Banking system and reforms

The first principle

A bank borrows short and lends long: it takes deposits that can be withdrawn any day and turns them into loans that run for years. That lets savings finance investment, but it rests on trust, because no bank can repay all its depositors at once. Banking regulation therefore exists to make sure banks lend prudently, recognise losses honestly and hold enough capital of their own to absorb those losses before depositors are hurt.

The core

The structure

• The Reserve Bank of India (RBI) regulates and supervises banks under the Banking Regulation Act 1949 and the RBI Act 1934. Banks listed in the Second Schedule of the RBI Act are scheduled banks, which may borrow from the RBI and must meet its reserve requirements.
• Scheduled commercial banks are public sector banks, in which the government holds a majority, private sector banks, foreign banks, regional rural banks (RRBs), small finance banks and payments banks. Fourteen banks were nationalised in 1969 and six more in 1980, spreading branches into villages.
• Regional rural banks, set up from 1975 and owned by the Centre, a sponsor bank and the State, serve rural borrowers; amalgamation under the principle of one State, one RRB reduced them from 43 to 28 in May 2025.
• Cooperative banks (urban cooperative banks and the State and district central cooperative banks) were long under dual control of the RBI and State registrars; the Banking Regulation (Amendment) Act 2020 brought their banking functions much more fully under the RBI after the failure of the Punjab and Maharashtra Cooperative Bank in 2019; small finance and payments banks are covered in the financial inclusion note.

Bad loans and capital

• A non performing asset (NPA) is a loan whose interest or principal has remained overdue for more than 90 days. It is substandard for its first twelve months as an NPA, doubtful after that and a loss asset when it is judged uncollectable, and the bank must set aside provisions, a charge on its profits, that rise with each stage.
• The ratios. The gross NPA (GNPA) ratio is GNPA divided by gross advances; the net NPA ratio deducts provisions from both; and the provision coverage ratio is provisions as a share of GNPA.
• Capital is the bank's own money, which absorbs losses first. The capital to risk weighted assets ratio (CRAR) divides capital by assets weighted by their riskiness, so a government bond carries a weight of zero while an unsecured corporate loan carries a full weight.
• Basel III, the framework of the Basel Committee on Banking Supervision adopted after the crisis of 2008, requires in India a minimum CRAR of 9 per cent, above the Basel minimum of 8, with common equity of at least 5.5 per cent, plus a capital conservation buffer of 2.5 per cent, making 11.5 per cent in all. It also requires a liquidity coverage ratio, so banks hold enough liquid assets for thirty days of stress, and a leverage ratio. Systemically important banks, at present the State Bank of India, HDFC Bank and ICICI Bank, must hold extra common equity.

A worked example

• Ratios. A bank has gross advances of Rs 1,000 crore, of which Rs 50 crore are NPAs, and holds Rs 40 crore of provisions. Its GNPA ratio is 50 ÷ 1,000 = 5 per cent, its provision coverage ratio is 40 ÷ 50 = 80 per cent and its net NPA ratio is (50 − 40) ÷ (1,000 − 40) = 10 ÷ 960, about 1.04 per cent.
• How bad loans squeeze credit. Suppose the bank has Rs 120 crore of capital against Rs 1,000 crore of risk weighted assets, a CRAR of 12 per cent, just above the 11.5 per cent it needs. If Rs 30 crore of fresh bad loans must be fully provided for and it has no profit to absorb them, its capital falls to Rs 90 crore and its risk weighted assets to about Rs 970 crore, so its CRAR drops to about 9.3 per cent. To return to 11.5 per cent without new capital it must shrink risk weighted assets to 90 ÷ 0.115, about Rs 783 crore, cutting risk weighted lending by about Rs 187 crore. This is how bad loans turn into a credit squeeze.

Dimensions

• The twin balance sheet problem, as the Economic Survey 2016-17 called it, describes overleveraged companies that could not repay and the banks whose balance sheets carried those loans. Infrastructure, power, steel and telecom projects financed in the boom of the mid 2000s stalled, and banks kept rolling the loans over.
• Recognition, the first of the government's four Rs (recognition, resolution, recapitalisation, reform), came when the RBI's asset quality review of 2015 forced banks to classify these loans as NPAs, and the GNPA ratio of scheduled commercial banks rose to a peak of 11.2 per cent in March 2018, much higher in public sector banks.
• Governance. Public sector banks carry dual regulation by the RBI and the finance ministry, government appointments to boards and pressure to lend for policy aims, which the P J Nayak Committee of 2014 identified as a root cause of weaker performance.
• Fiscal. Recapitalising public sector banks costs the government money; it put in about Rs 3.1 lakh crore between 2016-17 and 2020-21, partly through recapitalisation bonds.
• Depositors and stability. Deposit insurance by the Deposit Insurance and Credit Guarantee Corporation covers up to Rs 5 lakh per depositor per bank since 2020, and the prompt corrective action framework restricts lending, dividends and branch expansion when a bank breaches thresholds of capital, net NPAs or leverage.

In practice

• The Insolvency and Bankruptcy Code (IBC) 2016 replaced a slow and fragmented system with a time bound process. When a company defaults, a creditor applies to the National Company Law Tribunal (NCLT); an insolvency professional takes over management; a committee of creditors, deciding by 66 per cent of votes, chooses a resolution plan; and if none is approved the company is liquidated. The process should end within 330 days including litigation, a limit set in 2019 that the Supreme Court allows to be exceeded only in exceptional cases, and Section 29A bars defaulting promoters from bidding for their own companies. The Insolvency and Bankruptcy Board of India (IBBI) regulates the system.
• The courts upheld it. In Swiss Ribbons v Union of India (2019) the Supreme Court upheld the constitutional validity of the Code, and in the Essar Steel case (2019) it held that the commercial wisdom of the committee of creditors is not open to judicial review on merits.
• Outcomes. By September 2025 about 1,300 insolvency cases had ended in resolution plans, and creditors had realised roughly a third of their admitted claims, with resolution taking far longer than the legal limit on average (IBBI data, November 2025). The Insolvency and Bankruptcy Code (Amendment) Act 2026, of April 2026, added a creditor initiated insolvency process, in which notified financial creditors can start resolution out of court while management stays in place, and enabled rules for group and cross border insolvency.
• Other recovery tools. Debts Recovery Tribunals (1993), the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act 2002, which lets secured lenders seize collateral without a court, and the National Asset Reconstruction Company Limited (NARCL), set up in 2021 with a government guarantee of Rs 30,600 crore on its security receipts, to take over large bad loans.
• Consolidation. Public sector banks fell from 27 in 2017 to 12 in 2020. The State Bank of India absorbed its associate banks and the Bharatiya Mahila Bank in 2017; Bank of Baroda absorbed Vijaya Bank and Dena Bank in April 2019; and on 1 April 2020 ten banks merged into four, with Oriental Bank of Commerce and United Bank of India joining Punjab National Bank, Syndicate Bank joining Canara Bank, Andhra Bank and Corporation Bank joining Union Bank of India, and Allahabad Bank joining Indian Bank.
• The result. The GNPA ratio of scheduled commercial banks fell to 2.3 per cent in March 2025 (Financial Stability Report, June 2025) and to a fresh low in March 2026 (Financial Stability Report, June 2026).

Issues and way forward

• Recent regulation. The Banking Laws (Amendment) Act 2025 allows up to four nominees on a deposit account, raises the threshold of substantial interest in a bank from Rs 5 lakh to Rs 2 crore and lengthens the tenure of directors of cooperative banks; the RBI has also proposed moving from provisioning on losses already incurred to an expected credit loss approach from April 2027, so that banks provide for likely losses early.
• Governance of public sector banks. Boards still lack full autonomy over appointments and pay; the P J Nayak Committee's proposals, of which the Banks Board Bureau, now the Financial Services Institutions Bureau, was one, remain only partly done.
• Delays in insolvency. Cases take far longer than 330 days because the NCLT has too few benches and members; more benches, specialist members and a working framework for group and cross border insolvency are needed.
• New risks. Unsecured retail loans, lending to non banking financial companies and fraud are the stresses to watch, which is why the RBI raised risk weights on some consumer credit in 2023.

Common confusions

• Gross and net NPA. Gross NPA counts all bad loans; net NPA deducts the provisions already made, so it shows the loss still exposed.
• CRR and CRAR. The cash reserve ratio is a liquidity rule on deposits used for monetary policy; CRAR is a solvency rule that measures the bank's own capital against risky assets.
• IBC and SARFAESI. The IBC resolves the whole company as a going concern through creditors collectively; SARFAESI lets one secured lender enforce its own security.

For the exam

• Keyword bank: non performing asset, twin balance sheet, asset quality review, recognition resolution recapitalisation reform, provision coverage ratio, capital to risk weighted assets ratio, Basel III, capital conservation buffer, prompt corrective action, Insolvency and Bankruptcy Code, committee of creditors, Section 29A, bank consolidation, NARCL, expected credit loss.
• Previous year questions: Practise the previous year questions on this topic →
• Use in an answer:
  • Introduction with data: The gross NPA ratio of India's scheduled commercial banks fell from a peak of 11.2 per cent in March 2018 to 2.3 per cent in March 2025, and lower still in March 2026 (RBI, Financial Stability Reports, 2025 and 2026).
  • Introduction with a judgement: In Swiss Ribbons v Union of India (2019) the Supreme Court upheld the Insolvency and Bankruptcy Code, noting that it moved India from a regime where the debtor stayed in possession to one where creditors take control.
  • Conclusion: India repaired its banks through recognition, resolution, recapitalisation and reform; the task now is to keep governance strong so the next credit boom does not repeat the last.
  • Conclusion: A healthy banking system is measured not only by low bad loans but by how much productive credit it extends to farms, small firms and new industries.