In today’s Finshots, we tell you about the proposal to relax the foreign institutional investor cap for public sector banks from 20% to 49%, and the good and bad of it.

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The Story

There’s a quiet policy shift being whispered around Delhi. That the government may soon raise the foreign institutional investment (FII) cap in public sector banks (PSBs) from 20% to 49%. The move, still at the inter-ministerial discussion stage, has the classic trappings of a big-bang reform. It sends a signal to the world that India’s ready to liberalise the last bastions of state control. And most seductively, as per an analysis, it could unleash up to $4 billion in passive foreign inflows, as PSU bank weights get re-rated in global indices like MSCI.

So no wonder the markets cheered, PSB stocks popped and commentators clapped.

The logic makes sense. Private banks have been able to get 74% foreign FDI. The RBL Bank and Yes Bank stake acquisitions are recent examples. So why limit state run banks of this capital, no?

But if you look closer, it also brings up a few complicated questions. Do India’s PSU banks need capital? Sure. But will foreign capital help? Maybe.

To understand why, we need to rewind to the 1970s. That’s when India nationalised its top banks. It was a time of socialist planning, state-led lending, and institution-building. But to make sure new government-owned lenders weren’t eventually captured by private hands again, lawmakers inserted a clever clause into the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970: even if a private shareholder owned more equity, they couldn’t exercise more than 10% voting rights. That way, the power stayed with the government, and it was a telling that the ownership could be diluted, but never influenced. So even as the government considers raising the FII limit to 49%, the voting rights cap is likely to stay at 10%. In other words, a foreign investor can own nearly half the bank, but still have no say in how it’s run.

And that tells you something important. This isn’t about handing over control but more to do with handing over risk. Because public sector banks, for all their improved profitability in recent years, are still fragile. They’re still expected to open branches in rural villages where no private lender dares to do so. They’re still saddled with social mandates (from MSME credit to farm loans to Jan Dhan accounts). And they still lend based on nudges from the government.

So when India’s economy grows, averaging 8% in the last three fiscal years, and when deals in India’s financial sector have jumped around 130% to $8 billion between January and September, the pressure on PSBs to lend more also grows. For this, they need capital. But recapitalising them through the budget is politically tricky as a lot of taxpayer money has already been used to plug the bad loan or non-performing assets (NPA) holes in the past decade. And that’s where the foreign capital enters. It can allow passive money to come in and also lets index funds increase their stake in PSBs.

But that’s not necessarily a good thing. Because capital, in itself, isn’t the biggest bottleneck anymore. Sure, PSBs have done a decent job of cleaning the house post-2015. They have been recovering a higher percentage of bad loans. Plus, the much needed reforms that the Reserve Bank of India (RBI) rolled out in the past few years have made them more efficient, and helped them post the highest profits during FY25.

Nevertheless, you can’t miss that much of this progress was also a product of favourable macro tailwinds like lower interest rates, government-led capex that created loan demand without much risk, and a natural credit upcycle.

And perhaps the next decade will not be as forgiving. We’re moving into a world where banking isn’t just about who lends. It’s about who attracts deposits, who offers the best customer experience, and who can defend its turf in a world of UPI, fintechs, and AI-driven processes. On that front, PSBs are falling behind.

Their household deposit market share has shrunk from 70% in 2015 to about 60% today. Urban savers are fleeing to higher-yield savings accounts and slicker private bank apps. Even rural users are warming to non-banking finance corporations (NBFCs) and microfinance players.

So yes, throwing more foreign money at the problem won’t solve it. In fact, it could create new vulnerabilities. Because here’s the thing: FII inflows are not always benign. Especially when they’re passive, benchmark-linked flows. MSCI, for instance, assigns index weights based on foreign room (which is the difference between a stock’s FII holding and the maximum allowed). Now, if the cap rises to 49% and foreign ownership is low, the stock weight in the index goes up, and index funds are forced to buy those banks. But this overweightness also amplifies the downside when foreign funds leave the banks. Plus, not all PSU banks benefit equally. Take the State Bank of India (SBI). It’s already widely owned and has a decent index presence. A higher cap may not budge its weight much. But banks like UCO Bank or Punjab & Sind Bank that have low existing FII holdings and more headroom could see big upgrades.

And just relying on foreign capital could also breed complacency. If banks start to believe that market support is a function of foreign headroom rather than actual competitiveness, what incentive remains to fix the real issues?

Now you might say, fine, but more institutional ownership means more scrutiny and better governance. And you’d be right. There is indeed empirical evidence that when foreign capital participates in banks or firms, it often correlates with improved governance outcomes. For instance, foreign banks and FII-heavy firms often show better disclosure standards and more board-level oversight.

But that improvement isn’t automatic or guaranteed. Two conditions matter. First, the voting power. If institutional investors lack meaningful rights, their ability to influence governance is structurally weakened. And second, investment horizon. If the investor is passive, benchmark‑chasing and uninterested in long‑term value creation, the incentive to engage, monitor or demand reform falls away.

So what would real reform look like, you ask?

Well, it could start with tying capital to outcomes. If FIIs are being invited to invest, the money shouldn’t just go to buffers but fund transformation. Things like cybersecurity, core banking tech, digital onboarding, credit analytics. It would also mean addressing deposit attrition head-on. PSBs need to win back trust. That means better products, faster customer service, and the ability to compete with the fintech ecosystem on experience. And finally, it would mean revisiting the question of governance inclusion. Today, non-government shareholders can’t vote beyond a cap. But at the same time, there’s also a dearth of government leadership. Take Bank of Baroda or Indian bank, for example. They should have 16 directors but only have 10. That disincentivises long-term strategic investors and blocks accountability.

So yeah, in the end, the 49% proposal isn’t meaningless. It sure has teeth. But it’s also just incomplete since it seems like a headline now that hints at reform, without the fine print to prove it. And unless that fine print shows up soon in circulars, budgets, or branch-level execution, this could be another case of banking on optics over outcomes.

The market may love the story. But unless the story changes inside the banks themselves, we’ll be back here in a few years. Asking the same question.

“Where did all the money go?”

And let’s just hope it’s not too late to find out.

Until then…

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