The concept of bad banks is a new phenomenon in the Indian financial system because it is well-known that both public and private sector banks face emerging challenges due to distressed or non-performing assets. In these consequences, the present paper emphasizes the concept, evolution, prospects and challenges of bad banks and their effect on the Indian financial system. The study's methodology is based on the empirical-based survey and analysis of primary data with quantitative techniques. The study's findings show that there will be a significant impact of bad banks in the Indian financial system, and prospects and challenges will emerge in implementing bad banks in India. Therefore, there is a positive effect on the bad bank in the Indian financial system with the recommendation of better policies for setting up systematic bad banks in India. Additionally, this paper would encourage policymakers, researchers, and academicians for better policy-oriented research in the study area of bad banks in India.