Banks collectively had reported a gain on treasury of Rs 598 billion in FY17.
The 10-year benchmark yield has moved up to 7.60 per cent in January, up from 6.50 per cent as on July 2017, up 110 basis points.
According to the India Ratings, large losses emanating out of the quick rise in bond yields, especially in the past six weeks, will result in large mark-to-market losses on lenders' non held-to-maturity investment holdings.
"This will lead to a considerable fall in the banks' treasury income in the March quarter, with a spillover effect in FY19. We expect banks' profitability to be affected to the tune of Rs 305 billion in FY18, with return on assets of around 30 basis points," the report warned.
According to the agency, mid-sized banks would be the worst hit, considering their proportionally swollen treasury books, after a period of muted credit and large deposit growth, and a steeper treasury profit booking in FY17.
Out of the total potential loss, the share of state-run banks will be Rs 248 billion in FY18, while that of the private sector banks will be Rs 57 billion, the report said.
"The resulting treasury loss will impact the renewed vigour post announcement of bank recapitalisation," it said.
The report also expects the additional burden emanating from migrations to the new accounting standards, Ind AS, and step-up in provisioning due to faster resolution of stressed assets to further dent banks' profitability.
The agency feels scheduled commercial banks may need up to Rs 890 billion towards incremental provisioning for advances, while transiting to the Ind-AS 109 regime.
According to the report, with a recovery in demand for bank credit, banks with better capitalisation may raise lending rates to improve net interest margins.
"The building-up consensus towards a rise in rates by the Reserve Bank would entice banks to pre-empt asset repricing decisions. Hence, growth in advances and a likely improvement spreads will aid banks' pre-provisioning operating profitability," it said.