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Aren't 350 000 files too many arguments for for i in *?
Safer and faster is

find . -type f |
while read i

Try something like:
cd XYZ || { echo "directory does not exist" > &2; exit 1 ;}
n=0
for i in *
do
if [ $((n+=1)) -gt 10 ]; then
n=1
fi
todir=../XYZ$n
[ -d "$todir" ] || mkdir...

If preserving the order of lines in File 1 is important, this comes close to producing the output you requested:
awk '
BEGIN { # Set input and output field separators
FS = OFS = ":"
}
NR == 1 {...

Try something like this:
awk 'NR==FNR{A[$1]=$2; next} FNR in A{print $1, A[FNR]}' FS=": *" file1 FS=" " OFS=: file2 > newfile
If succesful replace file1 with newfile.

Output:
xyz1:Banana...