The Reserve Bank of India (RBI) on Wednesday issued draft guidelines on penal charges levied by lenders, bringing them under the strict preview of regulatory instructions issued by it.

RBI has invited comments from various stakeholders on the draft guidelines on “Fair Lending Practice - Penal Charges in Loan Accounts” by May 15, 2023.

The new rules would be applicable to all entities regulated by the RBI, including all commercial banks, co-operative banks, NBFCs (including housing finance companies), and All India Financial Institutions like EXIM Bank, NABARD, NHB, SIDBI and NaBFID. These rules, however, will not apply to Credit Cards which are covered under product specific directions, RBI clarified.

The instructions emphasise that the determination of interest rates on credit facilities, including conditions for reset of interest rates, will be strictly governed by the relevant regulatory instructions issued in this regard. It prohibits lenders from introducing any additional component to the rate of interest.

“Penalty, if charged, for default / non-compliance of material terms and conditions of loan contract by the borrower shall be treated as ‘penal charges’ and shall not be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the advances. There shall be no capitalisation of penal charges, i.e, no further interest computed on such charges. However, this will not affect the normal procedures for compounding of interest in the loan account,” RBI said in the notification on these draft guidelines.

The instructions also state that penal charges, if charged, for default/non-compliance of material terms and conditions of loan contract by the borrower shall be treated as 'penal charges' and shall not be levied in the form of 'penal interest' that is added to the rate of interest charged on the advances. The quantum of penal charges would have to be proportional to the default or non-compliance of material terms and conditions of loan contract beyond a threshold. The threshold, RBI said, is to be determined by lenders, and cannot be discriminatory within a particular loan or product category.

RBI has asked lenders to clearly disclose penal charges and the conditions precedent therefore to the customers in the loan agreement and most important terms & conditions in a Key Fact Statement (KFS) as applicable. It has also asked lenders to display such charges on their website under Interest rates and Service Charges. Whenever reminders for payment of instalments are sent to borrowers, the applicable penal charges would also have to be communicated, RBI said.

All regulated entities are also required to ensure that there is a clearly laid down Board approved policy on penal charges. The operationalisation of the 'penal charges' in place of 'penal interest' will be subject to appropriate review during supervisory examination by the RBI, it said.

RBI said that the instructions will come into effect from a date to be indicated in the final circular, and REs may carry out appropriate revisions in their policy framework and ensure implementation from the effective date.

Background

So far, the Reserve Bank has issued various guidelines to the Regulated Entities (REs) to ensure reasonableness and transparency in disclosure of penal interest. Under the existing guidelines, lending institutions have the operational autonomy to formulate Board approved policies for levy of penal rates of interest.

However, RBI noted, “many REs use penal rates of interest, over and above the applicable interest rates, in case of defaults or non-compliance by the borrower with the terms on which credit facilities were sanctioned.”

RBI said that the intent of levying penal interest or charges is essentially to inculcate a sense of credit discipline among borrowers through negative incentives and to ensure fair compensation to the lender. Penal interest or charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest, it said.

“Supervisory reviews have indicated divergent practices amongst the REs with regard to levy of penal interest/charges leading to customer grievances and disputes,” RBI said in its note.

Currently, penal rates and charges vary across banks, and other lenders. These charges are levied when borrowers miss or delay repayments of EMIs on time, or in case of cheque bounces, for pre-payment of loans, among other cases.

(Edited by : Sangam Singh)