Prime Minister Narendra Modi has reason to be wary of ambitious reforms to India’s economy, given the fraught rollout of his plan to ban Rs500 and Rs1,000 currency notes overnight. For his country to reach its true economic potential, however, he will need to do something about India’s ailing state banks.

These institutions, which account for more than 70% of lending in India, are in no immediate danger of collapse. But they’ve become a huge drag on the economy. Stressed assets now make up nearly 17% of all loans in India, worst among the world’s major economies.

Banks are understandably reluctant to lend more, just as debt-burdened companies are reluctant to borrow: Bank credit growth hit its lowest point in nearly two decades in January. Some economists have warned of the risk of Japan-like stagnation if the issue isn’t addressed.

The problem isn’t new. Many of the soured loans date to India’s most recent boom nearly a decade ago, when banks were pressured to lend to politically connected tycoons. Those same connections are hampering efforts to sort out the mess. Big companies have enough clout to resist foreclosure or harsh repayment demands. Bank officials fear that if they let borrowers off too easily, they’ll be accused of coddling government cronies.

More limited measures meant to break the logjam haven’t worked. A bankruptcy code passed last May has yet to have much of an impact, given India’s slow courts and lack of insolvency experts. Meanwhile, a slew of acronym-heavy schemes meant to encourage debt restructuring have proven ineffective.

This has given rise to calls to create a “bad bank" that would take these loans off the books of state banks. Whether structured as a full-fledged government agency or as a more limited asset management company to settle simpler cases, the idea has merit: Several of the most-stressed companies have loans with various state banks, and it would help to concentrate and resolve them together. More than half of the top 100 stressed borrowers require debt reductions of 75% or more, which only the government can force creditors to accept.

That still leaves questions about how to fund such a bank and, more important, how to price the loans: too cheaply and banks will be reluctant to sell; too expensively and taxpayers will be paying for others’ mistakes. Ultimately, the market should be setting those prices, not the government. It’s telling that India’s private-sector banks, which have largely sorted out their own non-performing assets, are by comparison thriving.

The government has tried various means to impose more market discipline on state banks, from mergers to governance reforms, while still maintaining majority ownership. There’s little reason to think such measures will work any better in future than they have thus far. The only real solution is to sell off most of these banks once they’ve been cleaned up, a prospect the government has been needlessly reluctant to entertain. Modi didn’t create today’s problem. He shouldn’t miss the opportunity to prevent tomorrow’s.

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