Push for Public Sector Bank Reforms

Why Merging Five Small PSBs May Not Solve India's Banking Puzzle

In 2020, India’s public sector banks (PSBs) were reduced from 27 to 12 through a massive consolidation exercise. Now, barely five years later, the Union Budget 2026–27 is poised to launch Consolidation 2.0—this time targeting the five smallest PSBs for mergers with mid-sized banks. Parallel reforms propose loosening government control by hiking the FDI cap to 49% and diluting state ownership closer to 51%. These twin strategies aim to create stronger, more competitive banks while simultaneously reducing fiscal burdens on the exchequer. But beneath the bold plans lie several unresolved tensions.

The Policy Instruments: Consolidation 2.0 and Ownership Reforms

At the forefront of proposed reforms are two interconnected strategies:

• Consolidation 2.0: The government intends to merge five of India’s smallest PSBs, which collectively hold just 3–4% of the PSB sector’s total assets, with mid-sized banks. The stated goals include reducing fragmentation, improving operational scale, and enhancing balance sheet strength.
• Ownership Reform: Proposals include raising the FDI limit from 20% to 49%, privatizing two remaining PSBs, and diluting the government’s stake closer to 51%. This would ostensibly grant boards more operational autonomy while encouraging independent capital raising.

Complementary measures like tweaking debt tribunals’ pecuniary jurisdiction (₹10 lakh to ₹20 lakh in revised thresholds) and improving credit recovery mechanisms such as the Insolvency and Bankruptcy Code (IBC) further shore up the underlying framework for healthier banks.

The Case For Consolidation and Ownership Reform

The rationale behind these reforms is not without merit. Banking systems perform best when they balance systemic resilience with competitive efficiency. The first wave of mergers in 2020 successfully addressed operational weaknesses in smaller banks and expanded resource sharing, particularly in technology. Despite early skepticism, the average net profit of PSBs grew from ₹31,820 crore in FY20 to ₹66,500 crore in FY25—a doubling that reflects improving economies of scale.

International precedent also backs the case for larger, stronger banks. Canada operates a banking system where six major banks account for over 90% of sector assets. This concentration has created a stable system insulated from frequent financial shocks. Merged entities in India could theoretically adopt similar frameworks, enhancing global competitiveness while minimizing systemic risk.

Ownership reforms have equally compelling arguments. At present, PSBs remain shackled by state ownership structures that discourage innovation and prioritize compliance-driven operations over competitive strategies. Increasing FDI limits to 49% could catalyse private expertise and new capital inflows, bringing much-needed dynamism to these institutions. The idea of broader autonomy for PSB boards aligns with global best practices and addresses chronic inefficiencies caused by bureaucratic dependence.

The Case Against: Structural Risks and Blind Spots

Despite the optimism, past experience suggests caution, particularly regarding consolidation. The 2020 merger wave was marred by logistical hurdles—IT integration failures, workforce misalignment, and customer service disruptions. The proposed second phase risks more of the same, with challenges compounded by the lower operational capacity of the banks being merged. Reform proponents overestimate scale as a one-size-fits-all solution but gloss over geography mismatches. Merging regional banks, for instance, may dilute their focus on localized financial inclusion.

User choice and competition remain other critical blind spots. The share of PSBs in India’s total banking assets—dominating at 60%—fuels concerns that further consolidation will tighten market concentration. Less competitive intensity among PSBs could undermine innovation, leaving private banks unchecked in their rapid expansion.

Ownership reforms, too, raise complex questions. Will reducing government stakes to 51% truly grant PSBs operational autonomy, or will other distortions—political pressures, uneven regulation—replace outright state control? Hazy timelines for privatization have also left stakeholders uncertain about the depth and pace of execution, while employee unions remain staunchly opposed.

Lessons from Singapore's Banking Model

Singapore offers an instructive counterpoint. The city-state maintained a cautious approach during its banking sector restructuring in the early 2000s, opting for consolidation but with strict geographic and operational synergies. By limiting mergers to banks with complementary portfolios, Singapore preserved competition while bolstering scale. Its liberal FDI policy—allowing foreign ownership up to 100%—allowed capital inflows without compromising domestic oversight. The result? A banking ecosystem that ranks consistently high on efficiency and innovation indices.

India could borrow important lessons here regarding consolidation governance and ownership thresholds. Simply merging institutions or tweaking FDI caps without structural refinements in governance risks leaving systemic inefficiencies unaddressed.

Where Things Stand

India's banking sector faces hard choices. While Consolidation 2.0 and ownership reforms promise fresh momentum, execution risks abound. Much depends on the design of merger roadmaps—whether they prioritize compatibility or chase superficial metrics like size—and the behavior of new institutional stakeholders post-privatization. The tension between the government’s fiscal imperatives and public banks’ core mandate of financial inclusion remains unresolved. In calibrating reforms, policymakers must tread carefully to avoid sacrificing sector resilience for expediency.

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