India’s banking system is creaking. If the country doesn’t find the capital to revive its weak public-sector banks and to address the mounting problem of nonperforming loans, its banking system will founder, with devastating consequences for the broader economy. The government must thus undertake to reform and consolidate the sector while encouraging strong local institutions and foreign investors to increase their presence in India.

To fend off insolvency, Indian banks will need to find fresh capital of $9 billion to $15 billion—representing 2 to 4 percent of the country’s gross domestic product and 50 to 90 percent of the current capital of Indian banks—during the next five years, which is roughly how long it will take to reform the system. Up to 60 percent of this sum will be required to write off irrecoverable loans, 18 percent to finance productivity improvements, and the rest to support growth (Exhibit 1). Some 35 domestic banking institutions, accounting for about 40 percent of the sector’s assets, are particularly fragile because of the poor quality of their assets. It is from these troubled banks that the vulnerability of India’s banking system largely arises. In addition, the recent crisis caused by weak investment-management processes...