The banking regulator Reserve Bank of India (RBI) recently released a draft circular for banks to ensure fair lending practices particularly in disclosure of penal interest.
The RBI observed that banks tend to use penal rates of interest over and above of the applicable interest rates in case of defaults by the borrower.
The banking regulator made it clear that the penal interest/ charges are not meant to be used as a revenue enhancing tool over and above the contracted rate of interest.
The RBI pointed out that supervisory reviews have shown that banks tend to follow certain avoidable practices with regards to levy of penal interest/ charges, leading to customer grievances.
Consequently, RBI released a number of instructions:
After examining the practices followed by banks for charging penal interest/charges on loans, the regulator issued these instructions for adoption:
1) RBI stated that the banks will not introduce any additional component to rate of interest. And determination of interest rates on credit facilities will be strictly governed by the regulatory instructions.
2) Penalty that would be charged in case of default or non-compliance of loan contract by the borrower will be treated as ‘penal charges’ and not ‘penal interest’.
The regulator also stated that there will be no capitalisation of penal charges, i.e., no further interest computed on such charges.
3) The rate of interest on a loan includes appropriate credit risk premium reflecting the credit risk profile of the borrower. And in case borrower’s credit risk profile undergoes a change, banks will be free to alter credit risk premium.
4) The quantum of penal charges will be proportional to the defaults of material terms and conditions of loan contract. This threshold ought to be determined by the banks and will not be discriminatory within a particular category of loan or product. For instance, different penalties are not meant to be imposed for different categories of loans such as car, business, etc.
(5) The regulator further pointed out, in the circular, that the penal charges in case of loans sanctioned to individual borrowers, for non-business purposes, will not be more than the charges applicable in case of corporate borrowers.
(6) It is further highlighted that penal charges and the accompanying conditions will be clearly disclosed by the banks to their customers in the loan agreement. Besides, the most important terms and conditions are meant to be displayed on banks’ website under interest rates and service charges.
7) The RBI also highlighted that whenever reminders for payment of instalments are sent to borrowers, the applicable penal charges will also be communicated.
8) The banks will also ensure that there is a clearly laid-down Board approved policy on penal charges or similar charges on loans.
9) The RBI categorically mentioned that operationalisation of the ‘penal charges’ in place of ‘penal interest’ will be subject to RBI’s review.
10) These instructions will come into force from a date to be indicated in the final circular and banks are meant to ensure implementation from the effective date.
These instructions will not apply to Credit Cards which are covered under product specific directions, the RBI clarified. The RBI is currently accepting comments by the stakeholders on the circular, and one can submit the same by May 15, 2023.