China is slowly coming to terms with the enormous stock of bad loans that burden its banking system. Its financial regulators—the People's Bank of China and the Chinese Banking Regulatory Commission—have upgraded the country's loan classification system to uncover problem loans more quickly and consistently, established asset-management companies to help banks dispose of their nonperforming loans, and used billions of dollars from China's vast foreign reserves to sustain insolvent banks until the problems can be resolved.

Actively managing the current stock of nonperforming loans—especially cleaning them up more quickly—is a critical first step in righting China's banking system. The Chinese regulators must, however, go beyond merely fixing the mistakes of the past and confront an additional source of instability: a flow of new bad debt. Our frontline experience tells us that Chinese banks continue to make astounding numbers of questionable loans atop the existing pile. Any failure by regulators to control these bad lending practices may put China's future prosperity at risk.

China's banking system can safely sustain annual loan growth of only 5 to 7 percent, far below the level needed to check unemployment

Since the country's capital markets remain largely underdeveloped, banks serve as the primary source of...