The government should consider diluting its ownership in state-owned banks to reduce the country's financial burden and push for consolidation, while boosting the number of private lenders, the Reserve Bank of India said in a discussion paper on Tuesday.
The report also reiterated its preference for foreign banks to establish subsidiaries in India, in a move that is aimed at ring-fencing their local operations from the overseas parents and bring them at par with Indian banks in terms of regulations.
At present, all foreign banks including Standard Chartered (STAN.L) and Citigroup (C.N) operate in India by registering their branches.
RBI discussion papers compile thoughts from its various internal agencies and are meant to solicit outside views that are then incorporated into a final set of measures. The central bank set a deadline of September 30 for the feedback.
The long-awaited discussion paper on the RBI's thinking also supports the need for new entrants into the banking system, in line with the government's goal to reform a sector dominated by often lethargic state banks and which only reaches half the country's households.
"As a prudent economic decision, there is a case for government to reduce its ownership stake in the PSBs," the RBI said in the paper, referring to public sector banks.
"There is a need to boost the presence of private banks, while consolidating the existing public banking system," the RBI also wrote.
The central bank estimated the government would have to inject a combined 900 billion rupees over a period of five years to allow state-run lenders to comply with Basel III capital requirements.
"Clearly, providing equity capital of this size in the face of fiscal constraints poses significant challenges," the RBI said.
Investors have long worried about India's fiscal deficit. The rupee fell to a record low of 66.30 per dollar on Tuesday after parliament's approval of a $20 billion plan to provide cheap grain to the poor renewed doubts about government resolve to control spending ahead of elections due next year.
The paper also called for a "steady stream" of new bank entrants that would be considered for approval on a rolling basis, arguing "continuous authorisation keeps the competitive pressure on the existing banks and also does not strain the banking system."
The RBI is in the process of considering 26 applications from corporate houses looking to open banks, although it has not yet provided a timeframe of when the first approvals will be issued.