* Banks can spread Dec, March quarter bond losses over up to 4 qtrs
* Move to boost banks' profit, boost bank shares, bond mkt
* Banks must set aside profit on sale of bonds in reserve - RBI (Updates to add detail, comment, background)
By Suvashree Choudhury
MUMBAI, April 2 (Reuters) - The Reserve Bank of India has allowed banks to spread their bond trading losses, a change that is likely to boost profitability of lenders as well as spur a rally in stock and bond markets.
Under the change, lenders can spread bond-trading losses incurred in the December 2017 and March 2018 quarters equally over up to four quarters will come as a major reprieve to India's state-run banks, which have been hard hit by trading losses from a spike in bond yields over recent months.
State-run banks, which are struggling under a burden of provisioning for record levels of bad loans, have been further hit by mark-to-market losses on their huge bond holdings due to a sustained spike in bond yields since July.
Last month, Credit Suisse warned here that India's state-run banks could lose more than 200 billion rupees ($3.1 billion) in the January-March quarter, due to a continued spike in bond yields and as they held more bonds than are required by the regulator.
Indian bond yields rose by 67 basis points in the October-December quarter, their steepest since a currency crisis in September quarter of 2013 pushing banks to provide capital for massive mark to market losses and in turn leading state banks, the largest set of bond investors to stay away from buying.
However, since then, bond yields have cooled off with the 10-year benchmark bond yield rising by just 7 basis points in the January-March quarter as the government cut its borrowing amount for the fiscal year that started in April.
Expectations that the central bank might relax the maximum amount of bonds foreign investors can buy in the current fiscal year also kept sentiment upbeat.
"This will bring back state banks into the market," said a senior trader at a large state-run bank.
"Given that there is less credit risk appetite in banks due to several issues going on in the sector, the additional funds will now be invested in bonds and also boost profitability."
Traders expect bond yields to rally by 10-15 basis points on Tuesday after the RBI's relaxation of the accounting rules.
Banking stocks are also likely to rally as this will take pressure off banks' balance sheets given that they can now write back the large amount of provisioning they had done in the December quarter on account of trading losses, bankers said.
Meanwhile, in order to protect banks' balance sheets from any sharp spike in bond yields, the RBI asked banks to set aside their profits on sale of their investments in bonds into a reserve from the current fiscal year. The central bank directed banks to keep adding to this reserve until the amount was two percent of the size of trading portfolio of banks. (Reporting by Suvashree Dey Choudhury Editing by Euan Rocha)