Banking Sector Reform and Regulatory Architecture: Complete Notes

The Indian banking system of 1991 had reach without strength. It was large, state owned, directed in what it charged and whom it lent to, and not required to disclose how much of its loan book was likely to come back. The reform that followed did not change the ownership. It changed the standards: capital against risk, disclosure of asset quality, consequences for falling short, limits on who may own and run a bank, and a measured obligation to reach those the system had left out. These notes cover that architecture, which is the subject matter of almost every policy question in Indian banking regulation.

Figure 1: Four layers of the reformed architecture

1. The reform and the committees

Figure 2: What changed between 1991 and now

The Narasimham Committee, 1991

The Committee on the Financial System, chaired by M. Narasimham, reported in November 1991. Its diagnosis was that the system was not short of resources but was prevented from using them, and that it could not be judged because its accounts did not disclose its condition.

• Reduce the statutory liquidity ratio to twenty five per cent and the cash reserve ratio substantially, from 38.5 and 15 per cent.
• Deregulate interest rates and phase out directed credit.
• Introduce prudential norms on income recognition, asset classification and provisioning, and capital adequacy on the Basel pattern.
• Restructure into four tiers: three or four international banks, eight or ten national banks, local banks and rural banks.
• Create an Asset Reconstruction Fund and special tribunals for recovery.
• Abolish branch licensing, permit new private banks, end dual control by the Reserve Bank and the Ministry of Finance, and place supervision in a separate quasi-autonomous body.

The Committee on Banking Sector Reforms, 1998

• Raise capital adequacy to nine and then ten per cent, and assign a risk weight to government guaranteed advances.
• Bring gross non-performing assets to three per cent and net to nil, and move from the one hundred and eighty day norm towards ninety days.
• Create asset reconstruction companies, which produced the securitisation statute of 2002.
• Merge strong banks with strong banks, and expressly not a weak bank into a strong one. Apply narrow banking to weak banks.
• Reduce the Government's shareholding, and separate the Reserve Bank's ownership from its regulation by divesting its holdings in institutions it regulates.

The Mor Committee, reporting in January 2014, produced the differentiated licence and the idea of an account for every adult; the Nayak Committee of 2014 recommended repealing the constituting statutes of public sector banks, incorporating them under the general company law, and transferring the Government's holding to a Bank Investment Company at arm's length.

The honest assessment is that the prudential agenda was carried out and the structural agenda was not. Reserve requirements fell, rates were deregulated, classification and provisioning became binding, capital adequacy was introduced and raised, branch licensing went, and supervision was separated. Directed credit was not reduced but expanded, the Government's holding has not fallen below the statutory floor of fifty one per cent, and public sector banks remain creatures of their own statutes.

Figure 3: The sequence of reform and of its instruments

2. Capital adequacy and the Basel framework

Capital is not cash. It is a claim ranking behind every other claim, so that loss falls on the shareholder before the depositor. It is measured against risk weighted assets rather than total assets, which is the insight that distinguishes the Basel framework from a simple gearing limit, and the leverage ratio was later added precisely because that insight can be gamed.

• Basel I, 1988: eight per cent, credit risk alone, five risk weights from nought to one hundred per cent, with market risk added in 1996.
• Basel II, 2004: the three pillars, being the minimum requirement, supervisory review and market discipline, with a charge for operational risk and a choice between standardised and internal ratings based approaches.
• Basel III, 2010: better quality capital, buffers, a leverage ratio and, for the first time, liquidity standards.
• The final reforms, 2017: revised standardised approaches, constraints on internal models and an output floor. India adopts them for credit and market risk from 1 April 2027.

• The capital conservation buffer is meant to be usable: a bank may dip into it, at the price of progressively tighter restrictions on distributing profit and paying bonuses.
• The countercyclical capital buffer framework exists but has not been activated.
• A domestic systemically important bank carries additional Common Equity Tier 1 from 0.20 per cent in the first bucket to 1.00 per cent in the fifth, under a framework of 22 July 2014 fully effective from 1 April 2019.
• The liquidity coverage ratio requires high quality liquid assets against thirty days of stressed outflow, and the net stable funding ratio matches funding to assets over a year, both at one hundred per cent.

Prompt corrective action

Revised on 2 November 2021 and effective from 1 January 2022, for scheduled commercial banks other than small finance banks, payments banks and regional rural banks. The parameters are capital, net non-performing assets and leverage, each with three risk thresholds. The return on assets trigger was removed. Mandatory actions begin with restrictions on dividends and rise through limits on branch expansion and capital expenditure; discretionary actions extend to resolution under Section 45. Exit requires four consecutive quarterly statements without a breach, one of them audited.

3. Ownership, control and licensing

• Section 12(2) caps voting rights at ten per cent, with a proviso permitting the Reserve Bank to raise it in stages to twenty six per cent. Shareholding and voting rights are capped separately and may diverge.
• Section 12B requires the previous approval of the Reserve Bank before a person acquires shares or voting rights beyond the prescribed percentage, and requires that the person be fit and proper.
• Section 36AA permits removal of a chairman, director or officer; Section 36ACA permits supersession of the board.

On tap licensing of universal banks, 1 August 2016

• Eligible promoters: residents with ten years at a senior level in banking and finance; resident controlled entities, groups and non-banking financial companies with a ten year record.
• Large industrial houses are excluded as promoters. A group with assets of fifty billion rupees or more is ineligible if non-financial business is forty per cent or more of assets or gross income, though such a group may invest up to ten per cent.
• Five hundred crore rupees of paid up voting equity capital, with net worth never below it.
• A non-operative financial holding company where the promoter has other group entities, the promoter group holding at least fifty one per cent of it.
• Promoter holding at least forty per cent, locked in five years, diluting to fifteen per cent within fifteen years; aggregate foreign investment seventy four per cent; listing within six years; priority sector targets as for a domestic scheduled commercial bank; and at least one branch in four in unbanked rural centres.

The shareholding framework of 16 January 2023

Major shareholding is five per cent or more, requiring prior approval, and fresh approval if it lapses below that line. A person from a jurisdiction found non-compliant by the Financial Action Task Force may not acquire it. Promoters are capped at twenty six per cent once fifteen years have passed. Non-promoter ceilings are ten per cent and fifteen per cent by category. The Internal Working Group of 2020 had recommended permitting large corporate and industrial houses as promoters after statutory amendment; the Reserve Bank did not accept that recommendation in November 2021, though it accepted the increase in the promoter cap.

4. Corporate governance

Governance matters more in a bank because the shareholders supply a small fraction of the money at risk and the depositors supply the rest without a vote, a seat or information. The Reserve Bank's instructions of 26 April 2021 apply to private sector banks including small finance banks and wholly owned subsidiaries of foreign banks, not to foreign bank branches, and to public sector banks only so far as not inconsistent with their constituting statutes. Compliance was required by 1 October 2021.

• The chair of the board must be an independent director. The quorum is one third or three, whichever is higher, and at least half those present must be independent.
• The Audit Committee has only non-executive directors, meets quarterly, and its chair may not sit on a committee that sanctions credit exposures. The Risk Management Committee has a majority of non-executive directors and meets quarterly. The Nomination and Remuneration Committee has only non-executive directors and may not be chaired by the chair of the board.
• A chief executive or whole time director: upper age seventy, maximum tenure fifteen years, and twelve years where he is a promoter or major shareholder, extendable to fifteen at the Reserve Bank's sole discretion, with a three year cooling off covering group entities.
• A non-executive director: upper age seventy five, total tenure eight years, a three year gap before re-appointment, and fixed remuneration of up to thirty lakh rupees a year besides sitting fees, the ceiling having been raised from twenty lakh on 9 February 2024.
• Variable pay is capped as a proportion of fixed pay, partly deferred, partly in non-cash instruments, and subject to malus and clawback.

5. Financial inclusion

Inclusion has three dimensions and the distinction between them is the central idea: access, whether a person can obtain an account and a channel; usage, whether he actually uses them; and quality, whether what he uses is suitable, fairly priced and protected by a remedy.

• The Lead Bank Scheme of 1969 makes one bank responsible for coordinating credit in each district.
• The basic savings bank deposit account, recast in 2012, has no minimum balance, no charge for non-maintenance or activation, a card at no cost and at least four free withdrawals a month. From 1 April 2026 digital payments do not count towards those withdrawals, and a person may hold only one such account across all banks.
• The business correspondent model, permitted from January 2006, lets a bank appoint agents to transact at the customer's location. The bank remains responsible for the correspondent's acts. The distance restriction was removed on 24 June 2014.
• The Pradhan Mantri Jan Dhan Yojana, launched 28 August 2014, made the account the vehicle for the direct transfer of benefits, which is what solved the usage problem.
• The Financial Inclusion Index, launched 17 August 2021, runs from nought to one hundred on ninety seven indicators, weighted access thirty five, usage forty five and quality twenty per cent, published each July. Values: 43.4 in March 2017, 53.9 in March 2021, 60.1 in March 2023, 67.0 in March 2025 and 70.0 in March 2026.
• The National Strategy for Financial Inclusion, 2025 to 2030, released on 1 December 2025, carries five objectives and forty seven action points.
• Priority sector targets are forty per cent for commercial banks, seventy five per cent for regional rural banks, and sixty per cent for urban cooperative banks and, from the financial year 2025-26, for small finance banks.
• The Charter of Customer Rights of December 2014 states five rights: fair treatment, transparency and fair and honest dealing, suitability, privacy, and grievance redress and compensation.
• The microfinance framework of 14 March 2022 is activity based: a collateral free loan to a household with annual income up to three lakh rupees, with the household's monthly repayment obligations across all lenders capped at fifty per cent of monthly household income, and no prepayment penalty.

6. Quick Revision

1. Both Narasimham Committees were chaired by the same former Governor, in 1991 and 1998.
2. The prudential agenda was implemented; the ownership and structural agenda was not.
3. Capital is a residual claim measured against risk weighted assets, and the leverage ratio is the backstop.
4. The conservation buffer is usable at the price of restrictions on distribution.
5. Additional Tier 1 absorbs loss while the bank is a going concern, which is why the Yes Bank write down was possible and why its legality turned on the terms of the scheme.
6. Shareholding and voting rights are capped separately.
7. Large industrial houses may invest up to ten per cent but may not promote a bank.
8. The chair of the board must be independent, and the chair of the audit committee may not sanction credit.
9. A promoter chief executive is capped at twelve years, not fifteen.
10. Access, usage and quality are three different things, and the index weights usage highest.
11. The bank, not the correspondent, answers to the customer.

7. Frequently Asked Questions

Why did the reform make Indian banking sound without making it private?

Because the two objectives were separable and only one commanded agreement. The prudential recommendations, on disclosure, classification, provisioning, capital and supervision, could be implemented by the regulator and were not contested in principle. The structural recommendations, on reducing the Government's shareholding below fifty one per cent, on incorporating public sector banks under the general company law and on phasing out directed credit, required legislation and amounted to a decision about what public sector banking is for. Successive governments have taken the view that the banking system is the only machinery with the reach to deliver credit to agriculture, small enterprise and weaker sections, and have therefore kept both ownership and direction. The outcome is coherent rather than merely unfinished.

Does a higher capital ratio always mean a safer bank?

No, for reasons that are structural. The ratio depends on the denominator, which is risk weighted assets, and risk weights are either prescribed or, where internal models are allowed, estimated by the bank whose capital they determine. A bank may show a comfortable ratio while holding assets whose risk is understated, which is what the final Basel reforms and the output floor respond to. The ratio also says nothing about liquidity: a solvent bank can fail because its funding runs before its assets mature, which is why the liquidity coverage and net stable funding ratios exist. Capital must therefore be read together with asset quality, provisioning coverage, leverage and the liquidity standards.

Why are large industrial houses kept out of bank promotion?

Because an owner who is also a borrower cannot be supervised into impartiality. The risk is not that a loan will be made dishonestly but that it will be made on terms no unconnected borrower would get, appraised by people the borrower appoints, and that each such transaction will be individually defensible while the aggregate is ruinous. The contrary case is real: Indian banking needs equity at a scale few domestic sources can supply, and a prohibition pushes the same groups into lending through non-banking financial companies where supervision is lighter. The Internal Working Group of 2020 took the second view subject to statutory amendment; the Reserve Bank did not accept it.

Why is a promoter chief executive capped at twelve years rather than fifteen?

Because the discipline that constrains a professional does not operate on a promoter. A professional chief executive serves at the pleasure of a board that can decline to re-appoint him. A promoter who is also chief executive is the dominant shareholder of the company whose board would have to remove him, so the probability of that happening is low and a fixed limit is the only effective constraint. The Reserve Bank retained a discretion to extend to fifteen years so that a well run institution is not disrupted, and the three year cooling off that follows is drawn widely enough to cover group entities, so that the departure is real.

Has financial inclusion in India been achieved?

In payments, very nearly; in credit, not yet. The Financial Inclusion Index rose from 43.4 in March 2017 to 70.0 in March 2026, accounts are opened without a minimum balance, benefits are transferred directly, and a person with a telephone can move money at negligible cost. What has not followed is formal credit. A household can receive and spend money formally and still have no borrowing record, and a lender with neither record nor collateral has nothing to lend against, which returns the household to informal credit at informal rates. Closing that gap, rather than opening further accounts, is what the strategy for 2025 to 2030 is directed at.

Why is capital regulated as a ratio rather than as an amount?

Because the question a supervisor needs answered is not how much capital a bank has but whether it has enough for what it is doing. A fixed amount would be crushing for a small bank and trivial for a large one, and it would create no incentive to manage the asset side at all. Expressing the requirement as a ratio to risk weighted assets ties the capital to the risk the bank has chosen to take, so that a bank which lends into riskier segments must hold more, and a bank which grows must raise capital as it grows. The cost of the design is that everything then depends on the risk weights, which is why the leverage ratio was added as a weight blind backstop and why the final Basel reforms constrain the models that produce the weights.

8. Related Topics and Provisions

• Non-performing assets: classification and provisioning
• Public sector banks and the statutes that constitute them
• Priority sector lending and directed credit
• Management of banking companies and removal of directors
• Financial stability, systemically important banks and the resolution gap
• Small finance banks and payments banks
• The Reserve Bank Integrated Ombudsman Scheme, 2026