Why FPIs Are Pouring into PSU Banks While Selling Other Indian Sectors in 2026 – Improved Asset Quality, Mergers & Stake Dilution Drive the Rally

Indian public sector banks (PSBs) are the biggest gainer among all primary Nifty sectors, not only in recent times but also historically for the last one to three years, gaining almost 64% and 165%. Recently, PSBs have been the new focal point amid increasing interest by FPIs (Foreign Portfolio Investors) despite broader caution/sell-offs. 

FPIs are selectively increasing their holdings in quality PSBs like SBI, PNB, BOB, and also Canara Bank ─ pushing the PSU Bank index to almost 9680, around a record high; it gained over 13% (YTD till February 20, 2026) against the broader Nifty Bank, around 3%, and the Private Bank index, 1%. This contradicts the overall ‘exit’ stance by the FPIs with net outflows of around $18.9 billion from the Indian stock market in 2025. 

Despite India’s perceived structural economic tailwinds, FPIs are exiting due to high valuations, weak earnings growth, and lingering geopolitical fragmentations, including the Trump tariff tantrum and subsequent sector-specific cyclical headwinds. Also, FPIs are getting better opportunities back in their home & others (US/Europe/China/Japan, etc.), where stock markets are proving higher returns due to AI & industrial optimism, and valuations are relatively low.

Why are FPIs virtually scrambling for PSBs?

• Improving fundamentals, including asset quality and operational efficiencies
• Fair/reasonable & lower valuation; average PEG only around 0.17 against Nifty’s 2.5-3.0 (at present); PSBs may be re-rated
• Potential Merger 2.0 for PSBs ─ further consolidation of 12 existing PSBs into 4-5 large-sized PSBs led by SBI, PNB, BOB and Canara Bank will ensure scale and growth
• Potential stake sale by the government from the existing 60-90% in many PSBs to a 51% minimum floor will ensure proper governance and professionalism.
• Potential for higher dividend payments by PSBs from FY27. 

Improved Asset Quality and operational parameters

Several structural factors may explain this targeted optimism by FPIs for PSBs ─ driven by improvement in fundamentals, asset quality, robust credit growth, robust earnings momentum, lower credit costs, higher NPA recoveries, valuation comfort, and macro resilience. These micro improvements of PSBs are also a result of the pre-COVID RBI drive of Asset Quality Review (AQR) and robust NIM margin despite post-COVID volatilities in RBI interest rate and the surge in NPAs. The game changer may be the effective implementation of the IBC (Insolvency and Bankruptcy Code) in India and enhanced risk management. The ball is now practically in the Bank’s court, and unlike in history, lenders (Banks) are now not running behind the borrowers for recovery; the opposite is happening to prevent the company & management from being taken over by the bank or any other party (through IBC) in case of defaults. The average GNPA ratio for PSBs is now around 2.5% vs 12% on average in the 2018-21 period.

Potential Merger 2.0 for PSBs

Beyond fundamentals and process reforms, policy reforms are also fuelling expectations of further upside for the PSBs. India’s Federal Government, the primary promoter of PSBs, may be pursuing Merger 2.0 (Consolidation 2.0) to create 4-6 large-sized PSBs from the existing twelve. This will ensure large banks in India of global size & scale to support the ‘Viksit Bharat’ (Developed India) narrative by 2047 ─ can fund large-scale infra & other projects and also the real economy more effectively. During the 2017-20 merger/consolidation, 1.0 results in 27 into 12 PSBs, which will ensure scale and earnings visibility.

PSBs Merger 1.0 (2017-20)

• SBI: Absorbed five associates & regional State Banks (Bikaner & Jaipur, Hyderabad, Mysore, Patiala, Travancore, and Bharatiya Mahila Bank)
• BOB: Absorbed Dena & Vijaya Bank
• PNB: Absorbed UBI & OBC
• Canara Bank: Absorbed Syndicate Bank
• Indian Bank: Absorbed Allahabad Bank
•  Union Bank: Absorbed Andhra and Corporation Bank

The following six PSBs were not merged with any other during 2017-20 and remained standalone, as their fundamentals and balance sheet were not supportive.

• BOI
• CBI (Central Bank of India)
• IOB
• UCO Bank
• Bank of Maharashtra (BOM)
• Punjab & Sind Bank (PSB)

Looking ahead, the Indian government may further merge (consolidate) the current 12 PSBSs into 4-6 big PSBs of global size led by SBI, PNB, BOB, and Canara Bank as a part of long-term structural reform and regional synergies. Potential PSBs ‘merger 2.0’ candidates are six ‘standalone smaller/mid-tier/weaker PSBs (never merged post-nationalisation)' ─ as per the 2^nd list as above. Also, merger 1.0 of smaller PSBs (1^st list above) ─ like Indian and Canara Bank ─ may again merge to form a single bigger entity and then further absorb/merge with IOB for Southern regional synergies.

Potential PSBSs merger/consolidation 2.0 Plan

• Indian Overseas Bank (IOB): May merge with Indian and/or Canara Bank (Southern focus)
• Bank of India (BOI): May merge with BOB or SBI (Mumbai-based & global presence)
• Bank of Maharashtra (BOM): May merge with BOB for a strong Maharashtra footprint
• Central Bank of India (CBI): May merge with PNB
• UCO Bank: May merge with PNB
• Punjab & Sind Bank (PSB): May merge with SBI
• Indian and Canara Bank may merge into one bigger entity (PSB)

Countries like China also have four big PSBs, which are also the four largest globally (ICBC, ABC, CCB, and BOC), apart from the big six Chinese PSBs and other (PPP) banks ─ designed to serve various productive sectors of the real economy. 

Potential PSBs Stake Sales by the Government

After merger 2.0/along with this potential PSB Merger 2.0 (consolidation), the government may also go for steady take-sale (OFS) as a part of broader disinvestments of PSEs, involving reducing the stake from ~60-90%+ in many PSBs to a 51% majority floor (gradual process). The government stake in SBI (top PSB) is now around 55.5%.

A parallel reform involves gradual stake dilution by the government, aiming to reduce holdings from current levels (often 70–90%+) towards a 51% majority floor in select PSBs. These PSB reforms may ensure market-driven capital raising, attract more institutional and foreign investment (with proposals to raise FDI caps to 49%), and enhance banks’ operational efficiency through greater autonomy & professional management. FDI/FPIs and also DIIs would be major stakeholders for this PSB reform path going forward.

Over the last two decades, especially during 2008-22, the Indian Federal government has infused huge amounts of fresh capital (~₹3.50 trillion) into various fragile PSBs to prevent them from complete collapse. The government pumped these RECAP funds to recapitalise many ailing PSBs to address the legacy issue of the NPA crisis ─ not only for NPA provisioning, but also to cover a part of the permanent loss due to the waived-off NPA.  The government has also issued recap bonds (like ₹2.11 trillion in 2017–19). Overall, all these recaps helped to restore PSBS's solvency, borrowing/fundraising capacities, and lending power to the productive sector of the real economy; it also has a major fiscal cost for the government despite receiving healthy dividends. 

As most of the PSBs are now making adequate profits to self-sustain, it’s prudent for the government to monetise its higher stakes gradually to around 51%, just above the majority, through various instruments ─ FPOs (Follow-on Public Offers), OFS (Offer for Sale) and also QIPs (qualified institutional placements). This will also ensure recouping true market value, meeting disinvestment targets and shifting future capital needs for organic & inorganic expansion & diversification to markets, rather than repeated bailouts by the government. 

Potential payments of higher dividends to shareholders by PSBs

From FY27, RBI may allow all eligible banks to share up to 75% of net profit as maximum dividend payout, subject to strict regulatory requirements tied to appropriate capital adequacy, asset quality, and other prudential norms. For FY25, the actual dividend payout ratio for PSBs stood at 20%, and after the likely implementation of the new dividend-paying norms, PSBs may pay higher dividends to shareholders, including the government (promoter & largest shareholder). This will also ensure higher revenue for the government and less pressure to sell stakes at a discount.

Why are FPIs Betting on PSBs? 

Overall, these process & structural reforms—further consolidation for scale, stake dilution for capital efficiency and recovery from past recap costs—position PSBs as value plays in an otherwise expensive market. FPIs appear to be betting on structural tailwinds from improved PSB fundamentals, valuation safety, governance, re-ratings, and alignment with India's growth trajectory.

But some cyclical tailwinds also persist for the PSBs' growth story:

• Integration risks in planned merger 2.0
• Political and employee issues for further mergers and disinvestments
• Potential surge in retail NPAs, mostly unsecured
• The use of PSBs' priority sector lending (PSL) as a political (vote bank) tool

But still, with robust fundamentals and resilient structural policy tailwinds, PSBs are poised for sustained momentum despite some cyclical tailwinds.

Conclusions

India's PSBs have transformed from a source of fiscal strain to engines of economic growth. The combination of improved asset quality, earnings strength, and targeted reforms—Merger 2.0 for scale and gradual stake dilution to 51% for efficiencies & professionalism—addresses legacy issues while positioning them for future growth. The government's stance is pragmatic: recover value from past recapitalisation burdens and enable independent capital raising, attract global investment, and foster efficiency in a PPP mode.

Sustained execution of these reforms could elevate PSBs' global weightage, supporting India's ambition to become a truly developed economy by 2047. As the high-level banking committee deliberates and potential mergers unfold, PSBs' trajectory will remain a key barometer of India's financial sector maturity. A robust financial sector without the legacy pain of twin balance sheets (weak banks & weak corporates) is the essence of India’s economic resilience. And the selective FPIs' inflows into PSBs signal confidence that the best is yet to come for this revitalised sector.