboratories rose 1.6 percent after reporting a better-than-expected 32 percent rise in quarterly net profit as four new generic drugs drove sales in North America -- its biggest market.
Maruti Suzuki, India's biggest carmaker, rose 2.1 percent, despite posting July-September profits that missed estimates, as sales volumes were better than expected.