"If public sector banks become competitive, and especially if they do so by distancing themselves from the influence of the government without sacrificing their 'public' character, they will be able to raise money much more easily from the markets.
"Indeed, the better performers will be able to raise more, unlike the current situation where the not so good performers have a greater call on the public purse. Competition will improve efficiency," he said.
The remarks came in his annual day lecture of the Competition Commission of India (CCI).
Rajan said there are well-managed public sector banks across the world and even in India today.
"So, privatisation is not necessary to improve the competitiveness of the public sector. But a change in governance, management, and operational and compensation flexibility are almost surely needed in India to improve the functioning of most PSBs, as the P J Nayak Committee has just reiterated," he added.
The Governor said a number of eminently practicable suggestions have been made to reform PSBs, such as creating a holding company to hold government PSB shares, increasing the length of PSB CEO tenures, breaking up the position of Chairman and CEO and bringing more independent professionals on bank boards, among others.
"We need to examine all these ideas carefully, many of which will help give public sector banks the flexibility to compete in the new environment," Rajan said.
He noted that in the past PSBs had the best talent. But today, past hiring freezes have decimated their middle management ranks, and private banks have also poached talented personnel from PSBs.
"PSBs need to be able to recruit laterally, while retaining the talent they have, but to do so they need to be able to promise employees responsibility as well as the freedom of action," he added.
Referring to financial inclusion, Rajan said the RBI will come out with new relaxations on business correspondents shortly.
Also, he said some of the entities that become payments banks may be very well suited to support or substitute commercial banks in reaching remote areas.
"In sum then, we can increase competition in the banking sector while, at the same time, strengthening banks by reducing the burden of obligations on them," he said.
Speaking on the occasion, Competition Commission of India (CCI) chairman Ashok Chawla said the regulator has so far imposed more than Rs 8,000 crore worth penalties on various entities for anti-competitive practices.
The Commission has dealt with cases related to diverse sectors, he added.
He also said the regulator has so far received about 170 files pertaining to combination of entities.
CCI, which keeps a tab on unfair trade practices across sectors, has completed five years of existence.