Indian financial system and banking reforms

In short

The Indian financial system is the network of institutions (banks, NBFCs, insurers, pension and mutual funds), markets (money, capital, G-sec, forex), instruments and regulators that moves savings into investment. Banking is its core: the RBI regulates it under the RBI Act, 1934 and the Banking Regulation Act, 1949, and reforms since 1991 have moved it from an administered, directed-credit system to a prudentially regulated, competitive and largely digital one. The topic matters because bank credit and the payment system transmit monetary policy to the real economy, and because bad-loan cycles have repeatedly determined India's growth. It is examined in BA/MA Economics papers, UGC-NET, RBI Grade B, NABARD, SEBI and IBPS/SBI exams, and asked in interviews for banking, credit, risk, treasury, fintech and policy-research roles.

Explained

Structure of the Indian financial system

• Four components: financial institutions (intermediaries), financial markets, financial instruments (assets) and financial services (broking, rating, custody, advisory).
• Organised vs unorganised: the organised sector is regulated (banks, NBFCs, insurers); the unorganised includes moneylenders, chit funds and indigenous bankers (shroffs) — still significant in rural credit.
• Banking institutions: scheduled commercial banks — 12 public sector banks (down from 27 in 2017 after the mergers effective 1 April 2020), private banks, foreign banks, small finance banks, payments banks, and Regional Rural Banks (consolidated to 28 under "One State, One RRB" from 1 May 2025); plus urban and rural co-operative banks (dual control of RBI and the state registrar, tightened by the 2020 amendment).
• Non-bank institutions: NBFCs, housing finance companies, all-India financial institutions (NABARD, SIDBI, NHB, EXIM Bank, NaBFID set up in 2021 for infrastructure), insurers, mutual funds, pension funds.
• Markets: *money market* — call/notice money, treasury bills, commercial paper, certificates of deposit, repo and TREPS (up to 1 year); *capital market* — equity, corporate bonds, G-secs (dated securities, SDLs); plus forex and derivatives markets.
• Regulators: RBI (banks, NBFCs, payment systems, forex, monetary policy), SEBI (securities), IRDAI (insurance), PFRDA (pensions), IBBI (insolvency), with the FSDC (2010, chaired by the Finance Minister) coordinating systemic-risk oversight.

Functions of the RBI and instruments of control

• Functions: note issue (minimum reserve system — ₹200 crore of gold and foreign securities, of which ₹115 crore in gold); banker to government and to banks; lender of last resort; custodian of foreign exchange (FEMA, 1999); regulation and supervision; monetary policy; developmental and promotional roles.
• Quantitative tools: CRR (cash with RBI as a percentage of net demand and time liabilities, no interest paid), SLR (minimum holding of government and other approved securities, currently 18% of NDTL), open market operations, the liquidity adjustment facility — repo rate (policy rate), SDF (standing deposit facility, which replaced the reverse repo as the floor in April 2022) and MSF as the ceiling, forming a corridor of about ±25 basis points around the repo. CRR was reduced in phases during 2025 to 3% of NDTL; CRR, SLR and the repo change frequently, so verify the current figure before quoting.
• Qualitative tools: margin requirements, selective credit control, moral suasion, directives on sectoral exposure and risk weights.
• Monetary policy framework: a statutory flexible inflation targeting regime since the RBI (Amendment) Act, 2016 — a six-member MPC (3 RBI, 3 government-nominated, Governor has a casting vote) meets at least four times a year and targets CPI inflation of 4% with a ±2% band; failure for three consecutive quarters requires a report to the Central Government (Section 45ZN). The target is notified for five-year blocks (the 2021–26 block was due for renewal in 2026 — the 4% ±2% target has been retained in practice, but confirm the current notification).
• Transmission: administered rates → prime lending rate (1994) → BPLR (2003) → base rate (2010) → MCLR (2016) → EBLR (external benchmark-linked lending rate, mandatory for new floating-rate retail and MSME loans from 1 October 2019, usually repo-linked and reset at least quarterly).

Banking reforms: phases and committees

1. 1949–1969 — consolidation: Banking Regulation Act, 1949; RBI nationalised 1949; Imperial Bank became SBI (1955); deposit insurance (DICGC, 1961); social control (1967).
2. 1969–1991 — social banking: 14 banks nationalised in 1969 (deposits above ₹50 crore), 6 more in 1980; lead bank scheme, branch licensing with rural-branch obligations, priority sector lending, RRBs (1975), NABARD (1982). Result: huge branch and deposit expansion but low profitability, SLR up to 38.5% and CRR 15% (pre-emption of nearly half of deposits), no transparent bad-loan recognition.
3. 1991 — Narasimham Committee I: phased reduction of SLR to 25% and CRR to 10%; deregulation of interest rates; prudential norms — IRAC (income recognition, asset classification and provisioning) and 8% capital adequacy; a four-tier banking structure; entry of private banks; abolition of branch licensing; Board for Financial Supervision (1994); Debt Recovery Tribunals under the RDDBFI Act, 1993.
4. 1998 — Narasimham Committee II: capital adequacy to 9%, net NPAs below 3%, stronger supervision, merger of strong banks, greater operational autonomy, reduction of government stake, two-tier structure of a few global banks and many local banks.
5. Legal and structural reforms: SARFAESI Act, 2002 (secured creditors can enforce security without court intervention, 60-day notice; creation of ARCs; the Securitisation and Reconstruction route); CIBIL/credit information companies under the CICRA, 2005; Insolvency and Bankruptcy Code, 2016 (creditor-in-control, 180+90 days, outer limit 330 days including litigation, resolution plan needs 66% of the Committee of Creditors; waterfall under Section 53).
6. Governance and recapitalisation: P. J. Nayak Committee (2014) on PSB governance → Banks Board Bureau, now the Financial Services Institutions Bureau (2022); Indradhanush (2015); Asset Quality Review (2015–16) that exposed hidden NPAs; the 4R strategy — Recognition, Resolution, Recapitalisation, Reform; recapitalisation bonds; mega-merger of 10 PSBs into 4 from 1 April 2020; IDBI Bank reclassified as a private bank after LIC took majority stake, with strategic sale in progress.
7. Current-generation reforms: Basel III implementation; revised Prompt Corrective Action framework (effective 1 January 2022, triggers on CET1/CRAR, net NPA and leverage ratio); NARCL and IDRCL ("bad bank", 2021) for aggregating large stressed assets; scale-based regulation of NBFCs (Base, Middle, Upper and Top layers, from October 2022); the Banking Laws (Amendment) Act, 2025, which allows up to four nominees per deposit account, raises the "substantial interest" threshold from ₹5 lakh to ₹2 crore and aligns reporting fortnights.

Prudential norms, asset quality and capital

• Asset classification: *standard*; SMA-0/1/2 (special mention: principal or interest overdue 1–30, 31–60, 61–90 days) as an early-warning stage; NPA when interest or principal is overdue for more than 90 days (for agriculture, two crop seasons for short-duration crops and one for long-duration); *sub-standard* (NPA up to 12 months); *doubtful* D1/D2/D3 (sub-standard for over 12 months, by age); *loss asset* (identified as unrecoverable).
• Provisioning (minimum, RBI IRAC): standard assets 0.25%–1% by sector; sub-standard 15% (25% if unsecured); doubtful — 25%/40%/100% on the secured portion by age and 100% unsecured; loss assets 100%. The RBI has proposed a move to expected credit loss (ECL) provisioning with a glide path — treat the switchover date as not yet fully operative.
• Resolution: the 7 June 2019 Prudential Framework for Resolution of Stressed Assets replaced CDR, SDR, S4A and the 12 February 2018 circular (struck down in *Dharani Sugars*); a 30-day review period and an inter-creditor agreement, with additional provisions for delay.
• Basel III in India: minimum total CRAR 9% (above Basel's 8%) plus a capital conservation buffer of 2.5% → 11.5% effective; Tier 1 at 7% and CET1 at 5.5% (8% with the buffer); leverage ratio 4% for domestic systemically important banks and 3.5% for others; LCR ≥ 100% and NSFR ≥ 100%; D-SIB surcharge (SBI, HDFC Bank and ICICI Bank are the notified D-SIBs; the bucket list is reviewed annually). Tier 1 is equity, reserves and perpetual debt; Tier 2 is subordinated debt, revaluation reserves and general provisions.
• Priority sector lending: 40% of Adjusted Net Bank Credit for domestic banks — agriculture 18% (10% to small and marginal farmers), micro enterprises 7.5%, weaker sections 12%; 75% for RRBs and small finance banks; shortfall goes to RIDF with NABARD and other funds; PSLCs allow trading of surplus achievement. Categories include MSME, education, housing, renewable energy, social infrastructure and export credit.
• Depositor protection: DICGC insures deposits up to ₹5 lakh per depositor per bank (raised from ₹1 lakh in 2020), payable within 90 days when a bank is under an all-inclusive direction.

Financial inclusion, payments and digital finance

• Inclusion architecture: no-frills/BSBDA accounts, business correspondents, PMJDY (2014, over 55 crore accounts), Aadhaar-enabled e-KYC and DBT, JAM trinity, PMJJBY/PMSBY/APY, MUDRA loans, Stand-Up India, self-help group bank linkage, and the Financial Inclusion Index published annually by the RBI.
• Differentiated banks: payments banks (deposits up to ₹2 lakh per customer, no lending, must invest in SLR securities) and small finance banks (75% PSL, 50% of the loan book below ₹25 lakh) — both from the 2014–15 licensing guidelines, with on-tap licensing since 2016/2019.
• Payment systems: NPCI-operated UPI (now the world's largest retail real-time system, running at roughly 18–20 billion transactions a month in 2025–26 and still growing), IMPS, AePS, NACH, RuPay, FASTag, Bharat BillPay; RBI-operated RTGS (large value, 24×7 since December 2020) and NEFT; cheque truncation.
• New layers: Account Aggregator framework for consent-based data sharing, CBDC (digital rupee, e₹) in retail and wholesale pilots since 2022, co-lending and digital lending guidelines (2022), tokenisation of cards, the Unified Lending Interface pilot, and regulatory sandboxes.

Performance, achievements and continuing problems

• Achievements: gross NPAs of scheduled commercial banks fell from a peak of about 11.2% (March 2018) to multi-decade lows near 2.5–3% by 2024–25, with capital adequacy around 16–17%, record PSB profits and near-universal account ownership. Verify the latest numbers from the RBI's *Financial Stability Report* and *Report on Trend and Progress of Banking in India*.
• Problems: twin balance-sheet legacy and concentration of large exposures; low financial depth relative to peers; a shallow corporate bond market; crowding out by government borrowing through SLR; weak co-operative-bank governance (PMC, 2019) and NBFC contagion (IL&FS, 2018; DHFL); credit–deposit mismatch and rising unsecured retail credit; slow and partial monetary transmission; cyber and third-party risk; recurrent demands for PSB privatisation versus the social-banking mandate.

Key points

• Financial system - institutions, markets, instruments and services that channel savings into investment.
• Banking Regulation Act, 1949 - the RBI's principal licensing, branch, capital and management-control powers over banks.
• Nationalisation - 14 banks in 1969 and 6 in 1980; expanded rural banking but eroded efficiency and asset quality.
• Narasimham I (1991) - prudential norms, 8% CAR, lower CRR/SLR, private entry, free branch licensing.
• Narasimham II (1998) - 9% CAR, net NPA under 3%, consolidation, autonomy, lower government stake.
• CRR - cash reserve with the RBI, uninterest-bearing; SLR - approved securities (18% of NDTL), earns interest.
• MSF and SDF - ceiling and floor of the LAF corridor; the repo in the middle is the single policy rate.
• Flexible inflation targeting - MPC targets CPI 4% ±2% under the RBI (Amendment) Act, 2016.
• EBLR - floating retail and MSME loans linked to an external benchmark since October 2019, for faster transmission.
• NPA - 90 days overdue; SMA-0/1/2 are the pre-NPA warning buckets.
• Basel III India - CRAR 9% + CCB 2.5%, CET1 5.5%, LCR and NSFR at 100%.
• SARFAESI, 2002 - enforcement of security interest without court; IBC, 2016 - time-bound creditor-driven resolution.
• PCA framework - RBI's graded restrictions when CET1, net NPA or leverage breaches thresholds.
• PSL - 40% of ANBC (75% for RRBs and SFBs); shortfall parked in RIDF; PSLCs allow trading.
• DICGC cover - ₹5 lakh per depositor per bank.
• Differentiated banking - payments banks (deposit-only, ₹2 lakh cap) and small finance banks (75% PSL).
• 4R strategy - Recognition (AQR), Resolution (IBC), Recapitalisation, Reform.
• Twin balance-sheet problem - simultaneously stressed corporate and bank balance sheets, the core diagnosis of 2013–18.

Formulas and examples

Example 1 — reserve pre-emption and credit creation. A bank receives primary deposits of ₹1,000 crore. CRR = 3%, SLR = 18%.

• CRR held = 0.03 × 1,000 = ₹30 crore; SLR securities = 0.18 × 1,000 = ₹180 crore; immediately loanable = ₹790 crore.
• Reserve fraction r = 0.03 + 0.18 = 0.21 → credit multiplier = 1/0.21 = 4.76.
• Total deposits the system can build = 1,000 / 0.21 = ₹4,762 crore; credit created = 4,762 − 1,000 = ₹3,762 crore.
• In reality India's money multiplier (M3/M0) is only about 5.0–5.5, because of currency leakage, excess reserves and demand for cash.

Example 2 — capital adequacy. A bank has Tier 1 capital ₹9,000 crore (of which CET1 ₹8,000 crore), Tier 2 ₹3,000 crore, and risk-weighted assets ₹1,00,000 crore.

• CRAR = (9,000 + 3,000)/1,00,000 × 100 = 12% → above the 11.5% requirement (9% + 2.5% buffer).
• Tier 1 ratio = 9% (minimum 7%); CET1 = 8% — exactly the 5.5% + 2.5% buffer minimum, so there is no cushion on CET1: any loss would trigger restrictions on dividends and bonuses.
• If RWA rise to ₹1,20,000 crore with no fresh capital, CRAR = 12,000/1,20,000 = 10%, below 11.5% → the bank must raise capital or shrink risk assets.

Example 3 — asset quality. Gross advances ₹50,000 crore, gross NPAs ₹2,000 crore, provisions held against NPAs ₹1,200 crore.

• GNPA ratio = 2,000/50,000 × 100 = 4.0%.
• Net NPAs = 2,000 − 1,200 = ₹800 crore; net advances = 50,000 − 1,200 = ₹48,800 crore → NNPA ratio = 800/48,800 × 100 = 1.64%.
• PCR = 1,200/2,000 × 100 = 60%. A high PCR with the same GNPA means the losses are already absorbed — which is why PCR, not GNPA alone, tells you the residual risk.

Example 4 — profitability. Interest earned ₹8,000 crore, interest expended ₹5,000 crore, average earning assets ₹1,00,000 crore, net profit ₹1,100 crore on average total assets ₹1,10,000 crore.

• NIM = (8,000 − 5,000)/1,00,000 × 100 = 3.0% (Indian banks typically 2.5–4%).
• ROA = 1,100/1,10,000 × 100 = 1.0% — the conventional benchmark of a healthy bank.

Example 5 — monetary transmission through EBLR. A ₹50 lakh home loan for 20 years at repo 5.50% + spread 2.75% = 8.25% (illustrative rates; the repo changes with MPC decisions).

• i = 8.25/1200 = 0.006875, n = 240 → EMI ≈ ₹42,600.
• The MPC cuts the repo by 25 bps; at the next reset the rate becomes 8.00%: i = 0.0066667 → EMI ≈ ₹41,820, a saving of about ₹780 a month.
• The same cut on an MCLR loan would reach the borrower only at the annual reset — the reason EBLR was mandated.

Where it is used

• Banking and credit roles: credit analysts and relationship managers in SBI, HDFC Bank, ICICI Bank and Axis Bank apply IRAC classification, PSL tagging and CRAR-driven pricing on every proposal.
• Risk, treasury and compliance: Basel III capital and liquidity computation, ALM and LCR reporting, CRR/SLR maintenance, RBI returns under the ADF/CIMS reporting system.
• Policy and research: RBI, NABARD, SEBI, NITI Aayog, Finance Ministry and rating agencies (CRISIL, ICRA, CARE) analyse credit growth, transmission and NPA cycles; the RBI's *Financial Stability Report* and *Trend and Progress* are the standard sources.
• Insolvency and recovery: insolvency professionals, ARCs, NARCL, DRT and NCLT practice, stressed-asset funds.
• Fintech and payments: NPCI, PhonePe, Paytm, Razorpay, Account Aggregators and digital lenders work inside RBI's payment-system, co-lending, digital-lending and data-consent rules.
• Microfinance and inclusion: SFBs (Ujjivan, Equitas), NBFC-MFIs, SHG-bank linkage and business-correspondent networks delivering PMJDY, MUDRA and DBT.

Interview questions

• Q: What is the difference between CRR and SLR? A: CRR is cash kept with the RBI earning nothing; SLR is a minimum holding of government and other approved securities that stays on the bank's books and earns interest, so it also funds government borrowing.
• Q: When does a loan become an NPA in India? A: When interest or principal is overdue for more than 90 days (two crop seasons for short-duration agricultural loans); it then moves through sub-standard, doubtful and loss categories.
• Q: Why was EBLR introduced when MCLR already existed? A: MCLR was internally computed and reset annually, so policy cuts reached borrowers slowly; EBLR links the loan to an external benchmark such as the repo with a reset at least quarterly, improving transmission.
• Q: What did Narasimham Committee I change most fundamentally? A: It replaced directed, administered banking with prudential regulation — income recognition and asset classification norms, capital adequacy, lower CRR/SLR and competitive entry.
• Q: What is the twin balance-sheet problem? A: Over-leveraged corporates after the 2003–08 investment boom could not service debt, which simultaneously impaired bank balance sheets, so both stopped investing and lending.
• Q: How does SARFAESI differ from the IBC? A: SARFAESI lets a secured creditor enforce its own security outside court; the IBC is a collective, time-bound process in which the Committee of Creditors decides on resolution or liquidation of the whole entity.
• Q: Can a payments bank give loans? A: No. It takes deposits up to ₹2 lakh per customer, offers payments and remittances, and must park funds in SLR securities and bank deposits.
• Q: What triggers Prompt Corrective Action? A: Breach of thresholds on CET1/capital adequacy, net NPAs or the leverage ratio; the RBI then restricts dividends, branch expansion, lending and, at severe levels, management itself.
• Q: Is a high CRAR always good? A: Not necessarily — it protects depositors but excess capital held idle lowers return on equity, and a high ratio can also mean the bank is not lending.
• Q: Why does the RBI hold the SLR at 18% when banks voluntarily hold far more G-secs? A: It serves liquidity and depositor-protection purposes and assures demand for government paper; critics argue it crowds out private credit, which is why it has been cut from 38.5%.
• Q: What is the inflation target and who sets it? A: 4% CPI with a ±2% tolerance band, notified by the Central Government in consultation with the RBI for five-year periods and implemented by the MPC.
• Q: Should PSBs be privatised? A: Defensible both ways — privatisation can improve efficiency and remove the fiscal recapitalisation burden, but PSBs carry the inclusion, DBT and counter-cyclical lending mandate; the government has so far chosen consolidation plus selective divestment (IDBI).

Common mistakes

• Treating SLR as money locked away: SLR securities are interest-earning assets on the bank's own balance sheet, unlike CRR.
• Computing the net NPA ratio on gross advances — the denominator must also be net of provisions.
• Confusing the deposit multiplier (1/r, a textbook maximum) with India's actual money multiplier of about 5, and forgetting currency leakage.
• Saying CRAR uses total assets; it uses risk-weighted assets, so the asset mix matters as much as the size.
• Mixing up the committees — Narasimham (banking), Chakravarty (monetary system), Urjit Patel (inflation targeting), Nachiket Mor (differentiated banks), P. J. Nayak (PSB governance).
• Quoting the repo rate, CRR or GNPA figure from memory; these change at every policy review, so state the date or say the figure needs verification.
• Writing that the reverse repo is the floor of the corridor — the SDF has been the floor since April 2022.
• Claiming the IBC must finish in 180 days — 180 + 90 days extendable, with an outer limit of 330 days including litigation, and actual cases often run longer.

Related topics

Economic reforms since 1991 · Federal finance and GST · Indian economy basics · Planning in India and NITI Aayog · Indian agriculture: policy and challenges · Poverty, inequality and employment in India