Is another wave of mergers fuelling the PSU bank stock rally?

In his bestselling book The Alchemy of Finance, Soros recounts an investing episode which offers a window into his mindset and tactical nous.

In the early 1970s, banking stocks were among the least favoured by investors. Banks were seen as stodgy, old-school institutions which had still not recovered from the traumatic failures of the Great Depression. Regulations were onerous and there was hardly any innovation or fresh thinking in the industry.

But beneath the still waters, Soros spotted pools of opportunity. Some new bankers, educated in business schools, were entering the workforce, injecting fresh vigour into the sector. The banking industry was beginning to see mergers and acquisitions, and regulatory winds too began blowing in its favour, leading to the launch of some new products.

Realizing the sector was at the cusp of a transformation, Soros decided to strike while the iron was hot, and loaded up on a few aggressively managed banks. The bets paid off handsomely and he made about 50% on his bouquet of bank stocks in a short period.

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Imperfect as they are, historical parallels often serve as useful guides in markets. Which is why many participants are playing close attention to the recent spate of headline-grabbing moves in India’s banking sector. But while the usual stars bask in the glow, the real drama could well be building up away from the spotlight.

Deal street

India’s banking sector has suddenly shot to the top of the wish list of global marquee investors. And this is not the fickle ‘hot money’ of foreign portfolio investment (FPI) inflows, but stable, long-term capital, with foreign investors taking controlling stakes and occupying board seats, signalling smart money’s conviction in the sector’s long-term potential.

Last month, Emirates NBD, one of the largest banks in Dubai, announced acquiring a majority stake in RBL Bank for ₹26,850 crore (about $3 billion), marking the largest ever foreign direct investment (FDI) in the Indian banking sector, as well as the largest fundraise via preferential issuance by a listed company. The deal comes just weeks after Japan’s financial services giant Sumitomo Mitsui Banking Corp completed acquisition of 24.2% stake in Yes Bank in two tranches for ₹16,333 crore.

In October, again, Blackstone, the world’s largest alternative asset manager, announced it will invest ₹6,196 crore ($705 million) for a 9.9% stake in Federal Bank, becoming its largest shareholder. In April, Warburg Pincus and sovereign wealth fund Abu Dhabi Investment Authority (ADIA) signed a deal to inject up to ₹7,500 crore ($877 million) in IDFC First Bank for a combined 15% stake.

₹26,850 crore.” title=”Emirates NBD acquired a majority stake in RBL Bank for ₹26,850 crore.”>

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It is easy to overlook that this flurry of deals is an anomaly. There have been very few instances of foreign banks acquiring Indian lenders. Prior to this, the Reserve Bank of India (RBI) had allowed the takeover of struggling Lakshmi Vilas Bank by the local unit of Singapore’s largest lender DBS Bank in November 2020. In 2018, the India arm of Canada’s Fairfax picked up a majority stake in Catholic Syrian Bank.

“Several factors are converging to drive this renewed global interest. First, India’s macroeconomic stability, robust GDP growth trajectory, and improving financial inclusion metrics are making the banking sector an attractive long-term play,” Anil Rego, founder and fund manager at Right Horizons PMS, told Mint.

“Second, ongoing reforms such as adoption of ECL provisioning norms, and accelerated digital transformation are enhancing governance standards, transparency, and operational efficiency, thereby improving investor confidence,” he added.

ECL refers to the RBI’s expected credit loss norms, to be implemented from 1 April 2027. It would require banks to estimate and set aside provisions for potential credit losses for their loans, in line with global best practices.

At a broader level, higher FDI inflows into banking can act as a force multiplier for the economy. It can deepen the capital base of banks, improve liquidity, and facilitate faster credit transmission to productive sectors such as manufacturing, housing, and infrastructure. Additionally, global participation can bring in best practices and risk management sophistication, further elevating the resilience and competitiveness of India’s financial system, Rego said.

‘Higher FDI inflows into banking can act as a force multiplier for the economy.’ — Anil Rego

While India’s FDI regulations allow overseas investors to purchase up to 74% in banks, RBI regulations restrict ownership by a single investor at 15%. The regulator has relaxed these norms in certain cases, for example those involving restructuring or strategic investment, but voting rights remain capped at 26%.

“The Indian banking industry has always been attractive, given the stringent bank approval process and the country’s intrinsic growth prospects. While there have been few instances of FDI in the sector in the past, the regulator now seems more open,” Christy Mathai, fund manager, equity, at Quantum AMC told Mint.

Winds of change

Thanks to its strict regulatory oversight, the banking sector is among the most responsive to policy and regulatory shifts. Which is why savvy investors track these changes as closely as earnings.

Through much of 2024, the financial landscape was marked by tightening conditions that weighed on credit expansion. The RBI held policy rates steady at 6.5%, accompanied by a regulatory clampdown on unsecured consumer credit announced in late 2023. This reined in household leverage and slowed the rapid rise in personal loans.

Adding to the strain, liquidity in the banking system remained persistently tight, with overnight rates hovering above the policy repo rate for much of the year.

Through much of 2024, the financial landscape was marked by tightening conditions that weighed on credit expansion. The RBI held policy rates steady at 6.5%, accompanied by a regulatory clampdown on unsecured consumer credit announced in late 2023.

That phase, however, appears to be turning. Experts say the pressure from slowing private-sector credit growth seems to have peaked, and a robust monetary and regulatory easing cycle is now underway.

The RBI has reduced rates by a hefty 100 basis points (bps) in 2025—the fastest easing cycle since the global financial crisis (apart from the pandemic years). Many analysts have penciled in another 25 bps cut before this financial year ends, given the favourable inflation dynamics.

At the same time, the central bank has introduced a wave of regulatory relaxations that has turbocharged sentiment towards this space. These include reducing the risk weights on bank lending to non-bank financial companies (NBFCs) and a 100 bps reduction in the cash reserve ratio (the share of deposits banks must hold with the RBI) being phased in from September through November.

“The cut in CRR would release primary liquidity of about ₹2.5 trillion into the banking system by the end of November 2025. It will also reduce the cost of funding for banks, thereby helping and accelerating the monetary policy transmission to the credit market,” RBI governor Sanjay Malhotra said while announcing the decision at the June policy meeting.

At the October meeting, Malhotra announced an unprecedented set of 22 measures to boost credit growth, bring down cost of funds and improve ease of doing business in the sector.

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These include allowing banks to finance acquisitions by Indian companies in non-financial sectors, raising limits on loans against securities and IPO financing, and revising risk weights on home and other retail loans. It also cut risk weights on NBFC lending to operational, high-quality infrastructure projects, which is expected to give a fillip to credit growth by channelling more long-term capital into the infra sector.

Supportive policy measures amid an easing monetary policy cycle are likely to lower banks’ capital requirement and funding costs, analysts at Goldman Sachs stated in a note last month. “Given transmission lags, and stabilizing asset quality, we expect credit growth to recover from 2H FY26 (second half of the financial year),” they added.

Role reversal

While private banks are grabbing all the eyeballs currently, among the most far-reaching trends in India’s financial landscape over the past few years has been the turnaround of public sector lenders (PSUs). This is amply reflected on Dalal Street as well. The Bank Nifty has gained around 115% in absolute terms over the last five years, while the benchmark Nifty 50 has advanced 108%. Leaving them in the dust is the Nifty PSU Bank index, which has surged nearly 500%.

The reversal of fortunes began a decade ago when the RBI initiated an asset quality review exercise to tackle the sector’s mounting pile of bad debt and shore up bank balance sheets. Later, more than 10 PSU banks were placed under the prompt corrective action framework which barred them from handing out new loans till they tightened their credit appraisal process and other operational gaps. And then began a wave of consolidations starting 2017. The State Bank of India merged five associate banks and the Bharatiya Mahila Bank. A slew of PSU bank mergers followed—in 2019 and 2020—which brought down their number to 12 from 27.

The operating metrics of these banks have improved remarkably as a result. From an aggregate loss of about ₹26,000 crore in FY20, PSU banks posted a profit of ₹1.4 trillion in FY24, which swelled to ₹1.7 trillion in FY25.

Having steadily lost credit market share for a decade, they clawed back about 40 bps in FY25, taking their share to nearly 58%. Strong balance sheets, robust asset quality, and comfortable liquidity allowed them to sustain healthy lending even as private peers ran up against high credit–deposit ratios.

In fact, PSU banks outpaced private banks in loan growth for the first time in 15 years (12% versus 10%), driven by momentum in retail and MSME portfolios amid lower exposure to unsecured lending.

“With low-cost deposits, digital investments, and a recovery in consumption demand, we believe PSBs are well placed to deliver 10-12% loan CAGR in FY26E, and unlike the sharp 200bp annual decline over FY11-21, their market share is now expected to decline only marginally over FY26-28,” analysts at Motilal Oswal Financial Services stated in a recent report.

Aiding this is the stunning improvement in asset quality, with gross non performing assets (NPAs) reducing from two-digit levels to 2.8% in FY25. With slippages contained below 1% and credit costs well managed, public sector banks enter the next phase of growth with cleaner books and stronger capital.

Not just that, until a few years ago, achieving a return on assets (RoA) of 1% was considered a dream, but consistent growth and improved risk management has made it a reality today. While private banks still lead in RoA (1.7-1.8%), helped by better fee income and margins, top public sector banks have matched them in return on equity (RoE) at 18-19%.

While some analysts are anticipating a near-term pressure on the margins, the pain is likely to be short-lived as state-owned banks have the cushion of replacing high-cost bulk deposits with granular retail funding. Despite a gradual erosion in market share, they still command over 60% of system deposits, thanks to their extensive branch network and strong depositor trust. In parallel, they are shifting toward higher-yielding retail, agriculture, and MSME segments, along with growing fee income.

“PSU banks have seen a strong re-rating over the past five years, shedding their legacy image of lenders with poorer underwriting capabilities to competitive players delivering consistent value to stakeholders,” Motilal Oswal noted. “Stronger capital positions, cleaner balance sheets, and prudent provisioning make them more resilient and limit cyclicality in earnings and asset quality relative to past cycles.”

Market mystery

The turnaround in PSU banks has been in motion for several quarters now, which makes this year’s sharp outperformance in the PSU Bank Index particularly intriguing. In recent weeks, there has also been a spike in the share volumes of Union Bank of India, Canara Bank and Bank of Maharashtra, among others. Could there be a deeper trigger at play this time?

“There is speculation of consolidation of some of the smaller public sector banks into the larger ones. We believe this is positive as smaller PSU banks suffer from relatively poor operating metrics, and any consolidation may lead to more focused growth and advantage of scale,” Quantum AMC’s Mathai observed.

The backdrop certainly looks ripe.

After years of cleaning up their balance sheets, public sector banks have emerged stronger with robust asset quality and profitability at record highs, which makes them particularly attractive to potential suitors. Record foreign capital inflows are reshaping the private sector banking space, making state-backed ones the prime candidates for the next wave of restructuring, whether led by domestic or foreign players.

While none of the PSU banks are anywhere near breaching their FDI cap of 20%, news reports say the government is mulling raising this limit to 49% to attract more capital. Adding to the momentum, the appointments committee of the Cabinet, in October, threw open top management roles in public sector banks to private-sector candidates. And just last week, finance minister Nirmala Sitharaman reiterated the government’s position that India needs many large, world-class banks.

Market experts say the stage looks set for another act in the public banking revival story.

“The earlier 2020–21 mergers have already delivered benefits such as stronger balance sheets, higher profitability, and improved cost synergies. With PSU banks now demonstrating normalized RoAs of ~1% and asset quality on par with private peers, the timing appears conducive for another phase of reform-led consolidation,” Right Horizons’ Rego said.

Reports of combining smaller lenders with stronger anchors and the possibility of allowing government stakes to fall below 51% indicate a shift toward greater autonomy, professional governance and private participation, he added.

Markets, of course, have a way of producing the unexpected. But if the ongoing rally and a supportive policy backdrop are any indication, India’s public sector lenders look poised for another phase of rerating and wealth creation.