He also favoured channelising "full savings" of the households into the financial system so that requisite resources for growth are made available.
"In the short term (up to 12 months) there is need to clean up the NPAs and then restructure other stressed loans so as to put the economy back on the track," Mr Rajan said at the two-day 'Gyan Sangam' here.
Total gross non-performing assets of public sector banks stood at over Rs 2.43 lakh crore as of end-September 2014. The top 30 NPAs account for Rs 87,368 crore or 35.9 per cent of total gross NPAs of public sector banks
Mr Rajan said the bona fide mistakes made by the bankers while taking commercial decisions should be protected by the government.
"If the officers are hauled up for such decisions this would to lead to delay in good decisions because of avoidance of risk."
The RBI Governor also stated that there was a need for internationalization of the banking system in the current global environment.
"The Capital base of the banks may need to be enhanced," Mr Rajan said while emphasising on the need for consolidation in ownership, improvement in governance, and enhancement of management capability.
With the licensing of the small banks and the payment banks, there would be new players in the industry and competition amongst the public sector banks will also grow to meet these challenges.
"Accordingly, PSBs (public sector banks) have to develop differentiated products," Mr Rajan said.
Stressing on the need for public sector banks to recruit young talent, train, and retain them, Mr Rajan said, "And that the government needs to have a re-look at the campus recruitment which at present is banned because of Supreme Court ruling."
Finance Secretary Rajiv Mehrishi raised the question whether bank nationalisation has been able to achieve the objectives of reaching out to all people and expansion of credit as necessary.
He urged that banks need to be healthy to drive 7-8 per cent growth in GDP.
Additionally, to provide that magnitude of financing, the PSU banks need to enhance their capital base. Non-banking payment solutions like Mobile Banking could be used to reach out to poor people.
"This may help cashless transactions and thus reduce black money in the system," Mr Mehrishi said.
He further said the government may take a relook at the legal system to deal with wilful defaulters.
In his address, Chief Economic Advisor Arvind Subramanian suggested ways by which the banking system can generate and efficiently allocate domestic savings to sustain the investment rate of 35 per cent of GDP to achieve the growth of 8 per cent in medium term.
He proposed that the public sector banks should be differentiated into weak, good and strong categories and accordingly consolidation and restructuring measures could be applied to them.
"There should be diversification both within and outside the banking system. There should be better bankruptcy procedures. The current overhang of stressed assets should be resolved by distribution of the pain between promoters, creditors and tax payers," Mr Subramanian said.