To anyone monitoring the Bankex, the index that tracks banking stocks listed on the BSE, 2014 looked rosy. The index had risen 65%, outperforming the broader market by a handsome margin. Given that the index is made up of the country’s 40 listed banks, and 27 of them are state-owned, it’s easy to assume that the Bankex rally was driven by public sector banks. The reality, however, is that the rise was driven largely by the top 10 scrips in the index, seven of which are private banks such as HDFC, ICICI, Axis, and IndusInd. Of the state-owned banks, only State Bank of India, Bank of Baroda, and Punjab National Bank figure in the top 10.

The bulk of banks on the index, most of them state-owned, and many of them mid-sized or small, are in trouble. It may, perhaps, sound overly dramatic to say they are fighting for survival, but in many cases, that’s the grim truth. To misquote George Orwell, all banks are in trouble, but some are in more trouble than others. And public sector banks (particularly the smaller ones) fall squarely in the latter category.

These banks are worse off than their private counterparts as they are constrained by the government (their largest shareholder) to enter unprofitable areas, such as offering “no-frills” accounts in semi-urban and rural areas. Of the 10,000 new branches opened in FY13, public banks accounted for 7,840. While furthering the cause of financial inclusion, these accounts do little to improve profitability. The public sector banks also struggle to implement stringent lending and borrowing mechanisms. Years of such inefficiencies have led to weak balance sheets. With an overall deposit share of 73.3% and bank credit of 71.2%, and a higher quantum of loans to big corporates, the loan books of public sector banks (PSBs) are far larger than those of their private counterparts. Since these banks lend heavily to corporates, they are vulnerable to industry and economic cycles.

Overall, the 40 banks comprising the Bankex reported a rise of Rs 4,024 crore in gross non-performing loans in the October-December quarter of FY15. Non-performing loans are those where chances of recovering the money lent is minimal, which means banks have to maintain sufficient reserves to make provision for the loss. And since state-owned banks form a large part of the Bankex, it’s fair to assume that they account for the bulk of the non-performing loans.

The rising tide of non-performing assets (NPAs) has been one of the major factors affecting banks’ profitability. Syndicate Bank, for instance, saw a 19% decline in net profits in the third quarter, when its net NPAs shot up to 2.38% (from 1.66% of the net advances in the third quarter of last year). Net interest margins—the difference between the interest a bank charges its customers and what it pays its depositors—fell to 2.22% from 2.65%. V.R. Iyer, chairperson of Bank of India, says the third quarter has been challenging and the bank doesn’t expect the situation to improve significantly in the next two quarters either.

Of course, an easy solution could be for the government, as the largest shareholder in these banks, to infuse fresh capital, through budgetary provisioning, which will immediately fix the books, though that’s easier said than done. But more on that later. So far, so obvious. The problem of rising NPAs has been discussed endlessly, with bankers, analysts, policymakers, and journalists all weighing in with their thoughts on how to reduce bad loans. But the sudden urgency, and the reason why the spotlight is on public sector banks, is because come March 31, 2019, all banks will have to implement a set of new norms set by the Switzerland-based Basel Committee for Banking Supervision.

Called Basel III, the new framework, which strengthens the capital structure of banks, calls for improving the quality and quantity of tier I capital—the core capital of the bank that needs to be maintained to protect depositors’ interest—leverage ratio, and liquidity standards, and enhanced disclosures.

Given the state of the balance sheets of many public sector banks (particularly the smaller, weaker ones), it is doubtful if they will be able to meet the Basel III norms. While the Basel Committee makes a virtue of the fact that the guidelines are voluntary, central banks are free to impose penalties, from fines to removal of licence, on individual banks that do not follow the rules.

Most central banks allow banks some leeway in terms of deadline extensions (the Reserve Bank of India has already extended the deadline by a year for Indian banks), but overall, they are keen that the Basel norms be adopted as a preventative measure; the shadow of the U.S. subprime crisis still looms large over the world of finance.

The Basel III norms have been designed to absorb shocks arising from financial and economic risks, thus reducing the risk of a spillover from the financial sector into the real economy. The basic idea of these guidelines is that banks need to shore up their capital during good times, and not be caught unawares when the tide turns. To this end, Basel III has increased the total minimum capital adequacy ratio from 9% to 11.5%, by adding a capital conservation buffer.

To get somewhat technical, tier I capital has now been divided into two parts—the equity part also known as common equity tier I (CET I) capital; and the non-equity part called additional tier I capital (AT I). While CET I (5.5% of the total risk-weighted assets) can be raised by the government by infusing fresh capital or raising funds from the market by reducing its stake to 51%, AT I (1.5%) will require banks to issue debt instruments such as bonds and bank deposits.

Here’s where the inherent strength or weakness of a bank is really felt. A weak bank can issue all the bonds it likes, but will there be any taker? Equally important, is the market deep enough to raise so much capital? Since these bonds have a higher “loss-absorption capacity”, banks can default on payment if their capital adequacy ratio falls below a threshold level. Investors know that, and are likely to stay away—unless banks pay a much higher interest on these bonds, making them attractive.

The government’s decision to infuse additional capital only in the more efficient banks based on return on assets and return on capital has added to banks’ woes, because even when the government did infuse Rs 6,990 crore as tier I capital, it did so only in the nine state-run banks. The real dilemma for these banks is that unless the government reposes enough faith in them by infusing capital, it would be difficult for them to convince investors—both domestic and foreign—to invest in their bonds or similar instruments. This year, too, the government has promised to infuse nearly Rs 8,000 crore in the public sector banks, but only in the more efficient ones, looking at factors such as return on equity and return on assets. For Ananda Bhowmick of India Ratings, the government’s commitment or those by other quasi-governmental institutions will be the key for the survival of the banks. “After all, midsized banks suffer from weak capitalisation, low internal accruals, and low valuations.”

All this is about big money, though nobody seems to have a handle on exactly how much is at stake. The Reserve Bank estimates that banks will need an additional Rs 5 lakh crore to become fully Basel III compliant—Rs 3.25 lakh crore in bonds and other instruments, and 1.75 lakh crore in equity infusion. Of the Rs 1.75 lakh crore, public sector banks alone will require at least Rs 1.4 lakh crore. Then, according to former RBI governor D. Subbarao’s estimate in 2010, if the government continues with its current shareholding, it will need to infuse Rs 90,000 crore in banks in the next five years.

By bringing down its stake to 51%, the burden of capitalisation will be only Rs 70,000 crore. Both rating agency ICRA and global accounting firm PricewaterhouseCoopers believe that the total amount required would be Rs 6 lakh crore, with state-owned banks requiring between 70% and 75% of that amount. Midsized banks would require Rs 1,80,000 crore (nearly 35% of the total amount) to become Basel III compliant. These banks have only raised Rs 7,300 crore till date in bonds from the market and the ability of individual banks to raise such capital will depend, to a large extent, on their branding, reputation, quality of management and assets, financial performance, operational efficiency, and so on.

As a recent Morgan Stanley report points out, even though the government has allowed banks to reduce their shareholding to 52%, there is plenty of scepticism regarding the appetite of investors for this quantum of equity. Again, smaller banks will struggle. “Also, this continued capital raising would likely be a big overhang on public sector banks’ stock prices once they start raising capital,” says the report.

While the four-year timetable may still seem doable, there is a far greater crisis at hand. By March next year, India Ratings believes that banks will require an additional 29% of tier I capital or Rs 1,53,700 crore, as certain other norms of Basel III like additional buffers for capital conservation kick in. This means even if banks manage to raise funds, it could mean higher cost of capital, lower return on equity, lower yield on assets, and pressure on credit offtake and profitability.

So what happens if the banks are not able to raise the necessary the AT I capital? Pavan Agarwal, chief analytical officer, Crisil Ratings, believes that any shortfall would have to be made up by capital infusion by the government, resulting in higher government borrowing, fiscal deficit, inflation, and pressure on the GDP. The government can take a number of steps to tide over this crisis, he adds. It can, for instance, ask public sector banks to keep their loan portfolios at current levels or even shrink them. But that would be a retrograde step and would adversely affect the funds available to the industry.

Merger of stronger public sector banks with the weak ones could be a viable alternative, but at the Gyan Sangam—a bankers’ retreat in Pune on January 3, 2015—which was attended, among others, by Prime Minister Narendra Modi, finance minister Arun Jaitley, RBI Governor Raghuram Rajan, and managing directors and chairmen of banks—it was left to the various bank boards to take a call.

However, one of the issues that found ready resonance was the recommendation of the former chairman of Axis Bank, P.J. Nayak, which called for the setting up of a Bank Investment Company (BIC) under the Companies Act, 2013. The BIC, formed along the lines of a sovereign wealth fund like Temasek, would hold the government’s share in public sector banks. All the banks will become subsidiaries of the BIC, which will be regulated by the RBI alone. The government is already talking of setting up a banking board bureau on similar lines.

The BIC will have voting powers to appoint a board of directors and make other policy decisions during the annual general meeting of shareholders, once they have an explicit agreement with the government that it will not interfere. It will then be the responsibility of the company, and not the government, to raise equity and pump it into individual banks. Injecting higher capital and making these banks Basel III compliant is not the silver bullet for financial stability of banks. There are other aspects that need to be looked into, such as risk management framework and practices, quality of assets and framework, rationalisation of bank branches, and product rationalisation.

The easiest way for banks to clean up their balance sheets would have been to sell their bad loans to asset reconstruction companies (ARCs) at a discount. But with the Reserve Bank setting more stringent guidelines for ARCs, that option has become tougher. Instead of allowing ARCs to make a 5% upfront payment of the total assets acquired, they now have to cough up 15%. This will not hike an ARC’s capital requirements substantially, and make it more selective.

“[ARCs] will now treat bad loans as an investment opportunity rather than act as a catalyst to sell off bad loans,” says Siby Antony, CEO, Edelweiss ARC. The impact of the RBI norms has been instantaneous. Sale of bad loans to ARCs tumbled to less than Rs 1,000 crore in the quarter ended September 30, 2014, compared to Rs 15,000 crore in the earlier quarter.

“Why should valuations of assets suffer just because ARCs have to pay more cash upfront? There is no link between the two,” says a banker with a public sector bank. Representatives of ARCs, meanwhile, argue that banks need to take a more realistic view because unless they can generate enough returns on assets, they would suffer from a reputational risk as most of the money for the buyout would have been raised from banks and other financial institutions.

On balance, the ARCs, even with the new norms, offer a way out. The higher cash requirements mean players with deep pockets will now be in the fray and will be able to stay the course. Then the new norms of valuing NPAs on their current market price (net asset value) rather than their selling price (book value) means that there will be “realistic pricing, and a greater effort by the ARCs to dispose of bad loans”, says Abizer Diwanji, partner and national leader, financial services, at consulting firm Ernst & Young. “They now have more skin in the game.”

He suggests that one of the ways to reduce NPAs could be to put them all or those at least from the same industry or company into a special purpose vehicle (SPV), after doing a proper audit to know their real worth. Then it can be sold either to an ARC or any other financial body that’s willing to take the risk. These players can either revive the projects or sell them.

Much of this sounds like a pipe dream for state-owned banks when viewed in context. And that context is poor GDP growth (credit growth in banks is generally 2.8 times GDP growth), low demand for capital from industries such as infrastructure and metals, high corporate leverage, low capacity utilisation, and weak deposit growth.

Indian exports are down 11% this January compared with last year. A slowdown in China means depressed commodity prices, as well as the threat of massive dumping. In 2014, steel imports from China touched 2.83 million tonnes, up 128% over the past year, making it the biggest exporter of steel to India. Steel manufacturers, whose balance sheets are already awash in red because of flagging demand from construction and infrastructure sectors (their biggest buyers), are pleading with the government to hike import duty as a safeguard.

A decelerating China is bad news for metals, chemicals, and engineering goods firms, which are in danger of losing their biggest export market. And that's not good for state-owned banks because the health of their balance sheets depends on the revival of these companies. With 90% of the total bad loans (gross NPAs) amounting to Rs 2.41 lakh crore at the end of September 30, 2014, compared with Rs 26,571 crore for the private players, asset quality has been deteriorating over the years.

Perhaps the worst affected is Kolkata-headquartered United Bank of India, with a gross NPA ratio (ratio of bad loans to overall loans) of 12.03% in the third quarter of FY15. Punjab National Bank is close behind, with a 5.97% rise in bad loans in the same period, compared with 4.96% in the same quarter last year.

Evidently the fate of the public sector banks, which accounted for 75.7% of the total market share of loans in FY14, is getting worse. More worrying is that public sector banks have been forced to write off more and more of their soured loans. Write-offs soared from Rs 20,752 crore in FY12 to Rs 32,992 crore in FY13 and further to Rs 42,447 crore in FY14, according to RBI data.

As it is, return on assets (0.5% in FY14) of state-owned banks tends to be much lower than the historic average of 0.9%, because of lower margins and higher credit cost. That makes analysts skittish and generally pessimistic about their future.

Pankaj Agarwal, an analyst at the brokerage Ambit Capital which published a report in January tempering the expectations of an early turnaround in banking, is particularly bearish on state-owned banks. “Whilst any transformational reforms could be a potential catalyst for the banks, the actual shape of reforms is too hazy to warrant a leap of faith,” he says.

As a Morgan Stanley report of September 2014 argues, public sector banks are not well-positioned to grow their loan portfolio. They will be growing at 12% in FY15 and 14% in FY16, compared with 20% by the private sector. Moreover they won't be able to service the consumer loan sector, not just because they will be cash-constrained but because of their historical focus on corporate loans.

“In the SME [small and medium enterprise] space, private banks
have managed asset quality significantly better than the PSBs.” The report says that the weakness in SME asset quality of state-owned banks means private banks are gaining market share in the micro and small corporate segments.

Big industry isn't helping either. Nearly 36% of the total Rs 2.67 lakh crore of NPAs have been created by six sectors—infrastructure, metals, textiles, chemicals, engineering, and mining. With most private sector infrastructure companies groaning under the weight of mounting debts and little action on the ground, not only will there be less demand for credit from this sector, but it will also hamper their ability to service their debts.

Diwanji believes that nearly 30% to 35% of the restructured assets will turn non-performing, which means banks will have less money to lend and also face problems in raising capital. For state-owned banks, the figure will be at a higher 45%. Even if they don’t slip into NPAs, banks will still have to make higher provisioning—from 5% to anywhere between 15% and 100%—from April 1, 2016, under the new Reserve Bank guidelines.

So what can the weak banks do to improve their profitability in the remaining four years? The solution lies in addressing issues of statutory liquidity ratio and priority sector lending in a comprehensive way, focussing on different customers and areas and finding new and diverse funding mechanisms within and outside banking. In other words, try and be different from one another.

As Walter Bagehot, the former editor of The Economist had once famously remarked: “No capital is required for a well-run bank and no amount of capital can save a badly-run bank.”

Follow us on Facebook, Twitter, YouTube & Instagram to never miss an update from Fortune India. To buy a copy, visit Amazon.