June 12 (Bloomberg) -- State Bank of India, the nation's largest, and ICICI Bank Ltd. led Indian banks lower in Mumbai trading after the central bank unexpectedly increased borrowing costs, adding to the risk of an economic slowdown.

State Bank of India fell 3.7 percent to 1,262.20 rupees, its lowest in almost a year, at 10:03 a.m. ICICI, India's second- largest bank, declined 4.1 percent to the lowest in almost two years. The Bombay Stock Exchange's Bankex Index lost 3.8 percent, the most in over two months.

Demand for loans may slow this year following the rate increase, State Bank Chairman Om Prakash Bhatt said today. The Reserve Bank of India increased the repurchase rate to 8 percent from 7.75 percent to curb inflation after India raised fuel prices at the sharpest pace in at least six years.

``We expect banks will raise lending and deposit rates in response to the policy announcement,'' Goldman Sachs Group Inc. analysts including Sampath Kumar wrote in a note to clients today. ``Uncertainty about further monetary policy tightening is likely to remain as an overhang to current market expectations.''

The government-controlled State Bank, which will hold a meeting tomorrow to make a decision on deposit and lending rates, may raise the interest rates on loans, Bhatt said today.

Loan growth has been slowing in the South Asian nation as the central bank raised its repurchase rate eight times in the past 2 1/2 years and increased the cash reserve ratio, or the proportion of deposits lenders must set aside, seven times since December 2006 to counter rising prices.

To contact the reporter on this story: M.C. Govardhana Rangan in Mumbai at grangan@bloomberg.net.

Last Updated: June 12, 2008 00:52 EDT