The BSE Sensex gained 359 points to 20,929 as the Reserve Bank of India reduced the cost of short-term funds for banks by slashing the marginal standing facility rate by a similar quantum to 8.75 per cent.
The CNX Nifty finished higher by 1.96 per cent or 119.80 points at 6,220.90.
In a move that will increase liquidity in the banking system, the RBI doubled the borrowing limit of banks against their cash positions to 0.5 per cent for both 7-day and 14-day repos.
However, the central bank, as widely expected, increased the repo rate by 0.25 per cent to 7.75 per cent.
Most banking stocks were in demand following a favourable Reserve Bank of India's monetary policy. BSE Bankex was up 535 points at 12,831.
Major banking stocks that gained include Axis Bank (5%), Bank of Baroda (4%), Canara Bank (4%), Federal Bank (4%), ICICI Bank (6%), Indusind Bank (5%), State Bank (4%), Union Bank (4%) and YES Bank (7%).
JSW Steel gained marginally by 0.19 per cent to Rs 861 after the company reported a consolidated net loss of Rs 116 crore against net profit of Rs 691 crore in Q2 September 2012.
Shriram Transport Finance rose 3 per cent to Rs 572 even as its consolidated net profit fell 3 per cent to Rs 352 crore on 23 per cent increase in total income to Rs 2104 crore in the second quarter of this fiscal.
Major gainers for the day include M&M Finance (9%), Maruti Suzuki (8%), HDIL (8%), Century Tex (7%), Jaiprakash Association (7%), YES Bank (7%), JP Power (7%), TV18 Broadcast (6%) and ICICI Bank (6%).
Major losers were Suzlon Energy (-5%), Bharti Infratel (-3%) and Muthoot Fin (2%).