Things are not looking good for Indian banks right now.

As the economy continues to stutter, questions have been raised about the amount of bad loans on their books. Public sector banks in particular, which account for three-quarters of India's banking sector, had a whopping Rs 1.74 lakh crore in net non-performing assets (which is bad loans, minus the cash set aside to deal with losses) as of September 2014. That's a third of their net worth. But Reserve Bank of India Governor Raghuram Rajan doesn't want you to worry.

"The market turmoil will pass. The clean-up will get done, and Indian banks will be restored to health."

— Raghuram Rajan

"While we should not underplay the dimensions of the task, we should be confident that it is manageable and that the Government and the RBI will do what it takes to make sure that banks are able to support the tremendous growth that lies ahead," Rajan said at a Banking Summit in Mumbai on Thursday.

Not everyone is convinced, a fact the RBI governor not only acknowledged but actively set out to address in his speech. As third-quarter results of various banks have come in over the last few days, the amount of trepidation in the market is becoming clear.

Moneycontrol's graph, comparing the NIFTY Index of Public Sector Banks in India against the Bombay Stock Exchange's benchmark Sensex index, shows you just how concerned investors are.

Why is this happening?
Because there are lots of bad loans out there. Or as Rajan put it, "a number of large projects in the economy have run into difficulty". RBI Deputy Governor SS Mundra added to this explanation earlier in the day by pointing to all the internal and external issues that caused the banking sector to run into doldrums, summarised in the slide below.

But why the sudden drop in bank stocks?
The central bank actually recognised the increasing load on bank's balance sheets last year and made it a clear priority to clean out the mess in the system. Rajan said "deep surgery" would be necessary and the first step towards taking on such an operation would be to carry out an accurate diagnosis.

Starting April 2015, it asked banks to clearly identify bad loans as Non-Performing Assets, so that they could be properly dealt with. Rajan has said that, once they identify the bad loans, they can work towards cleaning up balance sheets by March 2017.

Think therefore of the NPA classification as an anesthetic that allows the bank to perform extensive necessary surgery to set the project back on its feet. If the bank wants to pretend that everything is all right with the loan, it can only apply Band-Aids – for any more drastic action would require NPA classification.

— Raghuram Rajan

As a result, banks have had to report the number of NPAs on their books every quarter, and that, naturally, has taken a toll on their stock prices. The State Bank of India, which accounts for a quarter of the banking sector, reported gross NPAs of 5.10% on Thursday. Other public sector banks, like Dena Bank (9.85%) and Bank of India (9.18%) had even worse figures as of the third quarter of fiscal year 2015-'16.

Why is Rajan not worried?
The RBI governor on Thursday said that "wild claims" are being made by some financial analysts regarding the number of bad loans out there. "This verges on scare-mongering," he said. Only a "small minority" of public sector banks will breach the requirements that the RBI mandates, he added.

"What the Government has already explicitly committed is, in our view, enough to take care of all reasonable scenarios, and the Government has committed to stand behind its banks to whatever extent needed. The RBI will provide whatever liquidity is needed by any bank that needs it, though we do not foresee liquidity stress," Rajan said.

Is this the wrong time to fix the problem?
Rajan said some of the pain is actually a good thing. He admitted that the global turmoil, because of oil prices and a slowdown in demand, meant that this seemed like a bad time for banks to start cleaning up. But he also clearly stated that relying on growth could not fix the stressed-assets problem by itself.

"The stressed balance sheet of public sector banks is occupying management attention and holding them back, and the only way for them to supply the economy’s need for credit, which is essential for higher economic growth, is to clean up," he said.

Indeed, Rajan said that the difference between the operations of private sector banks, which have fewer stressed assets, and public sector ones, made it clear that the bad loans were holding banks back from growing rather than the other way around.

"In sum, to the question of what comes first, clean up or growth, I think the answer is unambiguously “Clean up!” Indeed, this is the lesson from every other country that has faced financial stress," he said.

Lots of bad loans are being written off. Should we, taxpayers, be outraged?
A Right to Information query by the Indian Express revealed that 29 public sector banks wrote off a combined Rs 1.14 lakh crore of bad debt between 2013 and 2015. A former RBI deputy governor has called this a "big scam" saying small loans are rarely written off, with most of them being large, presumably industrial loans.

Rajan insisted that not all bad loans are criminal.

Let me emphasize that all NPAs are not because of malfeasance. Indeed, most are not. Loans can go bad even if the promoter has the best intent and banks do the fullest due diligence before sanctioning. 

— Raghuram Rajan

That said he also pointed to "strengthened" fraud detection and monitoring and said any evidence of malfeasance by promoters would result in the "full force of the law" being brought against them, even while banks work to put the project back on track.

Will this happen again?
Rajan believes not, thanks to the Indradhanush plan aimed at restructuring the way public sector banks are run. "The Government, through the Indradhanush initiative, has sent a clear signal that it wants to make sure that public sector banks, once healthy, stay healthy," he said. Additionally, a new bankruptcy code would make collections through a judicial system much simpler.