Singapore: Desperate times call for ludicrous measures. Spooked by the relentless surge in bad loans in India’s largely state-run banking system, officials in New Delhi are floating a new idea: the creation of a government-backed bad bank.

Since the concept is getting bandied about ahead of the 29 February Union budget, hapless investors are being forced to suspend disbelief and start hoping for an Indian version of the US’s 2008 Troubled Asset Relief Programme. After losing 44% its value over the past 12 months, a gauge of India’s government-controlled banks has risen 5% the last four trading sessions. That compares with a 2.6% increase in the benchmark Nifty index.

The expectations are misplaced. It’s one thing to make broken private balance sheets whole by shifting the burden of potential losses to taxpayers, but how does one further socialize losses for which taxpayers are already on the hook? Cumulatively, state-run Indian banks lost 10,800 crore in the three months to 31 December, according to Fitch Ratings. If the March quarter proves to be just as miserable, almost 90% of the additional capital the government pumped into lenders this year will be used to absorb a six-month loss. Until the carnage stops—and that might take several quarters—private capital won’t touch these banks.

Annual tax revenue of India’s central government - $134 billion

A TARP-like solution could end up making matters worse. Move the toxic assets into a new financial institution at near their current book values, and the troubled lenders might be able to access capital from the market. But the bad bank’s heavy losses would still need to be made good by taxpayers. Force banks to get rid of soured debt at a deep discount, and the bad bank might become an attractive asset-holding company. Even so, those lenders divesting the non-performing loans will be taking a big one-time hit. And they’d need a pretty hefty equity infusion—courtesy of the taxpayer—just to maintain a minimum tier 1 capital ratio of 7.5%.

Standard and Poor’s recently warned of “multiple-notch downgrades" if capital falls short of this minimum regulatory requirement. Considering just how close some state-run banks are to the threshold, a botched bad-bank plan could be downright dangerous.

Indeed, the reluctance to swallow an upfront loss and take a hit on capital is one of the main reasons Indian banks haven’t sold enough of their bad debts to existing private asset reconstruction companies. The other is that the ARCs themselves are undercapitalized.

Separating lenders from the consequences of their past decisions, without imposing new rules on them for the future, will merely perpetuate India’s culture of weak lending discipline. It would be nice if instead of toying with the idea of a bad bank, the government used its annual budget to do two things simultaneously.

One, inject in one fell swoop something like $7 billion of fresh capital—double the current fiscal year’s allocation—to allow lenders to recognize more of their stressed loans as non-performing. That way they can make provisions against them and pull their loan-loss reserves up to at least 70% of soured debt, at which point investor concern would be allayed to some degree. At present, none of the state-run banks meet that requirement.

Two, listen to Arundhati Bhattacharya, chairman of the largest public sector bank, State Bank of India, and announce a bold plan to reduce the government’s shareholding in these lenders to below 51%. Politically, it will be a hard sell. Unionized bank employees will be up in arms. But without such a roadmap, an onerous chunk of the $150 billion or so of capital that Indian banks require will have to come primarily from taxpayers. That’s practically impossible, considering the entire annual tax revenue of the central government is about $134 billion.

Some nationalization of bank losses is unavoidable, but India’s priority should be speedy privatization of the nation’s lenders. Not the creation of (another) bad bank.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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