The scandal is one of the biggest to taint India, potentially harming the image of Asia's third-largest economy as destination for foreign investors, especially as it comes a few days after Prime Minister Manmohan Singh has had to defend his government in another graft scandal involving telecoms licences sold at rock-bottom prices.
The federal Central Bureau of Investigation (CBI) on Wednesday arrested five officials from state-run listed lenders, including the chief executive of LIC Housing Finance(LICH.BO), accused of taking bribes to facilitate large corporate loans.
Three senior executives from a listed private company were also arrested on charges of handing out the bribes.
Finance Minister Pranab Mukherjee said in a statement on Thursday he had asked all banks, financial institutions and insurance firms to look into their exposures to firms named by federal investigators in the case.
"The message is not good, both for the market also for the economy," said D.H. Pai Panandiker, head of private think tank RPG Foundation in Delhi.
"All these things create a very bad image about the country and it's kind of loss of faith in the system," he said.
The scandals are unlikely to deter investors from India, one of the four key BRIC emerging markets in the world and a hot investment destination, analysts say.
"Anyone who has been an investor in India, has to be familiar with issues like these," Vikas Pershad, Chief Executive of Veda Investments in Chicago.
"So, if someone is pulling out of India based on the recent events, he or she is really mistaken. The long-term growth story is intact."
Investors are keen to tap into a country with a young and fast-urbanising population of 1.2 billion. Economic growth is forecast at 8.5 percent in 2010-11, and then between 9 and 10 percent every year after that, levels rivalled only by China.
Shares in companies affected fell sharply since the scandal broke, dragging the Mumbai stock index lower.
"The gratifications are huge, more than thousands of crores (hundreds of millions of dollars)," CBI Joint Director P. Kandaswamy, who is in charge of the probe in Mumbai, told reporters on Wednesday. CBI's main spokesman in Delhi on Thursday said he could not confirm the size of the bribes.
The arrests are the culmination of a year-long investigation across five cities in India, the Delhi-based CBI said.
The Delhi government, however, sought to play down the scandal, saying it was an isolated incident.
"I do not think that the scale should be lost sight of. It's very small as far as the banking system as a whole is concerned," Planning Commission deputy chairman Montek Singh Ahluwalia told NDTV Profit.
"I think that our banking system is pretty well regulated. Both the RBI (Reserve Bank of India) and the (finance) ministry, I'm sure, are doing whatever is necessary to send the right signals," he said.
The CBI said those arrested included senior officials at state-run Central Bank of India(CBI.BO), Punjab National Bank(PNBK.BO) and Bank of India(BOI.BO) -- all major banks with operations across the country.
The executives in custody have yet to comment on the charges, but the companies involved have all denied any knowledge of wrongdoing and said they would review their internal regulations.
Life Insurance Corp of India (LIC), the country's largest insurer and parent company of LIC Housing Finance, said it would appoint a new CEO for its housing financing unit.
INDIA REELS FROM MORE SCANDALS
The CBI said the accused had received bribes from listed private broker Money Matters Financial Services, which acted as a "mediator and facilitator" of corporate loans and other facilities.
Lending to developers, which LIC Housing and the other state-run banks in question are heavily involved, has grown considerably in recent years as part of the economic boom.
Real estate firms, some lacking sufficient credit-worthiness, have often used intermediaries to lobby for loans.
"Basically these are corruption charges against public officials. There is no systemic risk, its not going to impact the retail lending," Indian top mortgage lender HDFC Chairman Deepak Parekh told Reuters.
The CBI declined to disclose details about the size of the loans, but they would have been significantly larger than the alleged bribes. Apart for Money Matters, the CBI did not disclose the names of the other companies that allegedly gave bribes.
Suzlon Energy confirmed it had used Money Matters in 2009 for a loan exercise and said in a statement it was confident that the transaction was in compliance with all regulatory and legal requirements.
This is the fourth big corruption scandal to blow up and linked to the Congress party in the past month and a half.
The government has been jolted by controversy over licences and radio airwaves that a state auditor says were given out too cheaply, and often to companies not eligible, depriving the government of up to $39 billion in revenues.
The telecoms minister was forced to resign and the prime minister has been asked to explain himself to the Supreme Court. Opposition parties want a full parliamentary probe and have blocked proceedings until the government relents.
Before that, the $6 billion Commonwealth Games that India hosted were also riddled with corruption allegations.
A large housing scam has also rocked the government where party officials, bureaucrats and military personnel are accused of taking land in Mumbai belonging to war veterans and building luxury flats.
The government has resisted additional probes into the telecoms scandal, saying a CBI investigation is under way.
Critics say the government fears it will be dragged into a long-running investigation ahead of state elections.
Parliament was again adjourned on Thursday as the opposition continue to disrupt business to press their demand for a full parliament inquiry into alleged corruption at the telecoms ministry.
That has weakened the government's ability to move key economic measures and delayed legislation in areas such as banking and mining, although the government is not at risk of collapsing.