Hit by a liquidity squeeze, a battered stock market, and the recent travails of big institutions such as ICICI Bank Ltd, India's banks are feeling the impact of the global financial meltdown. But there are also made-in-India problems brewing, caused by the recent surge in unsecured lending.

Indian retail lenders see non-performing loans (NPLs) rising across all lending classes, especially in unsecured lending which includes credit cards.

NPLs in credit cards are in the 10-15% range while the figure often crosses 20% in small unsecured loans.

The magnitude of the risk is worrying. Indian-owned banks made around Rs5 trillion of unsecured loans by March-a fivefold increase in five years. In just two years through March, banks' total NPLs rose by nearly Rs60 billion.

Though banks have pulled back on lending in the wake of the global financial crisis, they need to act more firmly and swiftly to prevent the NPL problem from growing to a point where it may undermine confidence in a banking system, already under strain due to a slowing Indian economy and deepening global recession.

The situation India's lenders face today shares features uncomfortably similar to those that prevailed prior to the Asian financial crisis a decade ago.

Let's examine the principal factors that underlie Indian banks' bad-loan problems:

Aggressive, undisciplined market growth: Lending has been increasing by some 35% a year for the past three years, with loans to new customers accounting for much of the growth. To boost growth, banks relied on direct selling agents and retail partners to offer loans.

The problem: the incentives were aimed at not only making good loans but for making just any loan.

Inadequate underwriting controls: When a bank lends to an existing customer, it knows the customer's savings balance and cash flows. When it lends to someone new, it relies on public information. The repository of that data is the credit bureau.

Unfortunately, in India, this data is unreliable and mostly dated. That's why Indian banks have largely depended on self-reported data and proxies, resulting in a number of unintended riskier loans.

Slowing economy: For the last five years, borrowers' incomes and wealth have grown rapidly. In such circumstances, people are unlikely to default on loans that looked profitable and appeared to bring a good return on capital.

Many of these loans are still on lenders' balance sheets, which means their reports and regulatory filings still show profit. But this hides the truth—that loans made most recently are under water. These new losses are increasing due to rising NPLs and high collection costs.

Much of the problem stems from the fact that most loans are too small to warrant the servicing costs associated with them. Loans in India are being made for as little as Rs5,000. The high cost of servicing also extends to credit cards, many of which are rarely used.

Indian consumers finance just 1% of their purchases using credit cards.

Banks will need to act fast to ward off what could be an impending, unsecured-lending mess. Here are three steps that will help in the near term and lay a foundation for healthier growth in the future:

1. Align costs to revenues: In an environment where the average loan is losing money, banks need a more efficient way to price and process loan applications.

Smaller and riskier loans generate much higher costs on a percentage basis. Banks, therefore, need to develop flexible pricing models that recognize this reality by ensuring that revenues reflect the true costs of servicing these loans.

2. Fix risk operations: Individually, banks need to use data they have from other products—as well as data they can access through partners—to develop an integrated profile of a customer's creditworthiness. This will not only prevent them from making bad loans but will also enhance opportunities to market credit products to their most attractive borrowers.

More broadly, banks need to take greater initiative at the industry level to build a reliable credit rating system that will allow them to share information on loan balances and loan applications along with delinquency rates. This will enable them to make smarter loans on a collective basis.

3. Clean up the balance sheet: Banks will want to remove the bad loans from their balance sheets by selling them to newly formed asset reconstruction companies. But they have an even bigger job of strengthening the much-neglected deposit side of their business.

The challenge for banks is to find attractive ways to boost deposits. They can do this by offering products that have worked in other markets such as offset accounts, which combine loans and deposits, and hybrid interest-bearing checking accounts.

Although banks have missed the warning signs, there is now an opportunity to use the lessons of the past to quickly navigate out of trouble by following these three steps.

In these turbulent times, inaction is not an option.

David Mountain is a partner with Bain & Company and leads the firm's financial services practice in India. Vikas Saggi is a principal in Bain's Indian financial services practice.