IF YOU owe a bank a hundred dollars, it is your problem. If you owe a hundred million, it is the bank’s problem. If you are one of many tycoons borrowing billions to finance dud firms, it is the government’s problem. That is roughly the situation India finds itself in today. Its state-owned banks extended credit to companies that are now unable to repay. Like the firms they have injudiciously lent to, many banks are barely solvent. Almost 17% of all loans are estimated to be non-performing; state-controlled banks are trading at a steep discount to book value. After years of denial, India’s government seems belatedly to have grasped the threat to the wider economy. Plans are being floated to create a “bad bank” that would house banks’ dud loans, leaving the original lenders in better shape. The idea is a good one, but it must be properly implemented and is only the starting-point for broader reforms.

The bad-loan mess has been years in the making. India skirted the financial bust of 2007-08, but then complacency ensued. Banks went on to finance large-scale projects—anything from mines and roads to power plants and steel mills—which often ended in disappointment. Over 40% of loans made to corporate India are stuck in firms unable to repay even the interest on them, according to Credit Suisse, a bank. The result is a “twin balance-sheet problem”, whereby both banks and firms are financially overstretched. Corporate credit is shrinking for the first time in two decades (see article).

In an ideal world, the banks would write down the value of the loans. The resulting losses would require fresh funds from shareholders. India is far from that ideal. It takes over four years to foreclose on a loan (a newish bankruptcy law should help). The government is the main shareholder of the worst affected banks, and has been reluctant to inject more cash. Bankers themselves are afraid to deal with loans pragmatically, because that often gets mistaken for cronyism.

Clean energy needed

The solution so far has been to pretend nothing much is wrong. The banks have rolled bad loans over, hoping that growth would eventually make things right. This is a poor strategy, as anyone who followed Japan in the 1990s and Italy since the financial crisis well knows. It is only a matter of time before the banks’ difficulties derail India’s economic prospects. Hence talk of setting up a bad bank to sort out the mess.

Bad banks have been used with success in the past—in Sweden in the 1990s, for example, and in Spain in recent years. But if they are to work, candour and cash are both needed. The candour is required to assign a realistic value to banks’ soured loans. Indian lenders must be compelled, and quickly, to sell loans to the bad bank even at a hefty discount to face value, no matter how much it may wound their pride or dent their profits. That is where the cash comes in. When those write-downs eat up capital, the state must be ready to make up the shortfall even if it means borrowing more to do so.

That is only a start, however. A bad bank could resolve this crisis. But to make future ones less likely, broader reforms are needed. Some are under way. Political interference (loans to a minister’s buddy, say) and dysfunctional governance (many bank bosses get only one-year stints at the helm, for example) are less of a problem than they once were. But lenders should not be instruments of the state. Private investors should be allowed to play a bigger role in cleaned-up banks, even if that means the government has to give up majority control.

India’s “promoters”, as the founders and owners of big businesses are known, also need to be reined in further. Tycoons have the upper hand in negotiations with their lenders because they know that red tape, patronage and antiquated legal systems make it all but impossible to seize the assets of defaulting firms. In effect, they cannot be replaced at the helm. Resolving this imbalance would make it more likely that dud loans are a headache for banks and borrowers, not for the finance minister. It is good that policymakers appear to be waking up to the magnitude of India’s banking problem. Whether they appreciate the scale of the solution is less clear.