Having bitten the bullet on bad loans, India`s state-owned banks now need to merge into half a dozen well-capitalised institutions than can underwrite economic growth, the official overseeing the sector`s overhaul said.

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Vinod Rai, the veteran bureaucrat appointed this year to run the new Banks Board Bureau, told Reuters the government stood ready to inject fresh funds beyond the $3.7 billion earmarked in the 2016/17 budget.

Restoring banks to health is vital for Prime Minister Narendra Modi to revive lending, investment and create jobs for the million young Indians who join the labour market each month.

Rai said stronger banks should decide which of their bad loans to shift off their balance sheets, while weaker banks need fresh capital before a round of consolidation that would cut the number of state banks to no more than six from 27 now.

"In the current budget, the government has put in about 25,000 crores ($3.7 billion), but it has not said that this is the end," Rai said in an interview.

"If the need arises, in the current year, the government has said it would be willing to come forward with more." State banks - which account for around 70% of lending in Asia`s third largest economy - hold most of India`s $120 billion in troubled loans after a lending spree under the last government hit trouble.

The government set up the Banks Board Bureau in April to drive balance sheet improvement and consolidation the sector. It will evolve into an investment holding company for state-owned banks, shielding them from political interference in management appointments and lending decisions.

Reserve Bank of India Governor Raghuram Rajan has set a deadline of March 2017 to clean up the sector.

MERGER DRIVE

Rai, a 68-year-old former auditor general of India, said consolidation has already begun with State Bank of India`s move to absorb five subsidiaries and Bharatiya Mahila Bank, a bank for women set up in 2013. He expects more mergers but declined to be specific on timeframes.

Well-performing larger banks could tie up with one another, he said, while smaller, troubled lenders could be taken over once recapitalised - if they offered good value to suitors.

Specifically, Bank of India - the country`s third-largest state bank by assets - would not be considered a merger candidate until it was recapitalised. Kolkata-based UCO Bank, the state bank with a large presence in eastern India, would be "re-energised" as a standalone institution and not merged.

And Indian Overseas Bank, after recapitalisation, could be absorbed by an acquirer that could leverage off its large branch network in southern India.

Rai said that, with state banks trading at just 0.5 times book value, valuations were attractive for minority shareholders to subscribe to planned rights issues, alongside the government.

TAKING A HAIRCUT

India`s state banks have been reluctant to write down loans, especially to high-profile borrowers like liquor tycoon Vijay Mallya. Rai said talks were well advanced on creating a separate mechanism to review such cases and expedite balance sheet cleanups.

This mechanism could be a committee, involve an existing joint lenders` forum, or new guidelines from the RBI, he said. A solution that could include all three options is expected within weeks.

Rai said there were no plans to create a "bad bank" to relieve lenders of dud loans. India has more than a dozen asset reconstruction companies, or ARCs, with state banks owning stakes in four. The government has let promoters take full control of ARCs and scrapped caps on foreign direct investment.

"There is sufficient financial interest to invest in the ARCs," said Rai. "But all are waiting to see whether the PSBs (public sector banks) are willing to transfer their stressed assets."