Banks should not ‘earn’ interest on penalty levied on borrowers for non-compliance: RBI

In an important change in rules governing penal charges on loan accounts, the Reserve Bank of India (RBI) has  said that any penalty, if charged, for default or non-compliance of material terms and conditions of loan contract by the borrower should be treated as ‘penal charges’ and should not be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the advances.

Therefore, the RBI has clarified that no further interest should be computed on such charges. However, this will not affect the normal procedures for compounding of interest in the loan account.

According to the RBI, 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,” it said.

Hence after review of the practices followed by financial institutions for charging penal interest/charges on loans, it has given the following instructions for adoption by banks and NBFCs.

(i) Determination of interest rates on credit facilities, including conditions for reset of interest rates, will be strictly governed by the relevant regulatory instructions issued in this regard. Banks and NBFCs should not introduce any additional component to rate of interest.

(ii) 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 — no further interest computed on such charges. However, this will not affect the normal procedures for compounding of interest in the loan account.

(iii) It needs to be recognised that the rate of interest on a loan includes appropriate credit risk premium reflecting the credit risk profile of the borrower. If the credit risk profile of the borrower undergoes change, lenders will be free to alter credit risk premium as per the contracted terms and conditions, in terms of extant instructions.

(iv) The quantum of penalty should be proportional to the defaults/ non-compliance of material terms and conditions of loan contract beyond a threshold. This threshold is to be determined by the lenders and should not be discriminatory within a particular loan / product category.

(v) The penal charges in case of loans sanctioned to individual borrowers, for purposes other than business, should not be higher than the penal charges applicable to non-individual borrowers.

(vi) Penal charges and the conditions precedent therefor, should be clearly disclosed by banks and NBFCs 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.

(vii) Whenever reminders for payment of instalments are sent to borrowers, the applicable penal charges, shall also be communicated.

(viii) The lenders should ensure that there is a clearly laid down Board approved policy on penalty or similar charges on loans, by whatever name called.

(ix) The operationalisation of the ‘penal charges’ in place of ‘penal interest’ will be subject to appropriate review during supervisory examination by the RBI.

(x) These instructions shall come into effect from a date to be indicated in the final circular and REs may carry out appropriate revisions in their policy framework and ensure implementation from the effective date.

These instructions are, however, will not apply to Credit Cards which are covered under product specific directions.

Also Read: Scourge of being identified as wilful defaulter, and the remedies