[Analysis] RBI’s Guidelines on Penal Charges Ensure Responsible Lending Practices

Table of Contents

1. Introduction
2. RBI Redefines Loan Penalties: Introduces Transparent ‘Penal Charges’ Policy
3. RBI enhances regulatory norms for Regulated Entities
4. Central Bank defines quantum of penal charges for loan non-compliance
5. Clarity in Charges: Quantum & rationale must be transparently communicated
6. Instructions to be applicable from 01.01.2024
7. Conclusion

1. Introduction

Earlier, the Reserve Bank of India (RBI) had made a ground-breaking move by releasing a draft circular on Fair Lending Practice – Penal Charges in Loan Accounts vide Press Release no. 2023-2024/56 dated April 12, 2023, aimed at establishing transparent and equitable practices for the imposition of penal charges.

Historically, the Reserve Bank has provided various guidelines to Regulated Entities (REs) to ensure clear and fair disclosure of penal interest. These guidelines allow lending institutions to autonomously create a board-approved policy for imposing penal interest rates.

The RBI has observed that many REs applies additional interest charges, beyond the standard rates, for instances of defaults or non-compliance by the borrower with the terms under which credit facilities were originally approved.

The intent of levying penal interest/charges is essentially to inculcate a sense of credit discipline and such charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest.

However, recent supervisory evaluations have highlighted varying approaches among the REs concerning the imposition of penal interest/charges, resulting in customer complaints and disagreements. The key instructions issued by the Central Bank for charging penal interest/charges on loans are discussed hereunder in detail:

2. RBI Redefines Loan Penalties: Introduces Transparent ‘Penal Charges’ Policy

Upon review, the RBI has instituted a provision wherein penalties, if imposed, for the violation of terms and conditions of a loan contract by the borrower, will be categorized as ‘penal charges’. These charges should not be imposed as ‘penal interest’ that is incorporated into the interest rate applied to the loans.

Further, 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.

3. RBI enhances regulatory norms for Regulated Entities

The Regulated Entities shall not introduce any additional component to the rate of interest and ensure compliance to these guidelines in both letter and spirit. Further, the REs shall formulate a Board approved policy on penal charges or similar charges on loans, by whatever name called.

4. Central Bank defines quantum of penal charges for loan non-compliance

The Central Bank has directed that the quantum of penal charges shall be reasonable and commensurate with the non-compliance of material terms and conditions of loan contract without being discriminatory within a particular loan/product category.

Further, the penal charges in case of loans sanctioned to ‘individual borrowers, for purposes other than business’, shall not be higher than the penal charges applicable to non-individual borrowers for similar non-compliance of material terms and conditions.

5. Clarity in Charges: Quantum & rationale must be transparently communicated

The loan agreement, along with the relevant Key Fact Statement (KFS) or essential terms, provided by the Responsible Entities (REs), must offer transparent information about the quantum (amount) and rationale behind penal charges.

Moreover, this data should also be prominently featured on the REs’ website within the “Interest Rates and Service Charges” section.

Whenever reminders for non-compliance of material terms and conditions of loan are sent to borrowers, the applicable penal charges shall be communicated.

6. Instructions to be applicable from 01.01.2024

These instructions shall come into effect from January 1, 2024. REs may carry out appropriate revisions in their policy framework and ensure implementation of the instructions in respect of all the fresh loans availed/ renewed from the effective date.

In the case of existing loans, the switchover to new penal charges regime shall be ensured on next review or renewal date or six months from the effective date of this circular, whichever is earlier

7. Conclusion

In conclusion, the Reserve Bank’s recent guidelines regarding the imposition of penal charges on loans underscore its commitment to fostering responsible lending practices while safeguarding borrowers’ interests. By categorizing penalties for non-compliance as ‘penal charges’ rather than incorporating them into interest rates, the RBI seeks to ensure transparency and fairness.

The emphasis on reasonable and non-discriminatory penal charges, especially for individual borrowers, and the requirement for clear communication of the quantum and rationale behind such charges, reflect the central bank’s dedication to promoting clarity and accountability in the lending process.