Patients in intensive care are usually low on optimism—but not so in the world of Indian banking. The Reserve Bank of India (RBI) has put 11 public sector banks on a special watch list because their balance sheets have almost been overwhelmed by a mountain of bad loans. Senior officials from the 11 banks under preventive corrective action (PCA) reportedly told a parliamentary committee this week that they were confident that these banks would get back on track by 2020. There is little reason for such sanguinity. Meanwhile, the central bank has released new estimates which show that the damage to these banks will continue to worsen.

Most of the headlines after the release of the new RBI Financial Stability Report on Tuesday focused on the fact that the banking regulator expects bad loans to go up even more this year. That is sobering in itself. However, there is more. The RBI has also provided some disaggregated estimates on the financial trajectory of PCA and non-PCA banks—or the crawling versus the limping. The estimates don’t make for pleasant reading, and, perhaps, the lawmakers who met the optimistic PCA bank chiefs should have confronted them with such numbers.

Here are the hard facts. The RBI says that gross non-performing assets of PCA banks will go up from 21% in March 2018 to 22.3% in March 2019. Their capital adequacy ratio will go down from 10.8% to 6.5% over the same period. In other words, nearly a quarter of the loans given out by these banks will have turned bad while the capital needed to support the loan book will be lower than the regulatory minimum. Remember that these 11 banks in the PCA watch list—Central Bank of India, Bank of India, IDBI Bank, UCO Bank, Indian Overseas Bank, United Bank of India, Dena Bank, Oriental Bank of Commerce, Corporation Bank, Bank of Maharashtra and Allahabad Bank—collectively account for 18.4% of total bank assets in India.

What now? The government has come up with the bizarre idea of selling IDBI Bank to the Life Insurance Corporation, a unique case where an insurance firm is being asked to use customer money as if it were a vulture fund in the business of buying distressed companies. Such financial engineering is not going to help in the long run. Most of the banking industry is in a mess, but the sirens are really screeching when it comes to the damaged PCA banks.

The Indian banking regulator has in effect converted the 11 banks from lenders into narrow banks that will only use depositor money to buy safe government bonds. Narrow banking is not much of an option in the long run. If depositor money is to be parked in government securities, then why do it through an expensive banking system—with the paraphernalia of branches and employees—rather than in a cheap money market mutual fund with checking facilities? The RBI has done well to put these banks under PCA, but permanent life support is not a sustainable policy option.

There are no easy answers, but the Narendra Modi government must stick to its original intent of providing fresh capital only to those banks that have viable strategies for the future. The Indian economy is clearly on the path of recovery, and economic activity needs to be supported with bank lending. The biggest companies have alternative sources of funding such as equity issues, bond issuance and overseas borrowing. Smaller enterprises have fewer financing options. They need a healthy banking system. It is also important to point out that some of the banks on the PCA watch list are clustered in specific regions, such as the eastern states. There are potential regional imbalance issues as well.

Indian households continue to put money into these damaged banks because of an implicit sovereign guarantee that all their money is protected. Such a variant of adverse selection means that fresh money continues to pour into organizations that are bad at financial intermediation. The RBI has done well to divide banks into two categories in its analysis of financial stability. It now needs to take the next step by providing information about how individual banks have performed in its stress tests—so that citizens have a better idea of the true financial health of their banks.

How can the government bring public sector banks on track? Tell us at views@livemint.com

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