Besides, a clean-up by the government should not signal that errant borrowers can get away with defaulting on their loans, the veteran industry leader said.
Asserting that India's macroeconomic parameters have never been more robust, Mr Parekh said the 'twin balance sheet problem' - a lethal combination of stressed corporate and stressed bank balance sheets - is worrisome and if private investment, which is stuck in a vicious cycle, does not pick up, India's true growth potential will not be attained.
Delivering a keynote address on financial reforms at the LSE Students' Union India Forum over the weekend, he said a big challenge for India is resolving non-performing loans.
He said there have been several attempts and schemes to resolve NPA problems such as flexible refinancing of infrastructure, asset reconstruction and debt restructuring which converts part of the debt into equity.
"The Asset Quality Review initiated by the RBI at least forced banks to disclose the true state of their non-performing assets. Unfortunately, all these efforts have yielded very limited results. Resolution in India is complex, tedious and time consuming. Barring retail finance, credit growth has dropped to historically low levels."
Mr Parekh said it is not uncommon to see banks falling into crises world over and the method adopted in most countries to resolve that has entailed a 'carve out' of non-performing assets, recapitalisation or a combination of the two.
Talking about the debate on what path India should take to resolve troubled assets in banking system, he said the public sector banks account for three-fourths of India's banking assets and these PSU banks have largely borne the brunt of NPA accumulation on their books.
Gross non-performing assets are now estimated at 11.2 per cent for PSU banks, while for private sector banks gross NPAs stand at 3.5 per cent, he said.
Mr Parekh, chairman of financial services giant HDFC, said there could be four key options to deal with the problem - enhancing regulatory forbearance, capital infusion, consolidation and transferring assets off the banks' books.
On consolidation, Mr Parekh said India has always had too many small banks when what we need is a few large banks.
"An option to resolve NPAs could be to perhaps look at merging a strong bank with a weak bank. However, this needs to be done very selectively because there could be a likelihood of the strong bank getting dragged down as well," he said.
Mr Parekh said the proposed merger of State Bank of India (SBI) with five of its associates was a good initiative as it would become one among the top 50 banks globally in terms of asset size, but there remain immense challenges in terms of actual integration.
On the "most debated" option of transferring assets off the books of the banks, Mr Parekh said it makes imminent sense, but much thought still needs to be put in on the optimum structure and design.
Calling for a debate, Mr Parekh said it needs to be discussed which structure would be more suitable - an asset management company or a bad bank and whether the majority stake should be held by the government or the private sector.
"If the government holds a majority stake, then where will the funds come from? If it is majority government owned, then the entity may have the same constraints that public sector banks have in managing their bad loans. It could be akin to transferring the loans from one arm of the government to another."
"It could also be construed as a government bailout using taxpayers' funds and could lead to a moral hazard issue. The clean-up by the government should not signal that errant borrowers can get away with defaulting on their loans," he said.
Mr Parekh said there are other dilemmas in looking at a majority-owned private sector entity -potential investors could be long-term investors like sovereign wealth funds, pension funds etc.
On the other hand, he wondered that a private entity also raises issues such as at what price would PSU banks sell their assets.
"If the price is too high, the asset management company will not be viable. If it is too low then the banks will be questioned by investigative agencies of the government for selling off assets too cheaply."
Despite these challenges, he said, there is a consensus on the need to free up the balance sheets of banks and one of the recent suggestions has been to segregate assets based on their economic value.
"Assets that have economic value in the short-run could be transferred to a private asset management company, while a national asset management company may be considered for economically unviable assets in the short to medium term."
"At another level one may ask whether there is merit at all in creating new institutions to resolve PSU bank NPAs or whether the more pressing need is to revisit governance and incentive structures in these banks?"
"For instance, in a private sector bank, they can write off loans with the approval of the board, suffer the loss and move on ahead with other business. In the case of PSU banks, they are unwilling to take haircuts lest they be hauled up (often several years after they have demitted office) by the deadly 4Cs - the CBI, CVC, CAG and courts."
"In this scenario a 'do nothing' approach may be a safer option, leaving legacy problems for the next incumbent to handle. The bottom line is that all NPAs are not bad credit decisions and often there are situations which are out of control of both, the lender and the borrower."
Mr Parekh said resolving NPA problems requires public sector banks to be able to sell assets at prices where there is a demand for them in the market.
"Alternatively, there has to be a 'carve out' of problematic assets either as an individual bank where there is a segregation of good and bad assets or a group of banks could collectively pool their bad loans together.
"Another option is to carve out troubled assets on a sector basis - for example, stressed loans in the power sector, since typically there are multiple lenders to such projects. To my mind, it is time to bite the bullet. Further procrastination will only worsen the situation," he said.
Mr Parekh further said there is not much to worry about the financial sector at the more macro level.
"India's investment needs are massive and the financial sector has immense scope to grow. The capital markets are deepening, insurance companies have matured and this year hopefully would also see some general insurance companies being listed."
"Assets Under Management of mutual funds has touched a record high of $260 billion, the IPO market has revived and large global private equity funds are keen to partake in the India growth story."
On the demonetisation exercise, he said it has been one of the many tools that the government has used to weed out corruption and Operation Clean Up is a follow-up trail exercise on large amounts of cash which was deposited during the demonetisation exercise.
"India needs to become a more tax-compliant society and we need to widen the tax net. Efforts like the Goods and Services Tax which is expected to come into effect in July this year may be challenging to implement initially, but it will be a game changer over the medium and long-term," he said.
Delivering a lecture, the ace banker also the country is showing to the world that it is truly open for business while a major achievement of the current government has been to weed out large-scale corruption at the Centre. He further said India's macroeconomic parameters have never been more robust and the country remains amongst the fastest growing major economies.
"One can quibble in decimal points on how much demonetisation could shave off GDP growth, but the bottom line is that India will still achieve a growth rate in the range of 6.6-7 per cent in the current financial year," he said.
On India being a "superpower in the making", he said that if one looks at superpowers from an economic lens, which seems imminently logical, several economic forecasters believe that by 2030, the US, China and India will be the superpowers simply by virtue of being the three largest economies.
"Two years of good monsoons has helped agriculture growth and has kept food inflation in check. Lower commodity prices have helped India given that the country imports over 80 per cent of its crude oil requirements," he added.