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The banking system: kinds of banks, bad loans and priority sector lending

Money and banking · Part 2 / 2 · Fact-checked on 21 October 2026 · how we check

Written with AI from the sources listed at the bottom of this page, then fact-checked by a separate AI.

How Indian banking is regulated and organised, nationalisation (1949, 1955, 1969, 1980) and the 2020 mergers, regional rural banks, payments and small finance banks, DICGC deposit insurance, the definition and grading of NPAs, the bad-loan cycle and its laws (DRTs, SARFAESI, IBC), and priority sector lending with its 2025 targets and certificates.

Part 1 showed how banks multiply money by lending. This part looks at the banks themselves. It sets out how Indian banking is organised and regulated, how it grew from a handful of private banks into a system shaped by nationalisation and later by reforms, and which new kinds of banks have been added to reach people that ordinary banks missed. It then turns to two issues that Prelims returns to again and again. The first is the bad loan, or non-performing asset: how it is defined, why bad loans piled up in the 2010s and which laws were built to recover them. The second is priority sector lending, the rule that steers a fixed share of bank credit to agriculture, small enterprises and weaker sections. Deposit insurance, which protects small savers if a bank fails, completes the picture.

Banks in India are governed mainly by the Banking Regulation Act, 1949, which the RBI administers. It decides who may carry on banking, licenses new banks and branches, and supervises how banks are run. A bank listed in the Second Schedule to the RBI Act, 1934 is a scheduled bank. To be included, a bank must meet the RBI's conditions on capital and on conducting its affairs soundly; in return it can borrow from the RBI and must keep the CRR with it under section 42. Banks fall into two broad families. Commercial banks are companies or statutory bodies run for profit; cooperative banks are owned by their members and long faced dual control by the RBI and state registrars of cooperative societies, which the Banking Regulation (Amendment) Act, 2020 reduced by giving the RBI wider powers over them.

Commercial banks themselves come in several kinds. Public sector banks are those in which the government holds the majority, such as the State Bank of India and the nationalised banks. Private sector banks are owned mainly by private shareholders; a wave of new private banks was licensed from the 1990s after the reforms that followed the Narasimham Committee (1991). Foreign banks operate in India through branches or wholly owned subsidiaries. regional rural banks were created to bring credit to small farmers, rural artisans and labourers: the first were set up on 2 October 1975 and the Regional Rural Banks Act, 1976 now governs them, with their share capital held by the Central Government (50 per cent), a sponsor bank (35 per cent) and the state government (15 per cent). Two newer kinds, payments banks and small finance banks, are described below; the table compares them.

The shape of Indian banking owes much to nationalisation. The RBI, set up in 1935 as a shareholder-owned bank, was nationalised on 1 January 1949. The Imperial Bank of India became the State Bank of India on 1 July 1955. On 19 July 1969 the government nationalised the 14 largest private banks, each with deposits of ₹50 crore or more, and on 15 April 1980 six more, each with deposits of ₹200 crore or more. The aim was social banking: to carry branches into villages, to end the concentration of credit in a few business houses, and to direct loans to farmers and small producers. Branch networks and rural deposits grew fast, but over time directed lending, high reserve requirements and weak management hurt profits. The reforms of the 1990s responded with prudential norms, new private banks and more freedom on interest rates. Consolidation followed: after mergers between 2017 and 2020, the number of public sector banks fell to 12 from 1 April 2020.

To reach people whom full-service banks found too costly to serve, the RBI issued guidelines in November 2014 for two kinds of differentiated banks and gave in-principle approvals in 2015. A payments bank may accept savings and current account deposits, issue debit cards, handle remittances and sell simple third-party products such as insurance, but it cannot lend or issue credit cards. Its deposits are capped per customer, a limit the RBI raised from ₹1 lakh to ₹2 lakh in 2021, and it must park most of its funds in safe government securities; the idea is a cheap, safe place for migrant workers and small savers to keep and send money. A small finance bank does both deposits and loans, but its business is aimed at small borrowers: small and marginal farmers, micro and small enterprises and the unorganised sector. It must lend a large share of its credit to the priority sector, and at least half of its loan book must consist of loans of up to ₹25 lakh.

Because a bank lends out most of what it receives, depositors need protection if it fails. That is the job of deposit insurance, provided by the Deposit Insurance and Credit Guarantee Corporation (DICGC), a wholly owned subsidiary of the RBI set up under the DICGC Act, 1961. It insures deposits in savings, current, fixed and recurring accounts with commercial banks, including regional rural banks, small finance banks and payments banks, and with cooperative banks. Since 4 February 2020 the cover is ₹5 lakh per depositor in each bank, counting principal and interest together; it was ₹1 lakh before that. Banks, not depositors, pay the premium. Suppose a family has ₹7 lakh in one bank that fails: ₹5 lakh is insured, and the rest depends on what is recovered from the bank's assets.

A loan stops earning for the bank when the borrower stops paying. Under the RBI's prudential norms a term loan becomes a non-performing asset (NPA) when interest or an instalment of principal remains overdue for more than 90 days; this 90-day rule has applied since 2004. Before that point, banks must flag stress early as special mention accounts: SMA-0 when payment is overdue up to 30 days, SMA-1 for 31 to 60 days and SMA-2 for 61 to 90 days. An NPA is then graded by age. It is substandard for its first 12 months as an NPA, doubtful once it has stayed substandard for 12 months, and a loss asset when the bank, its auditors or the RBI judge it uncollectible but it has not yet been written off. Banks must set aside provisions, money from their profits, that rise with each grade. Gross NPAs are all such loans; net NPAs are gross NPAs minus those provisions, so net figures show the loss not yet covered.

In the 2010s bad loans became the biggest problem in Indian banking. Large loans made to infrastructure and industrial firms in the boom of the 2000s soured as projects stalled and demand slowed. The Economic Survey 2016-17 called the result the twin balance sheet problem: firms carrying too much debt shelved new projects, while banks nursing stressed loans grew wary of fresh lending. The RBI's Asset Quality Review in 2015 forced banks to recognise hidden stress, and the gross NPA ratio of scheduled commercial banks climbed above 11 per cent by March 2018. Recovery tools had been built in layers: Debts Recovery Tribunals under a 1993 Act; the SARFAESI Act, 2002, which lets secured lenders take over and sell a defaulter's security without going to court and provides for asset reconstruction companies that buy bad loans; and the Insolvency and Bankruptcy Code, 2016, which hands a defaulting company to a time-bound resolution process. With recognition, recapitalisation of public sector banks and these laws, the ratio fell to 2.1 per cent by September 2025 (RBI Financial Stability Report, December 2025).

priority sector lending is the rule that a bank must give a fixed share of its credit to sectors that might otherwise be starved of it. The idea grew out of the nationalisation era; today it is governed by the RBI's Master Directions on priority sector lending, revised with effect from 1 April 2025. There are eight categories: agriculture, micro, small and medium enterprises, export credit, education, housing, social infrastructure, renewable energy and others. Domestic commercial banks and foreign banks with 20 or more branches must lend 40 per cent of adjusted net bank credit (ANBC) or of the credit equivalent of off-balance-sheet exposures, whichever is higher, to the priority sector. Within that, 18 per cent must go to agriculture (with 10 per cent to small and marginal farmers), 7.5 per cent to micro enterprises and 12 per cent to weaker sections. Foreign banks with fewer than 20 branches also have a 40 per cent target, most of which may be export credit; regional rural banks have 75 per cent, while small finance banks and urban cooperative banks have 60 per cent.

A bank that falls short of its priority sector target is not fined in the ordinary way. Instead it must deposit the shortfall in funds run by NABARD, SIDBI and other bodies, such as the Rural Infrastructure Development Fund, which pay a low return. To make the system more flexible, the RBI introduced priority sector lending certificates (PSLCs) in 2016. A bank that has lent more than its target to, say, small and marginal farmers can sell a certificate for the excess on the RBI's trading platform, and a bank that has lent too little can buy it to count towards its target. No loan changes hands; only the priority sector credit is traded.

Put together, the banking system is a set of trade-offs that the state keeps adjusting. Nationalisation and directed credit carried banks to villages and farmers but weakened their balance sheets; reforms brought competition and prudential norms; bad loans of the 2010s showed what happens when lending outruns judgement, and the NPA rules, SARFAESI and the IBC are the response. Differentiated banks and deposit insurance aim at inclusion with safety, while priority sector targets keep a floor under credit to agriculture, micro enterprises and weaker sections. Link this part to Part 1: CRR and SLR decide how much of a deposit a bank can lend, and priority sector rules decide where a share of that lending must go. The next chapter, on the RBI and monetary policy, shows how the central bank changes the price and quantity of this credit through the repo rate and its liquidity tools.

Exam traps

• Payments banks take deposits and issue debit cards but cannot lend or issue credit cards; small finance banks can lend.
• A term loan becomes an NPA when interest or principal is overdue for MORE than 90 days, not 60 or 180.
• DICGC cover is ₹5 lakh per depositor per bank (principal and interest together) since 4 February 2020; banks, not depositors, pay the premium.
• 1969: 14 banks with deposits of ₹50 crore or more; 1980: 6 banks with ₹200 crore or more. SBI dates from 1955 and the RBI's nationalisation from 1949.
• RRB share capital: Centre 50%, sponsor bank 35%, state government 15%.
• A scheduled bank is one in the Second Schedule to the RBI Act, 1934, not to the Banking Regulation Act.
• Domestic banks' PSL target is 40% of ANBC or CEOBE, whichever is higher; RRBs 75%; urban cooperative banks 60%; small finance banks 60% from 2025-26 (an RBI amendment of June 2025 cut it from 75%).
• Net NPA = gross NPA minus provisions. The 'twin balance sheet problem' is the Economic Survey 2016-17's phrase.

Recap

• Banks are regulated by the RBI under the Banking Regulation Act, 1949; scheduled banks are those in the Second Schedule to the RBI Act, 1934.
• Commercial banks: public, private, foreign, regional rural, small finance and payments banks; cooperative banks are member-owned.
• Nationalisation: RBI 1949, SBI 1955, 14 banks in 1969, 6 in 1980; 12 public sector banks since 1 April 2020.
• RRBs began on 2 October 1975 and work under the 1976 Act, owned 50:35:15 by the Centre, a sponsor bank and the state.
• Payments banks cannot lend (deposits capped at ₹2 lakh per customer); small finance banks lend mainly to small borrowers.
• DICGC insures deposits up to ₹5 lakh per depositor per bank since 2020.
• NPA: overdue more than 90 days; SMA-0/1/2 before that; substandard, doubtful and loss after.
• Bad-loan tools: DRTs (1993), SARFAESI Act (2002) and ARCs, IBC (2016); gross NPA ratio fell from above 11% (2018) to 2.1% (September 2025).
• PSL: 40% of ANBC or CEOBE for domestic banks, with 18% agriculture, 7.5% micro enterprises, 12% weaker sections; shortfalls go to RIDF-type funds; PSLCs since 2016.

Practice questions

Sources

• Banking Regulation Act, 1949, as amended (including the Banking Regulation (Amendment) Act, 2020) — https://www.indiacode.nic.in
• Reserve Bank of India Act, 1934 (s.42 and the Second Schedule) — https://www.indiacode.nic.in
• Reserve Bank of India: Master Directions on Priority Sector Lending (2025); guidelines for licensing of payments banks and small finance banks (November 2014); prudential norms on income recognition and asset classification; Financial Stability Report (December 2025) — https://www.rbi.org.in
• Regional Rural Banks Act, 1976 — https://www.indiacode.nic.in
• State Bank of India Act, 1955; Banking Companies (Acquisition and Transfer of Undertakings) Acts, 1970 and 1980 — https://www.indiacode.nic.in
• Deposit Insurance and Credit Guarantee Corporation Act, 1961 — https://www.indiacode.nic.in
• Recovery of Debts Due to Banks and Financial Institutions Act, 1993; SARFAESI Act, 2002; Insolvency and Bankruptcy Code, 2016 — https://www.indiacode.nic.in
• Economic Survey 2016-17, Ministry of Finance (chapter on the twin balance sheet problem) — https://www.indiabudget.gov.in/economicsurvey/