RBI releases guidelines for banks on penal charges, bringing some comfort to borrowers
MAS Team | 14 April 2023
The Reserve Bank of India (RBI) has released a draft circular for banks to ensure fair lending practices, particularly in the disclosure of penal interest. The regulator noted that banks tend to use penal rates of interest in addition to the applicable interest rates in the case of borrower defaults. The RBI made it clear that penal interest/charges are not intended to be used as a tool to enhance revenue over and above the contracted rate of interest. The regulator also pointed out that supervisory reviews have shown that banks tend to follow certain avoidable practices regarding the levy of penal interest/charges, leading to customer grievances.
As a result, the RBI released a number of instructions for adoption, after examining the practices followed by banks for charging penal interest/charges on loans. The instructions are as follows:
1. Banks must not introduce any additional component to the rate of interest, and interest rates on credit facilities must be strictly governed by regulatory instructions.
2. Penalties charged for default or non-compliance of loan contracts will be treated as "penal charges" and not "penal interest". There will be no capitalization of penal charges, meaning no further interest will be computed on such charges.
3. The rate of interest on a loan will include an appropriate credit risk premium reflecting the borrower's credit risk profile. Banks will be free to alter the credit risk premium in case the borrower's credit risk profile undergoes a change.
4. The quantum of penal charges will be proportional to the defaults of material terms and conditions of the loan contract. This threshold should be determined by the banks and will not be discriminatory within a particular category of loan or product.
5. Penalties charged for loans sanctioned to individual borrowers for non-business purposes will not be higher than those applicable in case of corporate borrowers.
6. Banks must clearly disclose penal charges and accompanying conditions in the loan agreement. The most important terms and conditions must also be displayed on banks' websites under interest rates and service charges.
7. Whenever reminders for payment of installments are sent to borrowers, the applicable penal charges will also be communicated.
8. Banks must have a clearly laid-down Board approved policy on penal charges or similar charges on loans.
9. Operationalization of "penal charges" in place of "penal interest" will be subject to RBI's review.
The effective date for these instructions will be notified in the final circular, and it is mandatory for banks to ensure their implementation from that date.
It is important to note that these instructions will not apply to credit cards, which are covered under product-specific directions, as clarified by the RBI. The regulator is currently accepting comments by the stakeholders on the circular, and submissions can be made until May 15, 2023. Overall, these instructions aim to ensure fair lending practices and increase transparency between banks and their customers, providing a clear framework for the imposition of penal charges in case of borrower defaults.