RBI Notification

RBI Asks Banks Not to Levy Penal Interest Charges on Loan Defaults

RBI Asks Banks Not to Levy Penal Interest Charges on Loan

What Does the RBI Say?

According to the central bank, there should not be capitalization of penal charges, meaning no further interest computed on such orders, the RBI clarified, mentioning that this will not affect the standard procedures for compounding interest in the loan account. The RBI announced the change after observing that many banks use penal interest rates, over and above the applicable interest rates, in case of defaults or noncompliance by the borrower with the terms on which credit facilities were sanctioned.

While levying penal interest effectively inculcates a sense of credit discipline, the RBI said supervisory examinations indicated divergent banks’ practices. “Such charges are not meant to be used as a revenue improvement tool over and above the agreement interest rate,” the central bank said. RBI’s observations are critical as customers have complained about a lack of clarity on the part of banks while imposing penal charges on customers.

The regulator said banks should not introduce any additional component to the interest rate and ensure compliance with these guidelines in both letter and spirit. Moreover, the central bank added that banks must cultivate a board-approved policy on penal or similar loan charges.

“The quantum of penal charges shall be reasonable and commensurate with the noncompliance of material terms and conditions of loan contract without being discriminatory within a particular loan product category,” the RBI estimated. More importantly, the RBI said the penal charges in case of loans authorized to individual borrowers for objectives other than business should not be higher than the punitive charges relevant to non-individual borrowers for similar noncompliance with material terms and conditions.

Focus on Clarity

Further, the central bank said the quantum and reason for penal charges need to be disclosed by banks to the customers in the loan contract or agreement and, most important, terms and conditions as applicable, in addition to being displayed on the banks’ website under Interest rates and Service Charges. Further, whenever reminders for noncompliance with material terms and requirements of the loan are sent to borrowers, the RBI says the applicable penal charges need to be communicated. Banks should also display any example of levy of punitive charges and the reason, the regulator said.

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Things the Banks Asked to Prepare 

The RBI has asked banks to make reasonable revisions in their policy substructure and ensure implementation of the instructions regarding all the fresh loans benefited or renewed from the effective date. In the case of living loans, the RBI said that the switchover to the new penal charges regime should be ensured on the following review or renewal date or six months from the effective date of this circular, whichever is earlier.

However, the RBI added that these teachings do not apply to credit cards, external commercial borrowings, trade credits, or structured obligations covered under product-specific directions.

RBI Bars Banks from Instructing or Levying Penal Interest:- Allows Them to Foist ‘Reasonable’ Punitive Charges

RBI’s notice said the quantum of penal charges “shall be reasonable and commensurate with the noncompliance” of material terms and conditions of loan contract without being discriminatory within a particular loan/product category. Concerned over the practice of banks and Non-Banking Financial Companies (NBFCs) using penal interest as a revenue enhancement tool, the Reserve Bank on Friday came out with modified norms, under which lenders would be able to levy only “reasonable” penal charges in case of default in repayment of loans.

In its notification on’ Fair Lending Practice-Penal Charges in Loan Accounts, the RBI said that banks and other lending establishments will not be allowed to levy penal interest from January 1, 2024. “Penalty, if charged, for noncompliance of material terms and conditions of loan agreement by the borrower shall be considered as ‘penal charges’ and shall not be levied or imposed in the form of ‘penal interest’ that is added to the rate of interest charged on the advances,” RBI said in a notification.

Also, there shall be no capitalization of penal charges and no further interest computed on such orders. However, the RBI said the instructions would not apply to credit cards, external commercial borrowings, trade credits, and structured obligations covered under product-specific directions.

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The RBI said that many commodities it regulates use penal interest rates, over and above the applicable interest rates, in case of defaults/noncompliance by the borrower. “The intent of charging penal interest/charges is necessarily to inculcate a sense of credit discipline, and such charges are not meant to be used as a revenue improvement tool over and above the contracted interest rate,” the Central bank said.

However, supervisory reviews have indicated divergent practices amongst the entities regulated by entities concerning the levy of penal interest/charges leading to customer grievances and disputes, it said, while issuing the modified norms.

RBI Issues Fresh Guidelines Asking Banks, NBFCs Not to Levy Penal Interest on Borrowers in Case of Default 

Reserve Bank of India (RBI) has issued or supplied fresh regulations and guidelines to the Regulated Entities (REs) such as commercial and other banks, Non-Banking Finance Companies (NBFCs), and other lenders to ensure reasonableness and translucency in the disclosure of penal interest. It follows findings that many Regulated Entities use punitive rates of interest, over and above the appropriate interest rates, in case of defaults or noncompliance by the asker or borrower with the times on which credit facilities were sanctioned.

“The intent of levying penal interest/charges is basically to inculcate a sense of credit discipline, and such charges are not meant to be used as a revenue improvement tool over and above the contracted interest rate,” the RBI said in a circular. “However, supervisory reviews have indicated divergent practices amongst the REs about the levy of penal interest/charges leading to customer grievances and disputes,” it added.

According to the new directive, the penalty, if charged for noncompliance with the material rules and regulations of the loan contract by the borrower, would be treated as ‘penal charges’ and shall not be levied or charged in the form of ‘penal interest’ that is added to the rate of interest charged on the advances. “There shall be no capitalization of penal charges, i.e., no further interest calculated on such charges. Moreover, this will not affect the normal procedures for compounding interest in the loan account,” the circular said.

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The REs have been asked not to raise any additional component to the interest rate and ensure compliance with these guidelines in letter and spirit.

Board-Approved Policy or Approach

The REs will formulate a Board-approved approach on penal or similar charges on loans, by whatever name. And the quantum of punitive costs shall be reasonable and commensurate with the noncompliance of material terms and conditions of the loan contract without being prejudiced within a particular loan/product category.

The penal charges in case of loans authorized to ‘individual borrowers, for purposes other than business’ shall not be higher than the punitive charges applicable to non-individual borrowers for similar noncompliance with material terms and conditions. Now the RBI wants the REs to disclose the quantum and reason for penal charges to the customers in the loan agreement, the most important terms & conditions / critical fact statement as applicable, and be displayed on the REs website under Interest Rates and Service Charges.

“Whenever reminders for noncompliance of material terms and conditions of the loan are sent to borrowers, the applicable penal charges shall be communicated. Further, any instance of levy of penal charges and the reason therefor shall also be communicated,” the RBI circular said. These instructions or guidelines will come into effect from January 1, 2024.

And the REs have been asked to carry out proper conversions in their policy framework and secure the performance of the instructions regarding all the fresh loans availed/ renewed from the effective date.

In the case of existing loans, the flyer said that the switchover to the latest penal charges regime would be ensured on the following review or renewal date or six months from the effective date of this circular, whichever is earlier. These instructions will, however, not apply to Credit Cards, External Commercial Borrowings, Trade Credits, and Structured Obligations, which are covered under product-specific directions, the RBI has clarified.

End Note

The RBI said banks must treat penalties for noncompliance as ‘penal charges’ and not be levied as ‘penal interest’ that is added to the interest rate charged on the advances. Besides, the central bank has declared many changes in the rules that will take effect from January 1, 2024. Moreover, it said the new policies follow findings that many REs use penal interest rates, over and beyond the suitable interest rates, in case of defaults/noncompliance by the borrower with the terms on which credit facilities were sanctioned.

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