But analysts warned that it may cause banks to take up undue risk.

India’s plan to create its first ‘bad bank’ to absorb non-performing assets from public-sector banks could accelerate the cleanup of the lenders’ balance sheet, reports S&P Global Market Intelligence. However, its effectiveness hinges on the amount of capital that the government will provide.

The proposed asset reconstruction company (ARC) in India will reportedly take over and repackage existing stressed debt of state-run banks and sell to alternative investment funds and other investors to "realize their value", Finance Minister Nirmala Sitharaman said in a speech regarding the government’s government proposal on 1 February.

Sitharaman did not say how much the government will fund the bad bank and when it will be launched, S&P's Ranina Sanglap noted in her report.

There are a total of 28 ARCs in India, all are privately owned and are seen not sizable enough to tackle the amount of bad loans straddling the state-run banks. A national bad bank is a good alternative for handling bad loans than relying on individual ARCs, Vikram Kuriyan, executive director at Indian School of Business, told S&P.

The economic slowdown caused by the COVID-19 pandemic is expected to push the nonperforming asset (NPA) ratio of state-run banks to 16.2% by September 2021, from 9.7% in the same month of 2020, according to stress tests recently conducted by the Reserve Bank of India.

If the nation's macroeconomic environment worsens in a severe stress scenario, the state-run banks' bad loan ratio could rise to as much as 17.6%, the central bank added in an 11 January report.

The central bank also expects the gross NPA ratio of the entire banking system to rise to as much as 13.5% by September 2021, from 7.5% a year earlier.

But not everyone is sold to the idea of having a bad bank, with critics warning that it may encourage lenders to take undue risks.

"Moral hazard is a key issue that must be addressed in the national ARC construct," Krishnan Sitaraman, senior director for the financial sector and structured finance ratings at CRISIL, told S&P Global Market Intelligence in an email before the budget announcement.

"Banks should be appropriately disincentivized from not completely adhering to necessary due diligence while originating assets given the knowledge of the existence of a national ARC which will take care of the situation if the account turns delinquent."

India may look at South Korea and Japan where government-run asset management companies were established following the Asian financial crisis,” the director added.

A successful model for India would rely on the new bad bank being sufficiently staffed, Indian School of Business’ Kuriyan noted.

Amongst other proposals for the financial services sector, the finance minister announced that the government will privatize two state-run banks and one general insurance firm. She didn't disclose the names of the companies the government plans to sell.