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What Banks do when Companies default

As rational human beings, we have the tendency to simplify things to suit our understanding. One among them is under-estimating the process followed by banks when companies default.

What is Default

In Bank’s parlance, any interest or principal repayment which got delayed and not paid on time is called as default. In an ideal scenario, companies have to repay the scheduled amount and its interest on time or they have to repay with some penalty.

Stress Levels

Banks consider a company’s financial performance under stress if it exhibits any of the following characteristics:

  • Delay in repayments to banks
  • Delay in payments to creditors/suppliers
  • Increase in Current Assets not in line with sales growth
  • Poor cash flows
  • Abnormal increase in utilization of banking limits beyond the assessed level

What Banks do when company is under stress

Reserve Bank of India (RBI) stipulated various measures related to handling of accounts/companies under stress. Primary among them are reporting and monitoring mechanisms.

  • If a company defaults bank payment on day 1 and repays the same with a maximum delay of 30 days from the date of default then it has to be classified as Special Mention Account level zero (SMA-0). The same will be reported to RBI and kept in its internal database available for access only to banks.
  • If the delay continues above 30 days but final payment of default amount done within 60 days then the company has to be classified under Special Mention Account level one (SMA-1)
  • For delay more than 60 days the company has to be classified as Special Mention Account level two (SMA-2)
  • Anything more than 90 days delay has to be classified as Non Performing Asset (NPA)

Once a company is classified as SMA-2, the bank with highest exposure has to call all the lending banks for a joint meeting. The objective of this meeting should be to finalize remedial measures and adopt a Corrective Action Plan (CAP). CAP may comprise of different measures to rectify the problem. These may include prioritizing the payments to various banks, providing top up loans to tide over liquidity crisis, setting up mechanism for efficient cash flow routing, opting for Corporate Debt Restructuring (CDR) etc.

All Banks are bound by CAP and close monitoring of the account will be formulated.

At the end of the day, the idea behind all these measures is to identify the company’s problem and help them solve it before it crosses 90 days and becomes an NPA.