Penalty should be a charge, not penal interest that will be compounded: RBI

The Reserve Bank of India (RBI) took a significant step on Friday to ensure fairness and transparency in the disclosure of penal interest by saying that the penalty should be a ‘charge’ instead of an ‘interest’ that will be compounded.

Through various guidelines, the banking regulator has issued various guidelines to the Banks and other Regulated Entities (REs) to ensure reasonableness and transparency in the disclosure of penal interest. Under the extant guidelines, lending institutions have the operational autonomy to formulate Board approved policies for the levy of penal rates of interest.

According to RBI circular penalty for 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. However, The RBI emphasized in its Friday notification that many REs impose penal rates of interest, in addition to the applicable interest rates when borrowers default or in case of non-compliance with the terms of credit facility approval.

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

Given the foregoing practices followed by REs for charging penal interest/charges on loans, the following instructions are issued by the regulator for adoption.

Penalty, if charged, for non-compliance of material terms and conditions of the 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. In other words, penal charges shall not be capitalized by further interest computed on such charges. “However, this will not affect the normal procedures for compounding of interest in the loan account”, the circular said.

Regulated entities are further instructed that they shall not introduce any additional component to the rate of interest and ensure compliance with these guidelines in both letter and spirit.

“The lenders must formulate a board-approved policy on penal charges or similar charges on loans, by whatever name called”, the circular said.

The quantum of penal charges shall be reasonable and commensurate with the non-compliance of material terms and conditions of the 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 businesses, shall not be higher than the penal charges applicable to non-individual borrowers for similar non-compliance of material terms and conditions, it added.

Moreover, the quantum and reason for penal charges shall be clearly disclosed by REs to the customers in the loan agreement and most important terms & conditions / Key Fact Statement (KFS) as applicable, in addition to being displayed on REs website under Interest rates and Service Charges.

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

The above 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 the next review or renewal date or six months from the effective date of this circular, whichever is earlier”, the circular said.

RBI also clarified that the above instructions shall, however, not apply to Credit Cards, External Commercial Borrowings, Trade Credits, and Structured Obligations which are covered under product-specific directions.