A prolonged economic slowdown has hit Indian banks' balance sheets, with stressed loans - those categorised as bad and restructured - amounting to about 10 percent of all loans. Fitch Ratings expects stressed assets to reach 14 percent of loans by March next year.
The bulk of these bad loans are related to infrastructure projects, which have made banks circumspect over lending.
"Is it of concern Yes. Is it scary No," Rajan told the Times of India, adding "...the point is there are two or three silver linings in the cloud of distressed assets."
He said many delayed infrastructure projects were "getting back on stream" as the economy improved, and booming equity markets will also help banks raise the required capital.
He also downplayed concerns that rising bad loans would lead to a liquidity crisis in the Indian banking system similar to the one witnessed globally after the Lehman Brothers went bust in 2008.
"Unlike the banking crisis in the West, where the worry was who would pony up the money, here there is no uncertainty," he said. "The government will do it. It has never let any bank it owns go under."
New Delhi has been injecting funds into state lenders to help them meet minimal capital ratios mandated by Basel III norms. This year it will infuse 112 billion rupees. But analysts say more funds will be needed.
With its finances in dire straits, the government plans to sell off a part of its holdings in the banks to help bridge their capital shortfall.
While a sluggish economy is the main reason for a rise in distressed assets, a RBI report last week also blamed lending to certain "excessively leveraged" groups.
The launch of a corruption investigation at state-controlled Syndicate Bank has raised broader concerns about weak oversight, graft and politically directed lending at state banks.
Rajan said a change in the process of appointments at these banks will help address the issue.
"When you are putting someone in charge of 5 trillion rupees of assets, you need an appointment process which is state-of-the-art," he said. "I think you can improve the process tremendously without going through the radical step of privatization."