Fair lending practices: RBI issues draft rules to regulate penal charges on loans

The Reserve Bank of India (RBI) has recently issued a draft circular for regulated entities to ensure transparency in the disclosure of penal charges and interest rates in loan accounts. The circular has been floated to ensure fair lending practices and prevent these regulated entities from using penal interest and charges as revenue enhancement tools over and above the contracted rate of interest. 

RBI has invited comments from various stakeholders on the draft guidelines, called 'Fair Lending Practice - Penal Charges in Loan Accounts,” by May 15, 2023. 

RBI, in its draft circular, said: “Penal charges and interest are essentially negative incentives used by lenders to ensure credit discipline among borrowers and to ensure fair compensation for the lender. However, supervisory reviews have revealed that many regulated entities have been using divergent practices when it comes to charging penal interest and charges, leading to customer grievances and disputes.” 

The new rules would be applicable on all banking entities regulated by the RBI, including all commercial banks, co-operative banks, NBFCs, housing finance companies, and All India Financial Institutions like EXIM Bank, NABARD, NHB, Sidbi and NaBFID. These rules will not apply to credit cards that are covered under product specific directions, the RBI said. 

Some of the highlights in the draft circular are:  

1.    The RBI has observed that many Regulated Entities (REs) use penal rates of interest, over and above the applicable interest rates, in case of defaults/non-compliance by the borrower with the terms on which credit facilities were sanctioned. 

2.    RBI says that the “intent of levying penal interest/charges is essentially to inculcate a sense of credit discipline among borrowers through negative incentives and to ensure fair compensation to the lender. Penal interest/charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest.”  

3.    It noted that supervisory reviews have indicated divergent practices amongst the REs with regard to levy of penal interest/charges leading to customer grievances and disputes. 

“Penalty, if charged, for default / 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. 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,” RBI said in the notification on these draft guidelines. 

4.    The RBI has proposed that the determination of interest rates on credit facilities, including conditions for reset of interest rates, should be strictly governed by the relevant regulatory instructions issued in this regard. REs should not introduce any additional component to the rate of interest. 

5.    The RBI has stressed in the draft circular that the rate of interest on a loan includes an appropriate credit risk premium reflecting the credit risk profile of the borrower. “If the credit risk profile of the borrower undergoes change, REs will be free to alter credit risk premium as per the contracted terms and conditions, in terms of extant instructions.” 

6.    The RBI has proposed that the quantum of penal charges should be proportional to the defaults/ non-compliance of material terms and conditions of loan contracts beyond a threshold. This threshold will be determined by REs and it should not be discriminatory within a particular loan/product category. 

7.    If this draft circular comes into effect then the penal charges in case of loans sanctioned to individual borrowers, for purposes other than business, will not be higher than the penal charges applicable to non-individual borrowers. 

RBI has also asked all lenders to clearly disclose penal charges and the conditions precedent therefore to the customers in the loan agreement and most important terms & conditions in a Key Fact Statement (KFS) as applicable.  

It has also asked lenders to display such charges on their website under Interest rates and Service Charges. Whenever reminders for payment of instalments are sent to borrowers, the applicable penal charges would also have to be communicated, RBI has said in the circular. 

Present rules 

At present, all registered lending institutions have the operational autonomy to formulate Board approved policies for levy of penal rates of interest. If a loan borrower misses an installment or delays repayments of EMIs, or if a cheque bounces, these charges are levied. These charges vary from bank to bank, and other private lenders. 

The RBI has noted before that “many REs use penal rates of interest, over and above the applicable interest rates, in case of defaults or non-compliance by the borrower with the terms on which credit facilities were sanctioned.” 

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